The return of volatility

Market Update , Multi Asset 10/11/2018
Reading time: 2 minute(s)
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Equity markets sold off heavily over the last 24 hours with the S & P 500, the Nikkei and the Hang Seng Index losing around 4 percent each. European equity markets have opened down 1.5 percent today, adding to Wednesday’s 1.5 percent pullback. Volatility as measured by the VIX index – Wall Street’s so-called fear barometer – has surged by 40 percent to 23 percent.

What are the factors behind the market weakness?

  • The recent rise in U.S. Treasury yields with ten-year maturities breaking above the 3-percent level is leading to a re-evaluation of a broad range of assets. This applies in particular to growth stocks where a higher discount rate leads to a lower present value, everything else being equal.
  • Although the implementation of punitive trade tariffs between the U.S. and China has not yet resulted in a broad, tangible impact on global growth, there are cracks appearing. For example, car sales in China dropped in September, and luxury goods sales have recently slowed given the stricter enforcement of Chinese customs rules.
  •  The Italian budget stand-off remains unresolved with the governing coalition taking a confrontational stance versus the European Commission.

What is our view?

  • The increase in U.S. Treasury yield has been driven by a robust U.S. economy growing at 3 percent, with unemployment at a record 3.7 percent low and (still) contained core inflation of around 2 percent (as measured by the U.S. Federal Reserve’s preferred core PCE metric). Fed Chairman Jerome Powell recently expressed his confidence in U.S. economic prospects, hinting that the Fed will continue on its hiking path. Our proprietary model for forecasting the U.S. ten-year Treasury yield points to little upside from current levels. Even if the U.S. economy didn’t slow down in 2019 – we currently see U.S. economic grow reaching 2.4 percent in 2019 versus an estimated 2.9 percent in 2018 – there is a possibility of the ten-year Treasury yield climbing towards 3.5 percent, according to our model. Clearly, a brisk increase in interest rates is a negative for risky assets, and the recent surge in yields has been a driver of market weakness. However, if our central scenario materializes, the probability of a further surge in U.S. yields appears highly unlikely.
  • The International Monetary Fund has recently revised down its global growth forecasts for both 2018 and 2019 from 3.9 percent to 3.7 percent, respectively, referring to a potential fallout from trade frictions and weakness in several emerging markets. The revision is moderate and the overall picture remains supportive. However, a sharper-than-expected slowdown would pose a clear threat to equity markets via downward earnings revisions.
  • Even though the Italian budget stand-off has not led to contagion beyond Italian-related assets, a disorderly widening of the spread between Italian government bonds and German government bonds could add to market stress. However, higher spreads might turn out to be a necessary evil to sharpen the minds of the Italian governing coalition in their confrontation with the European Commission.

How are we positioned?

  • We run a moderate underweight stance towards both equity and government bond markets as we see little near-term potential in both areas. Interestingly, government bonds are losing some of their diversification power in balanced portfolios with government issues barely rallying during the sell-off.
  • Within risky assets, we express a preference for high-yield bonds and commodities.
  • We stick to our longstanding overweight position in alternative strategies.

Overall, the current correction shouldn’t come at a complete surprise given that clouds have been building on the horizon for a while. As we believe the threat from surging bond yields is overdone, the current weakness might offer tactical buying opportunities, provided corporate earnings don’t disappoint. Therefore, the forthcoming earnings season will provide more visibility in this respect.