Is this just a (healthy) correction or the beginning of a prolonged period of weak bond and equity markets?
Let’s take a step back. We have characterized the market environment during the last couple of months and quarters as a “fragile goldilocks” environment. “Goldilocks”, because a) global growth has reaccelerated and remains at rates above potential (which will, ultimately, lead to central banks tightening beyond current expectations in light of rising inflationary pressures), b) inflation has moderately picked up but remains tame, c) monetary policy globally is still accommodative despite first rate hikes, and d) macro volatility is still low.
Nevertheless, we have identified potential market fragilities: a) rich valuations in several risky asset classes, including the S&P 500 and several spread markets, notably in HY, while b) monetary policy normalization in terms of prices and quantity (Quant Tigthening) has not been fully priced in by markets, c) an increasing likelihood of economic data to top out and, ultimately, d) signs of market complacency. The latter include very strong price momentum, insufficient pricing of political uncertainty, record earnings revisions (a contrarian signal) following the US tax deal and rising dispersion of earnings estimates, low levels of cash held by investors and very optimistic investors’ sentiment, as mirrored, amongst others, in the Bitcoin frenzy. Moreover, e) we have seen the build-up of new macroeconomic imbalances over the past couple of years, notably the overheating of several real estate markets (especially in Canada, Australia, Sweden) and the sharp re-leveraging of the US non-financial corporate sector.
Hence, just like a rubber band, which has been stretched by too much and ultimately snaps back, a repricing of market prices should not come as a major surprise.
Having said that, so far the market correction has been rather mild: global equities are trading at the prices of early January, corporate bond spreads have barely moved and real yields in sovereign bond markets remain stubbornly low, even negative in several major markets.
Going forward, our positioning reflects the following thinking:
- There are no signs of a recession or hard landing in developed markets. The economic upswing continues, at least for the time being.
- Various monetary leading indicators, however, are pointing to a slight moderation in growth dynamics 2H 2018. Changes in growth dynamics matter for markets.
- Monetary policy continues to normalize, most likely by more than so far discounted by markets.
- Consequently, bond markets are likely to trade higher in yields and lower in prices going forward.
- Nevertheless, monetary policy globally will remain highly accommodative.
- As asset prices have not moved a lot, valuations remain rich in US equities, sovereign bonds, and spreads.
- Market complacency has clearly been taken out to some extent, as, for instance, the spike in VIX and the sell-off in Bitcoin is telling us. However, we expect market volatility to normalize structurally and the VIX to settle at around long-term average levels of around 20 as response to monetary policy normalization as opposed to falling back to levels of around 10.
- Higher volatility and lower bond prices may ultimately trigger adverse portfolio rebalancing.
Stefan Hofrichter, 6 February, 2018