Moving closer towards the new norm?
The share and bond markets have long been overdue a correction as they have reached and blown past previous record high levels. The recent volatility we have witnessed over the last couple of weeks has been excellent “click bait” for news websites. They love to sensationalise anything that will get their audience to click through to read their opinion. Beyond the sensationalism, in reality we cannot be certain this is the long-awaited selloff.
At the time of writing, the concern is not so much the global sharemarkets – which may have a short sharp sell off before recovering on the back of rising inflation, global growth, and reducing unemployment. The concern is bond markets which, if we move into a sustained rising interest rate environment for the next 2-3 years, will struggle to produce positive performance. Fund managers holding long dated bonds in their portfolios will likely be the most negatively impacted if rates continue to rise.
All these possible outcomes remain uncertain. We have seen this sort of volatility back in 2015, which was referred to as the “Taper Tantrum”. This was short lived volatility on the back of concern that interest rates were rising, and instead we saw them continue lower as the European Central Bank (ECB) increased their stimulus in the form of Quantitative Easing (QE).
Today, we still have about US$150 billion of QE being pumped into the markets per month by the ECB and Bank of Japan. This is now forecast to slow and potentially stop in 2019, but this is not a forgone conclusion, and they could elect to keep the stimulus in place longer in an effort to control or slow the rise of interest rates.
In conclusion this volatility is certainly a sign of things to come, it is simply not clear when the long awaited “normalisation” of markets will finally occur. We continue to recommend underweight positions to growth assets in portfolios, as well as managers with good downside protection, and a lot of cash.
The end of bull
If the S&P500 had continued up for another 6 months we would have had the longest bull run since World War II. February 2018 however has produced the first meaningful correction in the S&P500 with the index down just over 10%, since its previous high earlier in the month. This ended 105 months of gains, which returned investors +368%.
To date this correction has been sharper than the average of the last 22 corrections, as well as the last 14 bear markets. If the S&P500 falls a further 10%, we will officially be moving from a “bull” market to a “correction”, inching closer to a market more “bearish” by nature. While we at PWA have been warning markets are overvalued for some time now, at this stage it is unclear if this decline will continue, or if this is simply a short term drop as the market comes to terms with rising interest rates around the developed world.
One of the reasons to believe this will be a short-term correction (less than 20% from top to bottom of fall) is that we are continuing to see profits in US companies climb higher. With improving corporate profits and lower share prices, the Price to Earnings (PE) ratio has dropped back to levels last seen in early 2016. This clearly indicates that stocks are becoming more reasonably priced. We are also seeing global growth accelerating, which may attract investors back in.
One of the indicators to watch over the next couple of weeks is the VIX index – a measure of the expected volatility over the next 30 days, as priced in by several different S&P500 options. As shown below, this spiked from a low in early 2018 of around 11 to 29. To put this move into context – the 2008 GFC saw the VIX spike to a level almost double this and the VIX has also reached this level previously in late-2015 (the Taper Tantrum).
Picking up pennies in front of the steam roller
Picking up pennies in front of the steam roller is a term used to describe investments where the potential positive returns are low, but the potential losses are large. An example of this sort of trade is the Velocity Shares Daily Inverse VIX Short-term Exchange Traded Note (XIV:NASDAQ). The XIV provided positive performance to investors, as the CBOE Volatility Index (VIX) moves lower, by betting on continued calmness. This investment fell 95% in minutes when the VIX spiked recently.
Several hedge funds, who had bet clients’ funds that volatility would stay low, using the XIV security, have seen large negative movement in their unit prices. As an example, the LJM Preservation and Growth fund fell from c.$11.50 to $1.94 in a day.
Interest rates rising in US
Ironically it was positive market news that caused this recent sell off in the US share markets. The US average hourly earnings increase came in at 2.9% year-on-year in January 2018, which lead investors to believe the US Federal Reserve would raise rates further than the market had been pricing in for 2018. We also had confirmation that the Republicans in the White House were planning some staggering levels of stimulus for the US economy. This included a US$1.5 trillion tax cut package (corporate tax rate from 35% down to 20%), a US$1.5 trillion infrastructure spend, of which the US government will fund US$200 billion through “unspecified cuts” and a US$300 billion in additional spending for military and domestic programs over the next two years.
This stimulus is all occurring at a time when the US national debt level is already over US$20 trillion. The long-term implication of this spending spree is that the US may now be on track to owe more to its creditors than the economy produces in a year.
Once again, while this is positive news for the citizens of the US, via unemployment falling, leading to higher wage inflation, the US Federal Reserve (Fed) will have to place a lot more debt in the bond markets. The Fed is expected to borrow (place bonds) a total of $955 billion this fiscal year.
This in turn will mean there is likely to be an oversupply of available bonds, and limited demand, meaning interest rates in the US may need to rise to attract investors in their bonds. The markets have already started to price in this expectation, with the US 10 year rising from 2.03% in September 2017 to 2.85% today. This equates to a reduction in bond value of 7.05% in only 5 months!
New Zealand interest rates
We have seen global interest rates move lower since 2008 on the back of the unprecedented levels of global quantitative easing (QE). This has forced investors to increase their exposure to riskier investments which, in turn, pushed the riskier asset prices higher and yields/interest rates lower.
Over the past 15 years there has been a spread (difference in rates), for NZ 10-year bonds versus US 10-year bonds of between 1.0% to 3.0%. Given the Fed has now commenced raising rates, and the shortage of available global debt due to QE, the spread between the US and NZ 10-year bond rates has been reduced to almost 0%. This means that investors are not getting paid any extra for investing into NZ government debt versus US debt. If we see this spread normalise, NZ 10-year bond rates must move higher (likely), or US rates must fall (unlikely), but at present the New Zealand government is getting some very cheap interest rates on our countries debt.
QE becomes QT
In late 2017, we received clarification from the Fed regarding the end of their Quantitative Easing (QE) programme which has driven share, bond and some property markets to record high levels. We are now underway with the Quantitative Tightening (QT) cycle.
Since 2008, the Fed has increased their balance sheet from US$900 billion worth of assets to over US$4.4 trillion by the middle of 2014. The other central banks later followed suit with their own printing. In order of magnitude, this is the current picture – the Bank of Japan US$3.7 trillion, European Central Bank US$3.3 trillion, Peoples Bank of China US$3.1 trillion, and Bank of England printing a miniscule US$435 billion.
The Fed has commenced “balance sheet normalisation”, allowing the US debt it owns to mature without rolling them into new investments. They are allowing US$10 billion per month of bonds to mature to test how this is received by the market.
Assuming all progresses well, the Fed will increase the amount of QE they are pulling out of the market to US$50 billion per month by December 2018. They will continue to do so until their balance sheet is reduced from US$4.5 trillion to a more “normal” level of around US$2.9 trillion by 2021. As discussed above, they are doing this at a time when the US government is requiring them to place new debt in the market. This is debt that the Fed will not be buying, hence interest rates will be determined by investors, not the Fed.
At the 30 January 2018 Federal Reserve meeting, Janet Yellen again confirmed that the Fed plans to hike short term interest rates to 2.7% by 2019, which is 1.2% higher than the current 1.50% cash rate.
Further to the US’s QT programme, analysts are also forecasting the end of the European Central Bank’s (ECB), and the Bank of Japan’s (BoJ) quantitative easing, along with an announcement that the ECB will commence normalising their balance sheet in 2019.
As stimulus is gradually removed, we remain concerned that this will take the downward pressure off interest rates, adding pressure to push interest rates to more normalised levels. Any rise in interest rates from the previous historically low levels will lead to shares, and more importantly bonds, having to reprice for a future with higher interest rates.
At the time of writing this commentary markets were in a simple correction phase, not a global rout, as financial commentators might have you believe. We do believe this is the pre-cursor to more volatility on 2018, but given the uncertainty around the possible end of the QE stimulus we still do not have any clear insight into when interest rates will normalise.
Long dated bonds continue to be a dangerous place to invest, and we continue to recommend higher weighting cash/term deposits for the foreseeable future.
The share markets’ recent volatility shows that there is a greater chance of increased volatility moving forward, hence we continue to recommend investors remain underweight growth assets and use managers that can add downside protection.
While the bell for the top of this cycle may have been rung in early February, only hindsight will confirm this. Hence, stay invested, but be smart about how you are positioned and hang onto your hat – 2018 could be a bumpy ride!