February 6th, 2018

Fixed Income Note Morning Note

This equity market sell-off lacks a bogeyman

  • Let’s get this straight first: equity markets are not our thing. However, given the strength and breadth of the sell-off, a commentary is in order here.
  • The sell-off very much looks like a rich men’s panic. Or the lazy traders lament. If you look around a bit, you will find countless of technical explanations for the crash. Volatility recoiling after punters pushed it lower and lower; algos running haywire, etc. Some blame is attributed to central banks, who might take the punchbowl sooner away than expected.

 

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  • We all know the drill. The market has been going up and up, with valuations so stretched and volatility so low that even our central bank overlords had to acknowledge at least some frothiness. This year there was a new twist. There are fears that central banks – the ECB and Fed in particular – might be tempted to tighten policy sooner and faster, given the mostly robust global economic background that has rekindled inflation expectations. While in the recent past expectations of more hawkish central banks tended to flatten yield curves, surprisingly enough we saw the opposite happen. Increases in long term yields outpaced increases in short term yields. And that started to eat into equities as the discount rate for future cash flows kept rising and rising.
  • Now I must admit that I was surprised about people getting caught off guard by the aforementioned central bank expectations. In the fourth quarter it was clear that economic strength in both the Eurozone and US would carry over in 2018. Given the positive output gap in the US, it was reasonable to expect the Fed to lean to four instead of three hikes. And, lo and behold, Fedspeakers are starting to dabble with four hikes. That must have been a rude awakening for many market participants. At the start of the year only two hikes were priced in.
  • But for the ECB it was clear that the economy wouldn’t have much of a bearing on its tightening plans, given the fact the bank is very much on autopilot as far as the winding down of QE and the timing of the first rate hike are concerned. More importantly, core inflation remained as moribund as ever. The ECB has been pushing back against too hawkish market pricing of rate hikes, but with only marginal success.
  • Taking a broader perspective, there’s no fearing of a blow-up in China, like in 2015 or 2016. There’s no Eurozone debt crisis, no fretting about an emerging market slowdown, or any other “angst of the month” (except for the central banks taking the punch bowl away story). If you look at global survey data (Markit PMI’s, OECD leading indicators), or look at data closer to home (US Conference Board Leading Indicators; Eurozone PMI’s and money supply), things are still very much looking up. This is no ‘the-end-of-the-cycle-is-near’ sell-off, a recession scare or any such thing. One could reasonably expect that the economy won’t be able to improve much further from here, and that growth is more likely to cool down than to heat up. However, the bond market is still some way off from pricing in a recession. That is, if you believe that yield curve inversions still precede recessions.
  • Folks will surely be licking their wounds today and in the next few days. For example, Credit Suisse was said to open 10% lower on fears over exposure to complex short volatility products. Undoubtedly there will be more skeletons in the closet elsewhere. But if a garden variety market rout is enough to cause financial instability, we should truly be worried. All the post-crisis regulation would be for naught. Taking a slightly longer term perspective, there is no reason to expect the market not to recover from the hit, unless punters come to their senses and demand less frothy valuations.