Research & Insights

MV Weekly Market Flash: Risk-Off, With a Side Helping of Large Cap Equities

June 14, 2019

By Masood Vojdani & Katrina Lamb, CFA

  • Comment

Let’s go back in time exactly one year – to June 14, 2018. Someone from the future visits you and tells you that in the first four months of 2019 – from the beginning of January to the end of April – the S&P 500 will rise by 17.5 percent. The future-visitor then beams out, leaving you with just that one piece of information and a portfolio strategy to plan. What would you assume about the world at large? That gain in US large cap equities is one of the strongest on record, so you would probably be inclined to imagine “risk-on” as the dominant sentiment in global markets. A healthy allocation to core equities and higher-risk satellite classes like small cap and non-US emerging markets would be a plausible strategy, while perhaps reducing core fixed income weights to the lower end of your approved range.

No Reward for Risk

Of course, being in possession of just that one snippet of information about the future means that you wouldn’t have known that stocks came within a whisper of ending their decade-long bull market in December 2018, or that the Fed would make a sudden and radical U-turn in January towards a more dovish policy stance. Even so, one of the noteworthy things about the 2019 incarnation of the equity bull is how confined it is to US large caps, while riskier asset classes have sputtered. The chart below illustrates this divergence between bonds and large cap stocks on the one hand and everything else on the other.

From that point in time one year ago both US small caps and non-US emerging markets are down around 10 percent – still in or close to a technical correction. Non-US developed markets haven’t fared much better, in part due to the translation effect of a strong dollar on foreign currency assets. So a broad-based risk-on mindset has never really set in. The star asset class for this period, particularly when looked at on a risk-adjusted basis, is fixed income. The US Aggregate Bond index is up low-mid single digits for this period, performing a little better than large cap value equities and just a bit behind large cap growth stocks but with much less volatility, as clearly seen in the chart.

Divergence Ahead?

Bonds are in favor largely because the market has talked itself into believing that a forthcoming economic downturn will necessitate aggressive action by the Fed and other central banks (the presumed downturn being global in nature and in fact catalyzed more by flagging economies outside the US than here at home, at least for now). But there is a twist here within the friendly confines of the fixed income space. If economic conditions really are set to turn down, then a logical assumption would be that credit risk spreads start to widen. But that has not happened. Investment grade corporates and high yield issues alike are holding up just fine. The iShares iBoxx High Yield Corporate Bond ETF is up around 6.4 percent in total return for the year to date.

So here’s the picture: while the market is definitely not in a “risk-on” mindset, as evidenced by the poor performance of many higher-risk asset classes, neither is it completely “risk-off” as shown by those healthy returns for large cap stocks and the absence of credit risk spread widening. It’s as if there is some arbitrary line, on the one side of which are assets thought to be protected by a dovish Fed, with the other side being for assets vulnerable to the full-on effects of a worsening economy.

In recent commentaries we have argued that this odd arrangement is not sustainable. At some point either we realize that the economy actually is stronger than expected – in which case asset classes should revert to a more traditional risk frontier (higher return for higher risk) – or that a global recession is indeed imminent, in which case the market goes full risk-off, credit spreads widen and large cap equities get their comeuppance.

But there is an alternative view, which appears to be the one embodied by today’s conventional wisdom. This view holds that the magic of central banks will continue to work well enough to keep the worst of a downturn at bay. In this world, holding a handful of traditionally higher-risk assets like large cap US equities and low investment grade / high yield bonds makes sense, but taking on additional risk from other asset classes doesn’t pay (since the source of market return is permissive monetary policy, not organic economic growth). To be perfectly honest we think this is a risky view with the potential for serious mispricing of certain asset types. But it’s 2019, folks, and strange is the new normal.

Download Article

MV Weekly Market Flash: The Problem of Non-Quantifiable Risk

June 7, 2019

By Masood Vojdani & Katrina Lamb, CFA

  • Comment

Consider the following: at some point between now and the end of July there will in almost all likelihood be a new prime minister in the United Kingdom, as current PM Theresa May has stated her intention to resign within that time frame. Now consider this: the next prime minister of a nation of 66 million citizens will be chosen by…approximately 124 thousand of them. These enfranchised citizens constitute the registered, card-carrying members of the Conservative Party and they alone will receive the ballots asking for their preference between two Conservative Members of Parliament (whose identities have not yet been decided). Whoever wins the larger percentage of those ballots will, given the make-up of the core Conservative Party membership, very likely be in the camp of “hard Brexit” and thus anathema to as much as 53 percent of the total UK electorate. For various reasons both constitutional and procedural, there is an entirely plausible case to make that this next Tory government could drive the UK over a no-deal Brexit cliff before or upon the current decision deadline of October 31.

Quantify This!

We bring up this particular issue not for the sake of political analysis, but to illustrate a particularly challenging issue in the current capital market environment: how to price in risks that are, for all intents and purposes, unquantifiable. Brexit is of course not the only issue whose multiple moving parts and lack of historical precedents befuddle conventional risk analysts. The health of global trade and of the very system of unfettered flows of capital, goods and services across borders that has served as the default backdrop for more than three decades of valuing assets is uncertain. The system’s most important player, the United States, has embarked on a program of weaponizing the tools of this system for perceived national gain. Elsewhere, the traditional center-right and center-left political parties that have dominated the political scene throughout the entire postwar period are in radical decline.

How does one price any of this into the valuation of this or that asset? Sure, it’s easy enough to throw together a conventional model, assigning probabilities to various outcomes and then matching each outcome with a guesstimate as to the price impact on stocks, crude oil or high yield bonds. But those guesses amount to no more than throwing a dart at the wall while blindfolded. Would a hard Brexit, or a hot trade war, or a sharp turn towards authoritarian populism in more of the developed and developing world be good or bad for Brent crude or the US tech sector or the euro? Who knows? There is literally no hard empirical data to suggest the correctness of one guess – one throw of the dart – versus another.

In Powell They Trust

In the absence of the ability to rationally price the various organic risks afoot in the global marketplace, all the eggs find themselves in one basket: the willingness of central banks, principally the US Fed, to do anything it takes to keep risk asset markets from falling. Last fall we saw what happens when that faith is shaken. For a period of weeks between late September and late December 2018 it became clear that there was a less than certain chance the Fed would step in to backstop falling markets. Had the Fed not radically reversed course in early January with a major policy U-turn, it is entirely plausible that the near-bear market reached on December 24 would have turned into a real bear market. But the Fed lived up to its reputation as the redeemer and comforter for the investor class, and all was well again.

The Fed put, in effect, has become the substitute for organic risk analysis in a world of profound macro uncertainties. This explains why the dominant characteristic of markets in 2019 to date is that bonds and equities are joined at the hip – the prices of both rising under the expectation that central banks will continue to – and continue to be able to – underwrite whatever disruptions actually come about as a result of a hard Brexit or a tsunami of tariffs or whatever else comes along.

We’ll have another chance to see, very shortly, whether this undiluted faith in the Fed is justified. The market is currently pricing in about a 70 percent chance that the Fed will cut rates three times in the next year. Some comments this week by Chair Powell provided succor to this view – equity markets surged on Tuesday on the interpretation that any negative outcomes from an aggressive US tariff policy will be offset by a flood of Fed dollars. On June 19 we will see just what combination of words and/or action support that view when the FOMC concludes its June meeting.

And therein lies the ultimate exercise in non-quantifiable risk. Either the Fed and other central banks can prop up asset markets indefinitely, come what may, or they can’t. Assign a probability to each outcome, put on a blindfold and throw the dart.

Download Article

MV Weekly Market Flash: Strange Curves

May 31, 2019

By Masood Vojdani & Katrina Lamb, CFA

  • Comment

Well, we’re 22 trading days into the pullback that started after the last S&P 500 record high set on April 30. That’s 123 fewer than the 145 trading days it took for the last pullback to regain its previous high, from September 2018 to April 2019. Which, by the by, was exactly the same number of market-open days – 145 – that it took the January 2018 correction to regain its former altitude. Interesting for those who like to read meaning into randomness, perhaps…But we digress! Because, yes, the S&P 500’s retreat of more than five percent from that April 30 high has the usual red lights flashing all across the CNBC screen and Dow point drops (always point drops, always the Dow, so much more dramatic than the more mundane percentage creeps) juxtaposed next to the head of a speechifying Robert Mueller. But the real story this week is in the bond market, and specifically the strange shape of the Treasury yield curve.

The Yield Scythe

The chart below shows the evolution of the Treasury yield curve’s shape over the past month and compares it to what a more normal curve looked like one year ago. The blue line represents the most recent configuration of the curve, which looks like nothing more than a scythe ready to attack a field of wheat. Or a Marxist sickle missing its hammer, perhaps.

We’ve talked about the yield curve in these pages before, of course. The shape of the curve is important because an inverted curve – which is what is currently happening between short and intermediate term maturities – has historically been an extremely reliable predictor of recession. Every recession in the past sixty years has been ushered in by an inverted yield curve (though the timing between a curve inversion and the onset of a recession is subject to high levels of variance).

Do the Math

The relationship between the yield curve and the economy is not complicated, as bond math is entirely straightforward. Yields drop when prices rise, and prices on low-risk securities like US Treasuries rise when investors seek safe havens from riskier assets like stocks. When intermediate yields drop, it can signal the assumption by investors that central bankers will be pushing down short term rates.

Right now the Fed funds rate – the overnight lending rate between banks that the Fed effectively controls through its open market policy operations – is within a target range of 2.25 – 2.5 percent. You can see that short term Treasuries, which tend to move more or less in sync with the Fed funds rate, are all bunched around the middle of that target range, while the intermediate maturities of two to ten years all trade below the floor of the Fed funds range. In many ways, this is just a visual confirmation of what we already know to be true from other data sources like the Fed funds futures market. Bond investors expect at least one, maybe two, rate cuts before the end of the year. In other words, they look into the future and see a Fed funds target range with a floor as low as 1.75  percent – and where the Fed funds rate goes, those short-term Treasuries will follow. Then the yield curve would revert to something more like a less-steep version of that yellow line on the above chart.

But Where Is the Evidence?

The one missing piece in this puzzle is…well, actual evidence. Recall that we have just posted the lowest unemployment rate – 3.6 percent – since 1969. Real GDP growth remains positive, if not necessarily going gangbusters, and while corporate earnings have decelerated from the tax cut-fueled high of 2018, businesses’ top line sales continue to grow at a healthy pace – over five percent for Q1 of this year with almost all S&P 500 companies having reported. Low inflation continues to perplex the Fed. But the core personal consumption expenditure (PCE) index, the Fed’s preferred inflation gauge, also stayed below two percent for most of the second half of the 1990s, one of the strongest economic growth cycles in US history. A PCE of 1.6 percent – where it is today – shouldn’t set off alarm bells.

All this aside, it is generally not a good idea to blithely ignore whatever message the bond market may be sending. No recession appears to be looming on the horizon, and the case for immediate Fed rate cuts is not as glaringly obvious to us as the conventional bond investor wisdom seems to have it. But the yield curve in its strange, scythe-like form doesn’t appear to be going anywhere either, and we must continue to give it due attention.

Download Article

MV Weekly Market Flash: Volatility, The Good and The Bad

May 24, 2019

By Masood Vojdani & Katrina Lamb, CFA

  • Comment

In our annual market outlook back in January (wait, is it already Memorial Day weekend?!) we had two principal things to say about volatility. First, that we expected to see a higher level of volatility as one of the key defining characteristics of risk asset markets in 2019; second, that volatility is not always associated with downward trends in asset prices (meaning that higher volatility could be present in both up markets and down markets). How has that prognostication played out so far this year? As we head into the summer season it seems a good time to revisit our January musings.

Peaks, Valleys and Mesas

Those of you familiar with how we have described volatility in the past will have encountered our topological renditions of the VIX index of market volatility, commonly known as the market’s “fear gauge.” Briefly, we have intermittent peaks when risk levels suddenly spike into the heavens like so many Gothic spires, and we have calm undulating valleys when investor attitudes are serene. And then we have mesas – extended periods where volatility is elevated but not as dramatic as those short spikes. The chart below provides a full rendering of this VIX topography over the market cycle of the past three years. In this chart the VIX is represented by the dotted green trendline, while the solid blue line shows the price trend movement for the S&P 500.

The peaks are pretty straightforward: they tend to happen when equity prices go into a tailspin. The most prominent risk spikes over the past three years, unsurprisingly, coincided with the sudden correction in stock prices in February 2018 and again in fall-winter of the same year. Those earlier, smaller spikes you see in 2016 coincided with the Brexit vote and the run-up to the US presidential election in the same year. Of course, in the aftermath of that election and throughout most of the following year investor sentiment was for the most part calm, and we experienced a long volatility valley that wound up setting successive new lows for the VIX throughout the summer and fall of 2017.

The mesas – that third topological element – figures into the interim period between the market correction spikes of February and October-December 2018, and again in the period since. Here we circle back to those comments about volatility we made in our January annual outlook. Higher volatility has indeed been a characteristic of asset markets this year, even though the overall price trend for most asset classes has been resoundingly positive. You can see that the VIX mesa between January and May 2019 is somewhat more elevated than that of April – September 2018, with more time spent above the long term average of 14.22 for this entire three year period. We think this is consistent with the contextual themes we discussed in our outlook: expectations for slower growth and a tougher set of comps for corporate earnings and margins, along with continued uncertainty about global trade. The mesa probably would have been higher still had not the Fed turned abruptly on its monetary policy towards a more dovish stance, with no more rate hikes in the foreseeable future.

Wider Intraday Spreads

The VIX, of course, is not the only way to look at risk and at times it can be misleading. VIX contracts are traded, bought and sold like any other asset, and as such what the index may be telling you on any given day can have more to do with flighty investor sentiment than with the underlying risk properties of the assets themselves. One such risk property is the intraday spread – the magnitude of difference between a stock’s intraday high and low price, expressed as a percentage of the closing price. In the chart below we show the intraday trend for the S&P 500 between August 2017 and the present.

Here’s how to interpret this chart: it shows the number of trading days each month for which the day’s intraday high-low variance (HLV) was greater than the average HLV for the entire period. For the entire period measured, the average HLV was 0.89 percent, meaning that the price difference between the high and the low was 0.89 percent of the closing price. So for any given day, if the HLV was higher than 0.89 percent that day was counted in that month’s tally. For example, in each of the months of September, October and November 2017, there was only one day in which the high-low variance was higher than the period average. By contrast, in both October and December 2018 the daily HLV was higher than average for nineteen days (in other words, for practically the entire month).

How does this chart help us understand the current risk environment? Well, the average number of higher HLV days for the first five months of this year (through the 5/23 close) is 8.2, including double-digit HLV days in both January and May. Again we want to make the point that volatility can be elevated even when the market is going up – January 2019 saw one of the strongest monthly price gains on record for the S&P 500, but there was higher than average intraday volatility for fourteen out of twenty-one total trading days. Conversely, the twelve HLV days recorded thus far for May coincide with a more risk-off mentality for investors as they pulled back in the wake of new record highs in April.

We believe there continues to be good reason to expect higher volatility in the weeks ahead. Remember – that may be good volatility or bad volatility. Given the way stocks trade in the present day, driven largely by reactive short-term quantitative models, any directional price trends are largely at the mercy of the daily headlines. The collective wisdom of the market may determine that trade war fears are overblown and the Fed has its back. Or, the consensus may be that the Fed’s toolbox is already pretty low on new surprises and global developments are unnerving. Either way, we will be looking at the elevation patterns in those mesas to gauge how much more volatility may lie ahead

Download Article

MV Weekly Market Flash: Seven and Ten In China

May 17, 2019

By Masood Vojdani & Katrina Lamb, CFA

  • Comment

This week’s financial news cycle has been all about China, and a wacky week it has been. On Monday major global equity indexes experienced their biggest pullback since January as trade tensions continued to fill up the Twitter feeds of the investor class and their trader bots. Not that it was all that much of a pullback: the S&P 500 was off a bit more than two percent, the Nasdaq a bit more than that. Predictably, of course, the mainstream news outlets chose to ignore the relatively minor percentage point drop and put up instead the screaming headline “Dow Plunges 600 Points!” “Six hundred” is sort of a big number, unlike “two percent” and so it had to be thus to maintain the focus of their audience for a few more minutes before they all went back to whatever this year’s Candy Crush diversion happens to be. Anyway, stock markets recovered as the week wore on though in a somewhat jittery state. But a potentially more consequential development was playing out a bit behind the scenes in the bond and currency markets. In numerological terms those developments played around the numbers seven and ten.

Unlucky Number Seven

The seven in question refers to the amount of Chinese renminbi that one US dollar buys. Right now the RMB/USD exchange rate is hovering above that threshold, at about 6.9 renminbi to the dollar. That’s not the lowest level for the Chinese currency since Beijing implemented a managed float system to replace the old fixed rate back at the turn of the decade, but it is close. The chart below shows the currency’s price trend over this period.

In the past, China has been accused of purposely undervaluing its currency in order to make its products more attractive to export markets. If that were the case, one would expect Beijing’s monetary authorities to be perfectly happy to let the renminbi fall below seven. The reality, though, is that currency manipulation of this sort has been out of favor for many years. Since the middle of the present decade China’s currency policy has consisted of two main aims: first, to open up the currency to a more prominent role in global financial flows in a manner more befitting of the world’s second largest economy; and second, to prevent massive capital outflows by domestic owners of renminbi-denominated assets. This second point, remember, was a major concern back in August 2015 and again in January 2016 when economic concerns sparked a wave of outflows. At that time Beijing commenced a sustained program of reducing their substantial holdings of foreign exchange reserves in an effort to bolster the currency – in effect, to keep the currency from falling below that threshold of seven to the dollar.

The Tenacious Ten

Which, in turn, brings us to the number ten, as in “10-year Treasury.” Because when talk turns to China’s store of foreign exchange reserves, the dominant asset in question is US Treasuries, the 10-year benchmark prominent among the spectrum of maturities therein. How important is it for China to support its currency above that seven threshold? Important enough to accelerate the pace of Treasury sales – perhaps goaded on by the parallel role such a move could play as a salvo in the trade disputes?

The good news is that a massive sale of Treasuries is probably not in the cards, at least not given the current state of things where China’s economic health remains relatively robust and the trade war is still more about posturing than actual infliction of damage. For one thing, it’s hard to think of a useful asset China could find to replace US government paper for its FX reserves. Japanese government bonds or German bunds? Those are similar in risk profile, but they also carry negative interest rates all the way out to the ten year maturity band. Nein, danke.

Nor is it even certain that substantial Treasury sales by the asset’s largest foreign holder would have a deep impact. The Treasury bond market is around $16 trillion in total size, of which China holds a bit more than $1 trillion in its FX portfolio. There is vanishingly little evidence of any widespread distaste for Treasuries among investors, many of whom expect Fed rate cuts in the next couple years and a general flight to quality sentiment as the global economy slows. That sentiment would likely attract plenty of buyers to any fire sale operation mounted by Beijing.

So that’s the good news. But it is also pretty clear that Beijing will try and do whatever it takes to prevent the kind of financial instability experienced in 2015-16, and a stable currency is a big part of that equation. The headlines may all be about bellicose trade war tweets (and they will no doubt continue to push and pull short term stock price movements), but there is much more going on with China that could play out in uncertain ways in the weeks and months ahead.

Download Article