Well hasn’t this new year just started with an overflow of euphoria? The best start to the year for Global Stock Markets since 2006!
As this chart shows, it was only two years ago that we were lamenting the absolute worst start to the year for stock markets ever. So we’ve gone from worst ever to one of the best ever, in just two short years. Perhaps that’s why it is hard for discretionary investors to shift the sinking feeling from the pit of their stomachs. The question is whether 2016 was the aberration, and bring on the euphoria… or is 2018 just too darn optimistic?
The answer is potentially both. In 2016 there wasn’t any strong fundamental reason to panic but a wobble in China set off a firestorm that engulfed Deutsche Bank CoCos and Oil. Now, in 2018, the global economy is looking a lot stronger but the perma QE central bank taps are being turned off just as politics becomes much more uncertain.
The reason for the over-reaction on both sides? The new nature of volatility. Rather than being linear, it’s a step function. Either we languish in the doldrums of zero vol, or we step up into a giddying spiral of ever-more panic.
We first flagged up in the summer of 2014 “How Volatility Eats Itself“. Central banks were worried. The NY Fed produced a blog post “What can we learn from prior periods of low volatility?” in which they compared the drivers of low vol at that time to those of 2007:
As we noted at the time: ‘This says: Volatility is low because Treasury yields are low and not moving around very much. It’s very different to Lehman, when household confidence was in disarray, credit spreads were high and random news was flying around.’
The authors concluded:
‘During times of relative market calm, like today, it could be that low financial market volatility is pushing these fundamental drivers lower, rather than the other way around.’
Yes, you got it, this means: stuff not moving around much makes things not move around much. Low vol begat low vol. But then we had a whole host of flash crashes, culminating in the Brexit induced fall in GBP. That crazy start to 2016 was a blow up whose time had come.
So what has happened between then and now which means we have returned to the low vol world?
The Fed have hiked 5 times, wasn’t that supposed to derail things? Well no, because the ECB took up the QE baton. As the ECB’s Coeure helpfully explained last summer, their asset purchase programme plus a negative deposit rate ended up as turbo-charged global QE. It depreciated the Eurozone’s currency, flooding the world with liquidity, which then found its way into other global bond markets, once again flooding the world with liquidity. Although this process began in 2014-15, it only really started to ramp up in 2016 onwards – see how the blue line runs significantly higher as we cross into 2016:
…and more importantly, it stays in high territory throughout 2016 and 2017. Meanwhile the next leg of the turbo charged QE was kicking into gear: the rise of passive money investments. Look at how money moved from active into passive funds in the first half of each year, and how this picked up speed from 2016:
And so we dropped quickly back into low volatility territory. So, 2016 is the lesson for what will happen when the next blow up comes. But 2018 can get more euphoric before that happens. At some stage, the passive money machine will realise the central bank money machine is stopping. Overnight, the Bank of Japan cut its purchases of >10y bonds by ¥10bn. The ECB is following suit, albeit slowly. If we go back to Coeure’s chart, we can see that it was a year after the APP began when the portfolio shifts really started to motor; and a year after that when the passive money inflows accelerated. So, it’s going to take some time before the market’s accelerator pedal realises the car is out of fuel.
Blondemoney believes political risk will lead to liquidity events, much as we saw in the flash crashes of 2015-16, and that Brexit, with its ticking clock deadline, provides the spark. We won’t escape this year without a wobble of some kind, with the realisation that developed markets have gone the full emerging market.
Until then, it’s like Loreen said:
Forever, ’till the end of time
From now on, only you and I
We’re going up, up, up, up, up, up, up…