Volatility returned to financial markets with a bang in the first quarter. After a strong positive start to the New Year, signs of rising inflation and a resulting shift in expectations over the trajectory of US interest rates prompted an abrupt turnaround in sentiment that left broad global equity benchmarks with negative returns over a calendar quarter for the first time in two years. Core government bond markets, by contrast, began the period with sharp losses before bouncing back as stock markets sold off. Meanwhile, on the geopolitical front, growing concerns over President Trump’s protectionist agenda added to the bearish mood and kept the US Dollar under downward pressure.
In terms of recent market history, and with specific reference to Wall Street’s S&P 500 Index, the period under review was notable for a number of milestone events. These included: the best January since 1987 (+5.62%); the first negative monthly return (in February) for 16 months; the largest ever daily spike in volatility (+20.01 points in the VIX index on 5th February); the worst weekly performance since January 2016 (-5.95%, from 18th to 23rd March) and the biggest one day gain (+2.72% on 26th March) since August 2015. On top of that, the 10.16% peak to trough fall suffered by the US market between late January and mid-February brought an end to the longest sequence without a 5% drawdown – 404 trading days – in the market’s entire history. As dramatic as this all sounds, however, the net result of all those ups and downs was a modest 1.22% loss for the quarter.
Though painful for any holder of equities, the spike in volatility that accompanied the market’s decline proved disastrous for participants in so-called “short vol” strategies. Thanks to the lack of (specifically downside) market volatility described above, alongside the traditional activity of writing/selling options for hedging purposes, shorting stock market indices as a stand-alone strategy has gained hugely in popularity over the preceding 2-3 years, with both institutional and private investors. So much so in fact, that, at the US market’s peak on 26th January, the capitalisation of “Inverse Volatility” S&P500 ETFs traded on the New York Stock Exchange was just under US$5 billion. Less than two weeks later, however, the toxic combination of a falling market, a high level of embedded convexity in their underlying options plus leverage saw the share prices of the two largest ETFs, representing most of that US$5bn, down more than 90% (Fig. 1) (one of them was subsequently closed down). The scale of losses elsewhere is unknown, but it’s a sure bet that the capital deployed through proprietary and unlisted vehicles was many multiples of that in quoted funds.
For the fifth quarter running, the broad emerging market benchmark outpaced its developed counterpart by a meaningful margin; since Q1 2016 the MSCI EM Index is some 18.11% ahead of its World equivalent in USD terms (+39.77% vs. 21.66%). Remarkably, it is the longest period of EM outperformance for more than a decade.
The quarter’s action played out against a backdrop of economic data that, for the most part, yielded few negative surprises. These included increases in the Composite Purchasing Managers Indices (PMIs) for the US and China over the previous period – up 1.7 and 0.3 to 55.8 and 53.3 respectively – which were mostly driven by healthy gains in service sector activity. Their Q4 GDP growth, meanwhile, came out marginally ahead of forecasts at +2.9% and +6.8%. The exception to this generally favourable trend was the Eurozone, where the corresponding PMI figure disappointed on the downside with a quarter-on-quarter drop of 1.0 (albeit to a still relatively elevated figure of 57.1), while industrial production, at an annualised 2.7%, also trended lower and fell short of expectations. GDP growth held steady +0.6%, for a year-on-year 2.7% improvement, which was in line with forecasts.
On the corporate front, reported earnings, both globally and in the US, grew by around 2% for the quarter (approx. 13% year-on-year in each case), putting the MSCI World and S&P500 indices on trailing Price/Earnings ratios of just over 19x and 21x respectively. In contrast to last year, when, unusually, expectations proved to be too conservative, current forecasts of 20+% earnings growth for the year (per Bloomberg) seem a tad unrealistic when viewed against the latest set of results. Where the US is concerned, this certainly fits in with a rise in the index of negative earnings surprises, although it’s worth noting that it (the index) remains at relatively modest historical levels. On a more positive note, global M&A volumes saw a sizeable increase, with the value of announced deals rising by 19.4% to US$1.6 trillion for the three months from December-end; for those who subscribe to the view that market tops tend to coincide with a blow-out in take-over and related activity, this is still some way below the peak seen in Q4 2015 (Fig. 2).
As we have contended for some time, a correction – “reality check” – of the kind we have just witnessed was long overdue. Accordingly, for those of us that have a few more hours in the logbook than many/most of the pundits, reporters and, indeed, market participants out there, the suggestion that we may have witnessed a watershed moment in the market cycle is, at this point, wide of the mark. While there’s no question that this was an unusually volatile quarter, it is only within the context of the recent benign market backdrop that the kind of hysterical media reporting of the period’s events can begin to make any sense at all. Needless to say, notwithstanding the preceding statement, we are monitoring data and news flow closely for indicators that may lead us to change our view.
Based on the combination of solid fundamentals and a supportive macroeconomic backdrop, then, we are maintaining our positive view of equities. Having said that (and at the risk of stating the bleedin’ obvious), given that we have just passed the ninth anniversary of its beginning, we’re clearly closer to the end of the current bull market than the start. As such, considerations and decisions relating to manager selection and style – active versus passive, growth vs. value, long only vs. long/short etc. – are arguably more important than at any time during the past two or three years. In this regard, we remain comfortable with the quality and composition of our current cohort.
The first half of the period under review saw sizeable falls in core government bond markets in response to a firming in US wage data and the potential inflationary impact of large-scale tax cuts. The yield on the benchmark ten-year US Treasury climbed from an opening level of 2.41% to 2.95% (a four-year high), the equivalent Bund from 0.43% to 0.77% and the corresponding Gilt from 1.19% to 1.65%, which, in price terms were not inconsiderable declines of 4.78%, 2.63% and 3.97% respectively. Whereas the aforementioned retracement left the German and UK (10yr) yields little changed for the quarter (+7 basis points at 0.50% and +16bps at 1.35%) and within established ranges, the Treasury’s’ 2.74% closing level (+33bps) signalled a clear breakout from its previous trading pattern and was the highest quarter-end figure since December 2013 (Fig. 3). The returns for Bloomberg’s US, Euro and UK government bond (>1year) indices for the period under review were, respectively, -1.18%, +0.24% and +0.07%.
In credit markets, the benefits of the later rally into safe haven government bonds were offset by a widening in yield spreads as risk assets sold off. That left EM sovereign, investment grade corporate (IG) and high yield (HY) indices all in red numbers over the quarter for, in the case of the first two, the first time since Q4 2016 and, for the HY benchmark, Q4 2015.
As we have described previously, one of the ways in which we choose to gain exposure to fixed income markets is through the selection of strategic bond fund managers, our rationale being that allocating capital to the smartest managers operating “go anywhere”, flexible mandates (albeit with sensible risk-based constraints) provides the best opportunity to extract value from an asset class facing potential headwinds from the gradual normalisation of global monetary conditions and interest rates. Despite enjoying the same freedoms offered by relatively unconstrained mandates, pursuing the same broad objectives and aiming for similar return/risk characteristics, the two “strat bond” managers through which we have chosen to invest have historically gone about the task in very different ways. Nevertheless, their general market views have, for the most part, been broadly similar. More recently, however, we have seen a meaningful divergence in their top-down perspectives: while one has maintained a macro-positive – short duration/IG credit-focused – strategy, the other is positioned for a less favourable economic outcome and has increased both duration and sovereign content in anticipation of less favourable economic conditions. Though this latter view is not aligned with our own, we are content to hold the fund, as both a hedge against the first manager’s bullish stance and based on its manager’s track record of generating consistent levels of alpha from a bottom-up stock selection.
Perhaps the biggest surprise of the quarter under review was the absence of even a semblance of US Dollar strength at a time when investor sentiment turned bearish; in normal circumstances, the US currency can be expected to benefit from a risk-off environment. After sliding throughout January to a four year low, the trade-weighted DXY Spot Index stayed within a narrow trading range for the remainder of the period and closed down 2.34%. Only the Canadian Dollar (-2.55%), Swedish Krona (-1.90%) and Australian Dollar (-1.66%) declined in US Dollar terms among the major currencies listed by Bloomberg, whereas the Japanese Yen definitely lived up to its safe haven status, hitting a fifteen-month intra-period high on its way to a 6.03% gain vs. the US Dollar (Fig. 4). The GB Pound was also a notable gainer, hitting a post-Brexit high of US$/£1.4877 during the quarter before ending up 4.33% in US Dollar terms as it edged up towards the top of its recent €/£1.11 – €/£1.15 trading range versus the Euro.
One factor that is said to have contributed to the US Dollar’s weakness is the declining level of US Treasury purchases by non-US investors. Statistics don’t bear this out, however: over the period since the US Dollar’s slide began in December 2016, net foreign inflows have held steady within an (admittedly) broad range. It is worth noting though, that total net issuance has risen during this time.
Despite little change in broad benchmarks – the Thompson Reuters/CRB Commodities Index was up 0.77% in US Dollar terms – there were some significant and divergent moves in individual commodities’ prices over the period. Among agriculturals, gains of 35.10% in Cocoa and 10.55% in Corn (maize) contrasted sharply with falls of 20.24% in Lean Hogs and 18.54% in Sugar (all prices refer to the generic futures contract in US Dollars, per Bloomberg). Base metals, meanwhile, were mostly weaker: Aluminium and Copper lost 11.62% and 8.33% respectively, with Nickel up 4.23%.
Within the energy complex, a tighter demand/supply picture, due in no small part to producing countries’ continued adherence to reduced output quotas, sent Crude Oil prices to a four-year high, with the front-month futures contracts for West Texas Intermediate and Brent closing out the quarter at US$64.94 and US$64.94 for gains of 7.48% and 7.75% respectively (Fig.5). While we pointed out in our last commentary that the US Dollar’s weakness had served to dampen the inflationary impact of higher (US Dollar) crude prices, the latest quarterly advance means that even when measured in Euro, Renminbi and Yen terms, the year-on-year increase – respectively +11.68%, +22.69% and +17.62% – is significant.
[Source: All chart data sourced from Bloomberg - April 2018]