We suspect that most experienced investors fully expected a correction in equity markets at some point (markets don’t go up in a straight line forever), however the ferocity and damage caused by the recent sell off has probably damaged the psychology of more than a few novice traders. At best, we will look back and see that this correction was no more than a painful shakeout, and the bull trend will reassert itself shortly. At worst, we have just seen the first leg down in a big bear market comparable to 2008 and 2000.
If we take a step back and consider what helped reverse the corrections we have seen in recent years, it has been central bank support measures. Whenever global markets have wobbled badly, central banks have either slashed rates further, printed money to buy bonds and even equities, or in the case of the Federal Reserve in 2015/16, scaled back their normalisation programme. This week, not so much.
Fed speakers have dismissed any meaningful negative impact that the market correction may have, and continued to focus on gradual rate rises and the prospect of inflation moving higher. Even the ECB and Bank of England have continued to guide the markets to think about further exit and normalisation policies. So far, this is a far cry from either the tumultuous times in 2011/12 during the European debt crisis or the China inspired corrections in August 2016 and again in early 2016.
Before we opine on what the odds are between painful shakeout and first leg of big bear market, we want to share a chart which we think is one that all investors need to think about carefully for the years ahead. The data is what the Bank of England has available going back 250 years, and this shows that up until relative recently (the last 20 years of so), equity and bond prices generally moved in the same direction. However, the correlation changed dramatically in the last 20 or so years and this, in hindsight, may well turn out to be the outlier, and not a new normal.
Chart 1 – Correlation (10 year rolling) between equities and bonds (source Bank of England)
Certainly, investors that held high quality bonds and equities benefitted from the negative correlation during the last two bear markets. The great bull market of the last 30 years in bonds, propelled along by the disinflationary trends apparent, and the increasingly aggressive central bank responses to crises have helped bonds in terms of providing the perfect diversification from an equity portfolio (as well as strong outright returns). The big question for investors now is if there is another major equity bear market, can high quality bonds currently yielding between 0.7% (Germany) and 2.8% (United States) really generate the returns necessary to cushion the blow from a decent equity weighting in portfolios?
Of course, the answer is no. Although we suspect that bonds would generate positive returns in the event of an equity bear market, they will only be in the low single digits and not enough to meaningfully offset equity losses. On top of that, what happens if rising bond yields are the major cause of an upcoming equity bear market, and as such, the correlation between equity and bond markets flips back to the historically positive position they held for most of the last 250 years?
And so back to today, and the odds between painful shakeout and first leg in a major bear market. We suspect it may be more nuanced that that. We have said numerous times since Q2 last year that the bull market is likely to experience a multi-month topping process before experiencing a period of rapid declines. If we are correct, then we suspect that the declines seen in the last two weeks are the first major shot across the bows. For some markets, they may well go on to make new highs in the months ahead but the pace of gains will be slower than 2016/17. Some markets may struggle to make new highs, and we suspect have entered a topping pattern. Collectively, we think the environment has changed.
We think what it is different this time, compared to the 2015/16 corrections, is that as well as the current response from central bankers, some capital has been permanently lost and this has to impact investor psychology. It may seem small fry, but billions if not tens of billions has been lost in explicit volatility shorting strategies then this money may never be regained, especially if the fund has shut down. At greater risk, in terms of the amount of money involved, are the implied short volatility strategies such as risk parity. All of a sudden, 2.1% on a two year US Treasury may not seem like such an idiotic place to park some cash when risky assets are falling.
What is also different from previous corrections is that bond prices only briefly rose (yields falling) at the beginning of the week when equity markets fell heavily. However, by the close on Friday, prices were falling again, with longer dated bonds closing at the low of the week with yields obviously at the high of the week. Not only that, but high yield bond spreads closed at their widest of the week and so yields on such bonds also closed at the highest on the week – corporate funding costs rising as the highly indebted economy staggers into the last cycle stage.
For those working on the assumption that the buy the dip strategy remains in force, and that equities are in a long term bull market, there is some comfort. On Friday, the S&P 500 tagged its own 200 day moving average, as can be seen in chart 2 below. This trade set up worked beautifully at the time of Brexit and the US Presidential elections, and no doubt will be seen as some as a reason to buy. Indeed, we actually have some sympathy with this set up.
Chart 2 – Daily S&P 500 chart with 200 day moving average
Although there is reason to be optimistic that the panic seen last week will dissipate in the weeks ahead, we would caution against getting too excited. The message from central bankers last week was that they saw the equity market decline as “small potatoes” (New York Fed Governor Bill Dudley) and that they expect to continue to raise interest rates (and ECB to end QE later this year). Indeed, for the US in particular, we expect inflation to rise above target in the first half of 2018, which will make it much harder to be ultra dovish if equity markets do fall further.
We would see any further rise in rates and credit spreads as a headwind to robust equity performance, and actually quite likely. We think it is likely that volatility calms down a bit, but remains higher than the absurdly low levels seen last year. This outcome would likely mean that leveraged investors are less able to buy assets aggressively, and so capping the upside at some point.
To try and conclude here, it appears to us that the tide is finally turning here. Those over committing to short volatility strategies have already been seen to be bathing in the sea without a costume on (to paraphrase a Buffett saying), but otherwise, the decline looks to be more of a flesh wound at this stage. Although predicting anything other than a rampant bull market in recent years has been idiotic, we think the odds that we are in the early stages of a topping process are quite high.
The end of QE is still on track for later this year, and the Fed and others are fully committed to raising rates further. We have said for some time that this could easily end in a policy error; a view we maintain. That, and the fact that the bond market is acting differently than during prior corrections, and bull market strategies have literally blown up almost overnight (remember the highly leveraged credit funds that blew up in 2007?) indicate that things have changed and will continue to change.
From a short term trading perspective, we would not be surprised to see risk assets improve somewhat over the next month or two, but this would likely be a rally within a topping process. Longer term, we fully expect both a vicious bear market, and zero or negative returns across many assets over the next 7 to 10 years.
Stewart Richardson
RMG Wealth Management
