Readers, welcome to my new regular column, Short and Sharp. This column consists of fortnightly articles, focused on current market discussion topics, taking a strong point of view and without using a lot of ink – short and sharp.
Fears of impeachment and potential delay to legislative agenda in the United States drove significant market moves and unsettled investors. Global equity markets fell 1% from record highs, recording their biggest single-day fall since November. Bond yields also fell and the dollar gave up all of its gains since the U.S. election. Markets subsequently steadied, but the episode has highlighted recent concerns that markets are being overly complacent about risk.
Volatility has fallen to unusually low levels. The Chicago Board Option Exchange’s Volatility Index, known as the VIX for short, measures the expected turbulence of U.S. stocks implied in the price of options and is considered to be a “fear gauge.” The VIX fell to a 24-year low in early May, briefly spiking last week in line with other market movements. While it may seem positive that markets are relatively calm, low volatility can encourage investors to take more risk, making the financial system more vulnerable to shocks.
You’d be forgiven for wondering how volatility can be so low given the political uncertainty that has been so abundantly on show the past two weeks. But, from the market’s perspective, it’s not just the political headlines that are important, but their impact on the economic and investment outlook.
While it is true that there is likely to be political paralysis this year, most investors had already downgraded their expectations for U.S. fiscal reform and stimulus before the latest allegations hit the Trump administration. So the last two weeks should not impact analysts’ forecasts. Indeed, after the knee-jerk reaction, markets swiftly recovered their losses last week. Of course, if the political uncertainty starts to create a crisis of confidence, then the economy will feel the repercussions. That is something to keep an eye on.
The favorable macroeconomic backdrop is one of the key reasons why volatility has fallen. In the current economic cycle, global growth has been quite low – and low growth tends to be more stable growth. The outlook is for more of this. Recent macro data indicates a continued U.S. and European recoveries, although growth momentum may have peaked in the United States.
In addition, since the financial crisis, consumers, banks, regulators, and fiscal authorities have become more cautious. As a result, economic shocks have been producing little contagion within a country, across countries, within asset classes, and across asset classes. This may be changing: as the global economy strengthens, I would expect caution to gradually erode. The U.S. president’s budget for 2018 certainly seems to suggest that fiscal prudency may be on its way out.
Another factor that has held down volatility is speedy central bank reaction – an economy is simply not allowed to fail these days. But central banks seem to have adopted a more moderate tone in recent months and over the coming year we will see some meaningful changes in policy. I think this is where the key vulnerabilities lie.
The U.S. Federal Reserve will take a considerable step towards normalising monetary policy next year when it starts to reduce the size of its balance sheet. The impact this will have on broader financial conditions is uncertain. Markets have also been pricing in a slower policy rate path than the Fed’s own policy projection (which itself is for very gradual rate increases), leaving them vulnerable to faster rate hikes. Investors should perhaps focus less on the likely disappointment from Trump’s fiscal plans, and more on the risk of sharper monetary policy tightening.
Where does that leave my investment view? Consider that European economic activity is gathering pace, while U.S. growth momentum may have peaked. Political risks in the United States are currently greater than in Europe (although beware the Italian election coming up later this year/early next year). The Federal Reserve is further ahead on the policy normalization path than the European Central Bank – and markets may be complacent about the pace of Fed interest rate hikes.
My answer is clear: reduce exposure to the U.S. in favor of Europe, both equities and credit. I consider that the safe thing to do.
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