Market volatility is a classic mid-cycle tantrum
Last year saw the lowest equity market volatility for 90 years which encouraged a build-up of leverage by volatility-related funds and increased market trend following strategies. So when US Treasury yields rose on the back of overheating concerns in the US economy, investors began to fear the Federal Reserve (Fed) might have to tighten monetary policy more aggressively than the market originally anticipated. The result in early February was a sharp de-leveraging of risk by these investors, a jump in market volatility and losses in global markets. Markets have already largely recovered much of those losses.
It does seem that the recent market volatility is more of a classic mid-cycle tantrum, rather than the start of a bear market — like the 2000 and 2008 moves — for three reasons. First, the growth outlook is improving and broadening. Second, contagion from the equity market has not spread to the credit markets, as it did in 2008. Third, underlying measures of inflation are still subdued. Excluding food and energy, this so-called “core” consumer price measure of inflation is running below 2% for the US, the Eurozone, China and Japan. Provided that inflation remains subdued, central banks are likely to remove monetary accommodation slowly. There is a new Fed Chair, Jerome Powell, who remains an unknown quantity. This may keep markets jittery in the short term, but essentially, we remain positive on markets and would add to equity positions from here.
Fixed income markets
US Treasury yields have risen to nearly 3%, a rate last seen in late 2013. Investors are wary that US tax cuts and increased infrastructure spending could drive yields even higher. However, provided global growth holds-up to backstop company earnings, rising bond yields should not be feared, and particularly when there is plenty of liquidity in the global financial system.
It is worth noting that the US$-denominated combined assets of the central banks of the US, Eurozone, Japan and China grew by more than 20% year-on-year in January. Moreover, US share buybacks are running at record rates so far this year, as companies repatriate capital from overseas due to the tax reform.
Importantly, interest rates are still too low to worry credit markets about debt defaults, a more serious risk to equity markets. For example, the cost of servicing US household debt is close to historical lows at 10.3% of take-home pay. The fact is that over the past 10 years US households have reduced debt relative to take-home pay by their biggest amount since World War Two. Lower debt should increase the ability of households to absorb higher rates.
Inflation could however surprise on the upside. Under that scenario, central banks would be viewed to be behind the curve on tightening monetary policy by investors. Bond yields could continue to rise and crimp output growth, increasing the probability that the economic cycle is coming to an end. Equities would struggle to perform under that environment.
Risks and misconceptions about China
China’s remarkable economic development has been viewed with caution in the West. The normal narrative is that China’s expansion is driven by an unsustainable expansion in debt that is being used to invest in unproductive assets. Indeed, there is a feeling that China risks a re-run of the Japanese over-investment boom-bust of the late 1980s and early 1990s.
Low market valuations on Chinese equities suggest that investors have discounted a high probability that China faces an investment bust and sharp economic downturn. Indeed, the Chinese Year of the Dog that started last month is considered to be a good time to be cautious when it comes to finances. Joking aside, we argue that much of the negative outlook on China in the media is a misconception.
Little attention has been given to government reforms. For instance, President Xi announced an economic agenda at the end of 2013 that called for market forces to take a “decisive” role in improving financial resource allocation to tackle the economy’s reliance on debt to drive growth. The result is that the capital productivity is rising and Chinese companies have been forced to become more efficient to remain viable concerns.
In a myopic world, China’s problem is that structural reforms are slow moving. Yet, if the government continues to implement reforms to deregulate and restructure the economy, China stands a decent chance of a successful transition to sustainable growth and a fully developed set of markets. Over time this should lead to a more balanced assessment of China. Under that appraisal, China would be viewed as an opportunity for investors, rather than a systemic risk to the global economy.