Author: Scott Brown, CFA, Founding Partner
An interesting thing has happened on the way to tighter central bank policy and looser fiscal policy. Risk aversion awoke, at least for a while. While we would term the rather pedestrian downdraft in stocks as nothing to write home about historically, the market for equity volatility did blow up as we had expected it would. That has perhaps ushered in a new market landscape that may force investors to reduce risk because it exposed how unsteady the equilibrium has been.
We have argued for years that the central bankers were trapped in emergency policies because the world had become addicted to them. We called it “Hotel California.” It’s important to realize that even the onset of minimal quantitative tightening in recent months has resulted in more volatility than we have seen in years.
At the same time, our current read is that the real economy may have seen its best point of the cycle. Most forecasters are not accounting for obvious special factors that are driving recent economic activity. As a result, the Fed may back away from tightening once it realizes that growth is not meeting targets.
As we have also discussed, central bank largesse encouraged participants in the markets and the real economy to add ridiculous amounts of debt in this cycle because money was considered “free.” All that additional leverage on top of already high debt loads means it does not take a major move higher in interest rates to upset the status quo. Mortgage rates at four-year highs are but one major drag. Corporate loans are impacted by rising short rates.
Rising yields are being disproportionately blamed for the downdraft in stocks. The reality is that stocks were and are at unsustainable valuations over the long-term. Most other discussions are a distraction from that fact. Short-term predictions about price moves are always guesswork and speculation.
Historically low measures of volatility were simply one manifestation of ten years of overly involved, coddling central bankers. It was one symptom of the disease of reckless monetary policy. The new chair at the Fed, Mr. Powell, is left to clean up the mess he helped create in his prior role there as he gingerly tries to normalize policy.
As for the fiscal side of things, most of those jokers who went to D.C. to reduce government spending apparently were just kidding based on recent budget discussions. As a result, astounding amounts of deficit spending will crowd out capital from the real economy as most politicians of all stripes don’t care about “no stinkin” deficits. Between the central banks’ quantitative tightening and deficit spending we expect close to a $2 trillion drain on the financial system this year. Markets are awakening to that fact.
Thinking economic growth was finally going to break free after years of malaise, market participants had for months piled into similar bets on growth and reflation, creating some very crowded trades. Suddenly those positions looked too risky once it became clear that many of them were predicated on the ideas that volatility would remain absurdly low and that rising interest rates would not ruin the party.
We suspect many investors have failed to account for the changing liquidity backdrop. We think it’s likely many positions will have to be unwound because the vice grip is tightening. If growth comes in stronger, tighter central bank policy will pressure these trades from the rate side. If growth softens, the fundamental underpinnings of positions will collapse. Add to this the fact that we are late in an economic cycle. That means risks to the downside for earnings and stock prices are high as the growth cycle impetus fades.
When volatility exploded higher, it caused large losses for some participants and the wipe-out of a few volatility-focused ETF’s and hedge funds. Today, the WSJ mentioned some large pension funds and endowments that had been playing this risky game. Remember, a wide range of investors are short volatility whether they know it or not. Essentially, given how stocks became priced for perfection, many a long-only portfolio can be said to be short volatility.
Markets sit at a critical long-term juncture from a quantitative perspective if one looks at bond yields versus stock prices. Bonds have become quite cheap versus stocks. We still suspect that the ultimate low in Treasury yields has not yet been seen. When risky assets are finally sold as the cycle completes, U.S. government debt will receive a tremendous bid.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.