Is the panic over?


Less than three weeks ago, the VIX index (the Chicago Board Options Exchanged S&P 500 Volatility Index – also known as the Fear Index) spiked to its highest level since August 2015 amid concerns of rising bond yields and expectations that the world’s central banks are likely to tighten monetary policy. Global equity market slumped around 10% as did oil prices, while the dollar rallied as traders rushed towards the safe haven of US treasury bonds. Although most analysts were in agreement that risk assets were looking over inflated and vulnerable to a correction, the speed at which the sell-off unfolded triggered alarm amongst money managers.

 

Chart 1 – VIX Index (2013 – 2018)

 

Source: Bloomberg

 

Looking at the markets this morning, European equity indices are a sea of green after a strong US session on Friday. Granted most indicines have only recovered around a third of their losses so far, but the wave of panic that overcame markets a couple of weeks back has passed and the seas appear much calmer again. The question we’re all asking ourselves is whether the volatility a couple of weeks back was a shake out of reluctant long positions or whether it’s a sign of things to come?

 

Clearly we’re not running a hedge fund at Validus and therefore I’m not going to try and make any bold predictions for the direction of equity markets. However, given the impact of risk appetite on all asset classes, the behavior of equity markets can help understand what is happening on a wider spectrum.  

 

A couple of observations worthy of further consideration:

 

  1. As highlighted in previous editions of this report, suppressed volatility often leads to hypervolatility. This has shown itself to be the case here and while volatility may well become suppressed again in the months ahead, traders are likely to be more cautious in the short term while remembering the moves witnessed a couple of weeks back.
  2. History tells us that bull markets typically experience heightened volatility when they are nearing a top. That is not to say we’ve seen the top yet, but the probability has increased significantly in recent weeks.
  3. Finally, the yield curve tends to steepen before the market finally tops out and the economy heads for recession.

 

Stepping back from the markets, many economic indicators suggest that the global economy is doing rather well. The US economy is growing at a steady 2.6%, the Eurozone is now growing 2.7% year on year and while the UK is a little more lackluster at 1.4%, it has been relatively steady between 1%-3% since mid-2010. Meanwhile, unemployment is close to record lows in both the US and UK, and is gradually falling within the Eurozone. Of course, it could be argued that these figures are all lagging indicators as the data tends to be too historic to provide much in the way of insight into what is currently happening let alone what may happen going forward.

 

Chart 2 – UK GDP (Red) US GDP (Green) EU GDP (Blue)

Source: Bloomberg

 

For us, the biggest danger is complacency. In recent years, investors have understandably become increasingly complacent amid low interest rates, low volatility and steadily rising asset prices. At this stage, it appears the market is relatively relaxed about the moves over the last couple of weeks and many see the pull-back as a buying opportunity and a chance to add more risk. Regular readers won’t be surprised to hear that this makes us increasingly cautious and we continue to maintain a contrarian view.

 

What does this mean for currencies?

 

Overall, the currency markets have been surprisingly quiet in recent weeks. The dollar was certainly a beneficiary during the risk off period although the magnitude of the move seen in the dollar index was surprisingly small. With GBPUSD trading back above 1.40 and EURUSD edging back towards 1.24, the impact of a stronger dollar was short lived and fast becoming a distant memory. However, we see the move as an important reminder of what can happen in a risk off environment and this remains one of the reasons why we maintain a marginal bull bias for the dollar in the months ahead.

 

 

Author: Marc Cogliatti



 

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