For years, markets have been becalmed by the soothing remedies handed out by central banks at the first sign of trouble. And for years, many (ourselves included) have warned that there must be unintended consequences of these extraordinary central bank policies….at some point. The natural time to begin worrying about these unintended consequences has to be when central banks begin to remove their accommodation. This, coupled with the political change that is occurring, should at the very least bring into question the bullish narrative that has been maintained since the last serious bout of volatility during the European crises in 2011/12.
However, parsing markets in early 2017, it seems that the investment community simply does not care that change is on the way, and that there is a chance that this change may not be smooth. Of course, this is a very generic observation, as most investors do care about the changes we are about to see, and are trying to assess just what they may mean for future asset class returns. Our point is that we all understand that change is coming, but price alone indicates that markets are very much sticking to the bullish reflation narrative that has been building in recent months, and especially since the US election. The main question we need to ask ourselves is; will the bullish narrative prevail, and if not, how and when should we position portfolios for change?
So, to start with, we feel compelled to point out just how low US equity volatility is today. This has been highlighted by quite a few commentators in the last week or so, but the current extraordinarily low level of volatility is certainly noteworthy. Chart 1 shows both spot volatility (which cannot be traded) and 3 month implied volatility (which can be traded). Both are basically at their lowest since 2007, or before the Global Financial Crisis.
Chart 1 – US equity volatility
Spot volatility can fall simply because markets are trending higher in a very uniform manner and sellers are very subdued. However, tradeable volatility (and we are using 3 month implied volatility for illustration purposes) can also be influenced by traders’ actions in either buying, as a way of say protecting equity portfolios, or selling as a way of enhancing returns. We view outright selling of volatility as a very dangerous activity akin to picking up pennies in front of a moving steam roller. It may work for long periods of time, but when it blows up, you get squashed.
Chart 2 below shows 3 month implied volatility in the upper panel (in white) along with the S&P 500 (in red) and speculators net exposure to Vix futures contracts in the lower panel (in orange). As of last week, speculators hold their largest ever net short position in Vix futures. In other words, speculators have actively been selling volatility in an attempt to pick up lots of pennies in front of a steamroller.
Chart 2 – 3 month implied Vix with speculators net Vix position
Low volatility in and of itself is not immediately bearish of equities. For example, when 3 month implied was trading at the post GFC low in the summer of 2014, this may have represented a “momentum” peak in equities, but there was certainly no imminent panic and the equity market actually traded a bit higher as the short Vix positions were covered. For what it’s worth, we would highlight that the Fed were still printing money in mid-2014, and the combined balance sheet expansion of the ECB and Bank of Japan was just getting going, and so there should not have been any panic assuming central banks maintained control.
What is perhaps more interesting is to look at the more recent positioning extremes. In September 2015 and again in February 2016, equity markets were in a bit of a panic, volatility had spiked and speculative accounts were holding long Vix exposure, i.e. they had bought insurance. In hindsight, these two periods were actually a good time to be buying equities and selling volatility.
In September of last year, we had the opposite position. Speculative accounts were record short Vix only weeks before a mini spike and a smallish decline in the equity market ahead of the US election.
So, we look at this chart in two ways. First, when Vix has already spiked, the equity market has fallen, and speculative accounts have already bought their insurance, it is time to look for a buying signal. Second, when Vix is very low and speculative accounts are holding record short Vix positions, it is time to book some profits and wait for a better time to buy, especially when the Fed is not printing money (of course, today it is slowly removing accommodation)
Stepping back from the somewhat esoteric world of volatility, it is clear that markets remain mostly committed to the Trump reflation narrative. Not only are equity markets nudging higher, Government bond yields have begun to do so again in the last week or so, and it appears that the Dollar may be trying to find support after a rockier few weeks. So, is this reflation narrative at risk of being wrong? Will the US economy accelerate during 2017? Well, we know where we closed the year. US GDP grew at a seasonally adjusted annual rate of 1.9% in Q4 2016, and that leaves the year on year rate at 1.9% also (see chart 3 below).
Chart 3 – US GDP
Although we do see a strong possibility that the US economy can gently accelerate in Q1 and inflation will pick up as well, we continue to think that there is plenty of room for downside disappointment in say Q2 or Q3 relative to the current bullish reflation narrative. As we have highlighted before, there is a chance that inflation peaks in Q1 and depending on the price of oil and the tracking of wage growth, we think inflation will undershoot thereafter. As for growth, yes the animal spirits seem to be getting all bulled up when looking at business and consumer sentiment surveys. However, there is very little that excites us in terms of Trump’s trade policies, and any tax, infrastructure and de-regulatory policies may not impact growth much this year at all.
If we are wrong, it will be
- that the bullish animal spirits are truly a leading indicator of better times ahead, or
- inflation is set to increase quite smartly likely leading to higher bond yields and perhaps a more hawkish Fed leading to a potential policy error or mini stagflation era, or
- Trump’s protectionist policies lead to some sort of trade war and global growth collapses (the 1930s analogy)
There are other potential scenarios, but our point is that as well as the bullish outcome, there are outcomes that would be bearish for both bond and equity investors alike. So far (and despite recent losses in Government bonds), investors seem to be pretty complacent about the risks that would become apparent in the alternative scenarios. And although this complacency may well prove right and therefore profitable, the upside for being right appears to be modest. In short, from current levels, the risk versus reward appears to be skewed in our opinion against buy and hold investors.
How or when will we know which scenario is becoming more likely? The business and consumer sentiment surveys along with inflation reports as well as the details in Trump’s policies proposals need to be watched carefully. Until such time as the data proves the current reflation narrative wrong, we suspect that markets will simply run with recent market trends (equities, bond yields and US Dollar all up), however, we will be watching carefully, and are on high alert that the shiny veneer of the current market narrative is wearing off.
Stewart Richardson
RMG Wealth Management
