Volatility returned in February, but not the kind of volatility we have been used to for much of the period since the financial crisis.
Instead of being about growth fears, the catalyst for the equity market drawdowns in early February was pressure on valuations caused by rising rates. In this world ‘good news’ about the economy can be ‘bad news’ for many assets.
No wonder ‘Mr. Market’ seemed confused. The number of Intra-day price swings in the S&P 500 were comparable to those seen in the global recession fears of 2016 (Figure 1 below shows the number times in each quarter that the market hit both +0.5% and -0.5% levels in one day).
Intraday swings need not be the same thing as a spike in the VIX. The latter may simply reflect rapid moves in one direction (usually negative), which can take place because a majority of investors change their minds in the same way at once.
By contrast, frequent changes in direction might be demonstrating the prevalence of conflicting views about the future (I wrote about the nature of beliefs and volatility this time last year). While it could be that we are simply getting conflicting pieces of data in the same day (good tech profits news followed by an angry Trump tweet for example), it seems more likely that the current interest rate dynamic is creating higher ‘pricing model uncertainty.’
For example, a good piece of macro news should suggest positive profits in the future for corporate America and higher stock prices. But the rising rates that could go with such strong data might mean that valuations have to get ‘cheaper,’ potentially meaning lower prices.
In ‘efficient markets world’ all investors would interpret the same piece of data the same way. In reality however, some may place more emphasis on the profits impact and others on the rates impact. This makes assets harder to value, and the range of differing views on the subject can cause more frequent changes in the direction of markets.
Are moves even about rates anymore?
The shifts in market direction made it hard for market commentators to keep on top of explanations for price behaviour. In Q1 narratives changed rapidly. Indeed, by the end of the end of the quarter, commentary seemed to have moved on from talk of rate pressures.
This was a reflection of what happened to prices. Despite ongoing increases in Libor and 2-Year Treasury yields, the yield curve steepening that been associated with the initial bout of equity weakness (see figure 2) had abated. However, this did not result in a US equity market recovery. Instead the S&P 500 re-visited its February lows, suggesting that something else was going on.
We have written before about the dangers of trying to fit a story to price action. It is well known that volatility has a propensity to ‘cluster’, so the fact that equity market volatility picked up in February may be the most important reason for why it persisted in March. However, a couple of stories came to the fore in Q1 that could be significant in the period ahead.
Perhaps the most genuine concern for investors should be signs of possible protectionist tendencies around the world.
In January, Donald Trump imposed tariffs on solar panels and large-scale washing machines. In March this was extended to steel and aluminium and to other Chinese products (largely geared at challenging intellectual property theft).
In themselves, these measures may have a limited impact on the US economy (though some point to the possibility of more meaningful downstream effects). What worries many commentators is the possibility that these are only initial steps, both in terms of where the US may end up (American economists still hark back to the effects of the Smoot-Hawley tariffs in the 1930s), and in terms of possible reprisals from other countries. Yesterday China announced its own countermeasures.
This situation is changing daily, but will need to be watched closely. Though elections often dominate the headlines, the real political issues that matter to investors are often deeper structural forces behind how a society is run. Globalisation has played an important role in the returns of all assets in recent decades, whether it has been in driving lower inflation outcomes and bond yields, or in the ability of global corporations to deliver stronger earnings than they have in the past.
Protectionism could serve to reverse these trends, though the ability to ‘put the genie’ back in the bottle given our increasingly interconnected world remains to be seen, as does the true willingness of politicians to close their economies.
Another big story of the quarter was the large swings in ‘FANG’ stocks in the US. These stocks, some of which are due to be moved into different sectors by MSCI and S&P in September, represent some of the largest companies in the US stock market. Their price moves can have significant effects, both directly on the overall US index, and indirectly on markets around the world.
The FANGS+ index of stocks was up by 25% before falling by 12% from its highs. During the quarter, Netflix was up as much as 73% and Amazon 37%, before each saw sharp declines into quarter end.
We can point to key drivers of the market weakness. Significant roles were played by Facebook (after the Cambridge Analytica scandal), Nvidia and Tesla (after concerns over driverless car safety), and Amazon (after suggestions that Donald Trump would increase regulation).
But is also the case that such volatility is to be expected. What these features have in common with the broader market moves discussed above is the role of pricing model uncertainty. These disruptive stocks are hard to value (as we saw in the tech bubble) because earnings streams are perceived (rightly or wrongly) as less certain.
When there is less of a ‘value anchor’ in the form of stable earnings expectations prices can move significantly. When this is combined with perceived challenges to these earnings in the form of regulation, and the confusion caused by rate moves in all assets it is no surprise to see meaningful short-term gyrations in price.
Behind all these moves were suggestions that global growth dynamics may have peaked, with the flattening of the yield curve prompting a re-emergence of suggestions that we should be worried about an upcoming recession. The idea that the yield curve reflects some information that is not already available elsewhere is an odd one, but it is certainly the case that global growth data has been weaker than expected, though still strong in an absolute sense.
I wrote last month about the attention that has been given to declines in many economic surprise indicators, and we can add to that some mentions of reduced stimulus out of China and signs of softer global trade as reasons to be fearful.
However, these dynamics were also in place in January, when equity markets were very strong. The fundamental economic backdrop must always be considered, but we should be wary of giving more weight to economic arguments just because short term asset price action appears to justify them.
It is worth noting that with the exception of generic concerns about growth, many of the major stories of the quarter centred on the US market (US rates, US technology, the US President). These are undoubtedly significant issues but investors should avoid the trap of focusing on these at the expense of all other factors.
We are beset daily by new information. Some will be useful (signal), but much will be noise. Choosing which to pay attention to is often driven by behavioural forces, both internal (our own emotive responses and biases) and external (how the information is framed). In the Western world there is a tendency for US developments to dominate discourse. This is often appropriate given the size of the market, but it also can create the risk of an overly narrow focus on a few issues at the expense of other signals.
This can be compounded when volatility is high, pricing models less certain, and news is emotive. In the current environment it is no wonder that developments are prompting frequent changes in direction in equity markets and other risk assets. This in turn can create further stress in the decision-making process. Investors need to be aware of these forces in their own behaviour and also on the lookout for the opportunities it can create.