10 min read 17 Dec 18
Summary: It is easy to lose sight of just how much investors have changed their minds about the global environment this year.
In January the watchwords were ‘melt up’ and ‘synchronised growth,’ today we are again on the lookout for signs of global recession.
How did we get here? There has undoubtedly been a slowdown in the rapid rate of expansion in macro and profits data since the start of the year:
Some indicators are more concerning, such as housing or auto figures in the US, certain global leading indicators, or expectations embedded in the yield curve. Much market commentary continues to fret over the reliability of Chinese economic data and the ability for the world economy to deliver growth with less supportive policy.
However, most global equity declines have been less about growth and more about the role of rising US rate expectations.
After a sustained period in which market beliefs about how high US rates would ultimately go seemed relatively anchored (as reflected in the flattening yield curve) , it was the two phases in which these anchors were challenged that resulted in heightened volatility.
This can be seen in figure 2: where the two marked increases in the Vix volatility index were associated with a step change in US long-dated index-linked Treasury yields.
These moves were also partially reflected in credit spreads.
Nor were these dynamics limited to the US; the two phases saw correlated weakness across global equity markets.
The only phase where growth expectations seemed to dominate was in the underperformance of most major equity markets relative to the US and the strength of the US Dollar in the middle part of the year.
That could however be changing as we reach the end of the year. Recent equity weakness has come in the absence of upward rate pressure and even yield curve inversion. It remains to be seen whether this dynamic will become more pronounced.
If the global discount rate was the main event in 2018, there were some other notable episodes that were more idiosyncratic in nature.
It has been easy to find things to worry about in European politics this year but perhaps the most notable market price action came in Italy in May.
These moves were arguably so large because the binary nature of the risks involved and the unpleasant echoes of previous periods of stress. Sentiment shifted accordingly.
The Italian equity market went from one of the stronger performers early in the year (with the banking system seen by rating agencies as on course for strong recovery) to delivering a double-digit negative return by year end. Meanwhile Italian banks are once again seen as deeply vulnerable.
Not helping the cause of Italian banks in the middle of the year was exposure to Turkish assets. In part related to the rate trends and US Dollar moves mentioned above, both Turkey and Argentina saw extreme currency declines that were among the biggest moves in major markets.
We wrote about these issues at the time, but it is worth noting the different paths the currencies have taken since then. Turkey has recovered relatively materially in spot terms, while Argentina has not.
As shown below, since the very start of August – before the most extreme declines in each currency – the Turkish Lira has actually delivered a positive total return versus the US Dollar (+2.2% using Bloomberg data). Sterling and Euro investors will have had more favourable returns.
Clearly, returns over 2018 as a whole will still be poor, but it was the August phase which represent the headline-grabbing moves and the peak of investor pessimism. We believe that it is such phases of deep stress that often represent episodic investment opportunities.
It is also worth noting that recent positive returns were delivered against the backdrop of October’s sharp decline in risk assets. Few would have expected this (and perhaps fewer risk models) but it is a phase that again illustrates how episodes can change the risk properties of assets.
More recent idiosyncratic episodic behaviour appears to have taken hold in Mexican assets. Against a background of concern about political developments (sparked by the cancellation of airport project and the rhetoric of the new President) Mexican assets have shown independent weakness. Here are the returns on equities over the last three months:
Bond market returns are even more idiosyncratic:
Until very recently, Mexico had been seen as the ‘best of a bad bunch’ among emerging markets, and the equity market has typically traded at a premium to most others in the world. Recent moves seem to have brutally reminded investors that any asset can be risky.
As we have written before, longer term structural shifts from pro-capital to anti-capital regimes can clearly make a huge impact on investors and are almost always far more important than the type of political developments that dominate short-term attention. However, the nature of recent price action looks interesting, given the rapidity of moves, their independent nature, as well as some recent signs of recovery which might indicate that value might be starting to act as a driver of price.
The observations above have one thing in common: they reflect huge changes in sentiment among investors. None of us should be surprised about how often the consensus is shown to be wrong. And yet it is very hard to fight off the temptation to go with the crowd.
The major shift this is year is in how degree of pessimism about global growth today is almost the mirror image of the optimism that existed this time last year.
Equally, the issues we thought were important proved not to be: when investors were worried about NAFTA’s impact on Mexico, they should have focused on domestic politics; concerns that the Turkish currency couldn’t recover without major policy change ignored the scope for the current account to adjust more rapidly than expected or the oil price to fall; those happy to hold negative yielding Italian two-year bonds based on a view that only QE mattered would suffer big losses…
This is in no way to mock market commentary: if pushed to make a forecast, many of the episode team would also have held consensus views. The point for investors is to try to ignore the things we are most confident about and acknowledge how surprised we frequently are. If we can do that, identify when market valuations are giving us good compensation for all types of risk, and spot the environments when market participants seem more worried about short term price moves than what matters over the long term, then we could be well placed to benefit from the opportunities that 2019 will bring.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.