A volatile mix

Henry Adams

Chief Product Officer

Thursday, Aug, 15, 2024

3mins

Just a few short weeks ago we talked of markets being poised for chop. What was not appreciated at the time was how right we would be in such a short space of time. As many were preparing to get away from the screens, compressing a week’s worth of clothing into a suitcase the size of a shoebox, trouble was brewing. Time to relax cut short by the mercy of some staggering market moves. This month we’ll take a deeper dive into what happened as well as what may come…

Macro

VIX, an index capturing perceived volatility of the S&P 500 and a crude but helpful measure of both fear and greed, has had a spectacular ride. Following various data releases and headlines, the index more than tripled from the low 20s to peak at 65 (30 being the point at which one should really start taking note). First it was US jobs coming in softer, followed by news that Warren Buffett had lightened up his stake in Apple considerably. This, along with Japan’s desire to increase rates causing a gigantic unwind of the “carry trade” (whereby folks would borrow cheap Yen, paying almost no interest, to reinvest in markets such as Mexico, where rates of 10%+ could be achieved, unwound), caused the main Japanese equity index to drop more than 12%, a move not seen since the late ‘80s. A cautious Fed did not help. Whilst much of the drop has since recovered, it remains a stark reminder that the environment can change rapidly and without warning. Add to this continued concern around event risk in the Middle East and increased frequency of attacks in the Ukraine-Russia war, front of mind should be capital preservation and risk-adjusted, as opposed to fickle outright perceived, return.

Risk

Tech stocks, arguably the only main driver of returns to date in the US, did not escape the carnage. The Magnificent Seven (largest) names were looking considerably less shiny. However, despite rates having held higher for longer in the US, for now, disaster has been avoided, the NASDAQ (as of Wednesday morning at least) has had a great run, sitting at a return close to 15% since January. In fact, of the major global indices there are only three to have posted losses over this time horizon. China continues to face challenges related to the property market leading, in part, to stresses within capital markets more broadly. This, coupled with a slowdown in the domestic economy as well as the potential for considerable tariffs being imposed not just by the US but Europe too, has affected sentiment and thus potential future returns in the nearer term. Away from there, Mexico and Brazil have had a challenging period driven by political upset and respective governments’ abilities to meet fiscal targets. Sounds familiar, but anyway… for now a problem over there only, apparently. In short, the rally continues with either a soft landing or relief to valuation coming in the form of monetary easing.

Credit

Despite the volatility we have seen, credit spreads (crudely the premium earnt to take on additional risk versus investing in government debt) have compressed . Lower borrowing costs are a good thing provided the risk is correctly priced, as ability to repay and thereby solvency is enhanced. It has been interesting to see that various private market professionals are feeling so bullish that there is a scrap to acquire European consumer loans at a pace not seen probably ever. Whilst summer is known for being quiet, here too activity also remains elevated. The good news? Primary issuance markets are liquid and functional with access to capital and the respective appetite holding up nicely. Emerging market debt has not missed out on the action, showing similar attributes, albeit slightly more muted in terms of tightening of spread. The fuel more recently? A US economy that continues to defy gravity despite what by recent standards remains a higher base rate. Some are not expecting this to go away any time soon, with the potential resurgence of inflation stemming from (regional) deglobalisation as the US will likely be spending the next Presidency bringing much more back onshore. The energy transition will also not be cheap. Jamie Dimon, long time CEO of JP Morgan, recently indicated that rates could well hit 8% in the not too distant future. Feels a little overcooked to me, but either way the impact on credit and spread would be considerable up there.

EUR

Leading on from credit, the ECB recently (8 August) published quarterly data around the percentage of non-performing loans (read borrowers in arrears/default), which remains healthy. Despite rates being higher, we sit at below 2% when assessing holdings on the balance sheets of credit institutions headquartered in the EU. Without doubt both the initial rate cut and future projected path of interest rates has helped lubricate the machine. The market (corroborated to a lesser extent by the recent removal of forward guidance from the central bank) is for an additional 0.25% cut to come at the next policy meeting of 18 September, with a 93% chance of two further cuts to come before year end. In so many ways it was a fantastic Olympics, and from an economic perspective with visitors back in stands, a diametrically opposite outcome for France than for Japan. Growth is expected to be up a whole 0.25% from this event alone. With a projection of 0.33%-0.45% from the Banque de France, this really is significant. Wednesday saw growth data for Europe come out exactly as predicted by leading experts, at 0.36% and 0.6% for the quarter and year respectively.

GBP

Tuesday had everybody, especially the Bank of England looking at what is part of quite a data dump across Western markets this week. Unemployment dropped unexpectedly to 4.2% whilst all-important wage inflation also cooled. It was precisely what the Bank wanted to see. Regular pay growth slowed to levels not seen since November 2021. Don’t get me wrong, I am all for pay rises, but if the sole purpose is to try and keep up with my cost of living, and it comes late, it’s not really winning. More broadly, CPI came in a little higher as predicted for the month, but lower by 0.1% at 2.2%, which further justifies the central bank is properly adjusting for and factoring shorter-term and smaller rises into the broader picture. In terms of where we now stand, the next full cut is priced for November with another in December thus, according to investors at least, we’ll be at 4.50% before Christmas. Worth highlighting though are words the BoE’s Catherine Mann, a voting member who has rightly warned that we should not be relaxed about the war on inflation having now been won. In other positive news, the IMF has changed its tone. The UK is now predicted to outstrip every other major economy in Europe next year; not that it’s a competition of course! Still, I’d rather be first.

USD

Earnings season has been interesting for many reasons. Constituents of the S&P 500, when giving forward-looking projections, have barely mentioned the idea of recession. Whilst it is anecdotal evidence gathered from quarterly earnings calls, it does corroborate one theory which is that the US economy continues to power ahead unaffected by higher rates. Worth mentioning though is that when looking across a longer time series, peak concern over recession from these guys was not a great leading indicator. On the data front, input and output costs have both come down and by more than previously thought, adding to the thinking that more easing is both tolerable and appropriate (so as to avoid recession). Annualised CPI also provided relief on Wednesday, with a print of 2.9%, 0.1% off what had been expected and providing further evidence that prices are getting back under control. In a consumer-driven society, debt burdens of the populous and thus share of income dedicated to servicing debt is a useful gauge. In the US, this is now relatively low at 110%, well inside that of the UK (147%) and Canada (187%). All this points to a healthy and resilient economy which still shows no real risk of shrinking any time soon. Worth being aware of though, leading investment banks have been publishing research of late indicating the odds of recession rising, and according to Goldman Sachs, a very precise 41%.

So what?

Well, money is poised to get cheaper and nearer term rates lower in the almost immediate future, set on a continued downward path well into, and in some cases beyond, next year. Away from the obvious political risks and unknowns (with the US election not far off now) there are signs of discomfort in financial markets. The moves of the last fortnight exemplify this and as always a good way to think about it is to be considerate when allocating liquidity to credit, taking security where possible, diversifying exposures, and last but not least, locking in higher for longer to avoid immediate and continued drops in return.


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