The big short
Markets have become a lot more turbulent since the beginning of 2015. Inspired by a broadening global recovery and the ECB’s willingness to enter QE space, markets still started last year on a positive note.
However, the benefit of hindsight teaches us that the excess optimism reflected in government bond and real estate markets in the first quarter of last year was actually a first sign that we had moved into a higher volatility regime.
History shows that markets often mislead and that turbulence tends to cluster. Last year, after misleading us all in the first quarter, the unexpectedly sharp correction in the German Bund market in the second quarter was the first “proof” of larger and more persistent market swings. Moreover, it was clearly the start of diminishing risk appetite among investors, as reflected in unusually high risk premia and a decline of investor sentiment metrics to extremely low levels. Our Risk Aversion Index, which consists of a weighted average of risk premia in different markets segments, shows that investors are currently demanding a significantly higher-than-average compensation for allocating capital (with a current score of 72 compared to an average of 48). US investor sentiment has even fallen to lows not seen since the peaks of the Euro and Lehman crises. It should be noted, however, that more globally oriented sentiment surveys are also weak, but less extreme than the US measures.
So, a lot of “short” thinking has been around in markets for the last ten months. Initially, this was mainly focussed on assets with a high interest rate sensitivity (due to the sell-off in German Bunds) and on Grexit contagion. As a result, global bonds, real estate and European equities suffered in the second quarter of 2015. Over the summer, however, the short-play moved back to commodity and EM (related) markets and, with fears of contagion into global growth, driving down equity and real estate markets later in the third quarter.
Ever since then, the rollercoaster ride in markets has continued with large swings in monthly risky asset returns. Part of the volatility in markets was also driven by reduced faith of investors in both the willingness and ability of central bankers to provide additional easing if needed. This probably explains why, initially, government bond markets hardly rallied in the risk-averse environment of the second half of the year. The latter is reflected in the fairly stable evolution of the monthly returns of German Bunds between September and January.
Only during the first two months of this year, market behaviour shifted again. Short-thinking was still dominant, but gradually it morphed from EM/commodity stress with potential contagion risks into DM space to rising worries about US recession risks. The latter then renewed market conviction that more DM policy easing (no more hiking by the Fed, more easing by the ECB and BoJ) might come after all, also because DM central bankers not only talked, but also acted as the Bank of Japan and the Swedish Riksbank cut rates (further) into negative territory.
We assess the fears of a US or global recession to be overdone, but acknowledge that growth risks have shifted down and understand that widespread short-thinking among investors continues to create a fragile market environment. Moreover, negative feedback loops from markets into underlying fundamentals can always alter the future track of the economy. That’s simply the way a path-dependent and complex adaptive system, like our global economic system, works.
At the same time we note that investor pessimism has reached very high levels, as have investors’ cash positions. Combined with renewed commitment from central banks to provide further support and tentative signs of a bottom formation in oil prices around $30, this creates the risk of short squeezes of the risk-aversion trades that investors are holding currently.
All in all, this makes the current environment difficult to read from an allocation perspective. Fear could easily build further in the near term and even create its own reality, but even with somewhat slower growth it seems that markets are overpricing the downside. Therefore, little positive triggers are needed for a normalisation rally that is kicked off by a short squeeze.
This environment keeps us fairly balanced in our allocation stance, but with somewhat more caution in those areas that could potentially create a more lasting negative feedback loop: commodities and fixed income spread products. At the same time, we balanced this somewhat by upgrading the asset class that would benefit most from low, but stable oil prices, more growth-oriented policy action and a reduction in growth fears among investors: equities.
Valentijn van Nieuwenhuijzen is head of Multi-Asset at NN Investment Partners.