23rd October 2014
Fund management veteran and Liontrust head of multi-asset John Husselbee examines the hefty bout of volatility investors have endured over recent weeks and considers what might happen next…
My favourite gauge of ‘fear & greed’ is VIX, a measure of equity market volatility derived from options on the S&P500. It leaped from around 15 in early October to over 26 in the middle of last week before easing to just below 20. This activity led investors to follow the well-worn path or ‘flight’ to safety; the FTSE100 lost 5.6% in the nine weekdays between the 6 October and last Thursday the 16th; over the same short period the FTSE Actuaries All Stocks index of UK government bonds gained 2.4%.
Many investors will now be asking themselves whether they have witnessed a market correction in valuations, a logical reaction to new information or the beginnings of a bear market.
My view is that it was simply a correction – one that I have been anticipating for some time now, albeit without attempting to predict when it would come, or what the catalyst would be. Importantly, there seems to have been little in the way of a specific catalyst. Markets do not appear to have been reacting to new information.
The risks to economic growth and geopolitical stability that have so preoccupied market participants over the last week or two are exactly those that had previously been comfortably absorbed and overcome as equity markets traded close to highs. Granted, the ECB’s decision to keep markets holding out even longer for QE would have caused nervousness among those that have become accustomed to a steady stream of liquidity, but that decision was announced on 4th September, a month before the correction began.
Last week’s sell-off has been dubbed ‘Taper Tantrum 2’ by some due to the likelihood that quantitative easings (QE) imminent, scheduled end has provoked the jitters seen over the last couple of weeks. In the great tradition of Hollywood franchises, the possibility of an unnecessary revival has been mooted, with St Louis Federal Reserve Bank President James Bullard’s suggestion of a QE extension evoking memories of Sly Stallone slipping on the big red gloves to churn out another Rocky.
Geopolitical risks will always be present and it is difficult to argue that tensions in Ukraine or the Middle East are any greater now than several weeks ago. Likewise, the threat of deflation in the eurozone and low-or-no growth worldwide has caused some alarm, but we view growth prospects as little changed. The world economy is no doubt subdued but we think an ongoing recovery in the US is capable of pulling other economies with it. The decline in the price of oil and other commodities has been cited as evidence of decreasing economic activity and increasing risk of deflation. But in itself, a lower oil price acts as an ‘automatic stabiliser’, reducing the ‘tax’ on global growth in a similar way that a progressive tax system increases fiscal stimulus as incomes decline. Our base case expectation is still for sufficient economic strength in the US to justify the termination of QE and the beginnings of interest rate normalisation through the end to ZIRP (Zero Interest Rate Policy).
The formation and bursting of valuation bubbles is clearly detrimental to the efficient functioning of capital markets and causes significant pain to the many that are caught up in the aftermath. We should be clear that such scenarios are usually the culmination of a long period of low volatility, as assets prices trends become entrenched. Volatility in itself is not to be feared. As long term investors, volatility is in fact our friend. Trend-following traders may despise it, but for us it represents the natural process by which new information is reflected in the price of assets and securities. In simple terms, we are all in the business of trying to buy low and sell high, and increased volatility gives us the opportunity to pursue this approach. Liquidity-fuelled asset price inflation has, however, smothered the normal market volatility.
The good news to come out of the correction from our perspective is that we can now buy into equities, an asset class which we previously viewed as fair value, at levels at least 5% lower than at the start of the month. The bad news is that the bond market correction that we expect and are positioned for has yet to transpire. Bond values have in fact been driven even higher by their perception as safe havens. Our default position on bonds this year has been that they offer little real value, and only look more expensive and detached from fundamentals following the recent move. The embedded complacency in equity markets looks to have been dislodged by the sell-off and accompanying volatility but we believe that a correction of at least the same magnitude is well overdue in fixed income markets. This is increasingly becoming a consensus position, but that does not detract from its logic.