Friday, 26 August 2016

Complacency in global markets

If you are a global investor, the responsible thing to do is cut risk and raise cash, no matter how painful it may be in the short term

Markets, globally, are showing signs of extreme complacency. Volatility has collapsed across markets. The past 30 days in US markets have seen the least volatility of any 30 day period for more than 20 years. Only on five days in the past month have we seen a move of more than 0.5 per cent in either direction for the S& P 500. Realised volatility for the S& P 500 has been lower only a dozen times in the past 50 years. We have seen this drop in volatility despite Brexit, the coming US elections in November, the upcoming Italian constitutional referendum and the possibility of helicopter money and other unconventional monetary experiments. This does not look like a low- volatility environment does it? Is there truly no reason to worry on any of these events or factors? There seems to be tremendous faith that central banks have the back of investors and will not allow large losses. The danger is that this complacency is not about markets, but rather the power of central banks and their ability to prevent a sharp downturn. It is quite astonishing that almost every asset class is up after Brexit! Most investors have taken it (Brexit) as a positive as it gives central banks even more of an excuse to continue or even accelerate their extreme monetary accommodation.
While we have this veneer of calm and low volatility in markets, below the surface, cracks are starting to appear. In equity markets, valuations seem high on certain longer term measures and earnings are under pressure. However it is in the fixed- income markets where there are more worrying signs. There are clear signs of dysfunction. Old rules of thumb and correlations are breaking down and most of the old hands are all at sea as to how to navigate this new world of never- ending monetary accommodation.
At turning points, the fixed income markets are normally more sensitive to change, and are a leading indicator for equities. One ignores their message at one’s own peril.
While clearly macro factors have become more important these days, should they have greater relevance than at the height of the financial crisis? Work done by the quant team at Citibank seems to indicate that macro factors today explain about 80 per cent of equity market variance. Macro is currently overpowering the micro fundamentals. This is also leading to herd- like behaviour by investors, as there is little micro- level stock or security- specific market differentiation.
Credit markets no longer seem worried by defaults. S& P has pointed out that defaults year- to date have equalled last year’s total and are at the highest run rate since 2009. Normally, such acceleration in defaults would have led to a widening of spreads, as credit risk gets priced in, but in 2016, we have seen a negative divergence between spreads and default rates.

There has also been a strong positive relationship between corporate spreads and leverage. Higher leverage at a company, leading to higher credit costs, perfectly rational. This relationship has also broken down.
It also seems as if policy uncertainty no longer matters. Citibank measures various policy uncertainty indices; they have historically had a very strong correlation with spreads, again perfectly rational. Yet, today, even this relationship has broken down. With policy uncertainty nowhere near as low as current spreads would seem to imply.
Other long- held relationships have also broken down in the fixed- income markets. Drops in inflation expectations used to be bad news for spreads, which has reversed. Credit spreads also were negatively correlated with rate movements. Good economy was good for spreads but bad for rates and vice- versa.
This has now reversed to whatever is good for rates is positive for equities and credit markets as well. In the past, whenever markets all moved together, it would be in response to some macro event and volatility would rise sharply. Today, all markets are correlated, but volatility has shrunk.
Global liquidity seems to be the reason all these relationships are breaking down. With negative rates pervasive across sovereign markets, this is also changing across asset relationships. The markets seem to no longer be heterogenous, everyone is on the same side and looking at the same central bank put, playing the short- term liquidity. Without heterogeneity in markets, short term liquidity overpowers everything else.
With all these relationships breaking down it is no surprise that many investors are confused, doing badly and very worried. I have very rarely seen so many top quality investors all so bearish, across all asset classes, at the same time. Whether it be Soros, Druckenmiller, Singer or others, most of the people with really good long- term records are asking you to exit the markets entirely.
As is typical, markets will keep us guessing, and test the conviction of the bears. I would not be surprised to see continued market gains globally driven by the liquidity. However, be rest assured, this will end badly, and when it does no- one will have time to react. The prudent thing would be to slowly take risk off the table, knowing that one may hurt returns in the short term, but preserve capital for the inevitable bust. If you are a global investor, the responsible thing to do is cut risk and raise cash, no matter how painful it may be in the short term.
India is in a structural bull market, but will also correct if global markets turn turtle. Any correction in India remains a buying opportunity.

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