Two thousand seventeen was one of the quietest years in the market. Many volatility indicators reached record lows during the year and selling volatility and buying the dip were two of the best-performing investment strategies.
Everything changed last week. Volatility came roaring back at more than 3% daily during the week of February 5th. So, why did volatility suddenly come back? Will it revert to 2017 lows?
I think the economy is the fundamental driver behind market volatility. We have lived in a low growth, low inflation economy post-crisis. Due to slow economic growth central banks all over the world have to make sure financial volatility will not drag the economy into recession. This is why every dip, be it caused by a Chinese currency devaluation or an oil bust, have all been great buying opportunities. The central banks need to support asset prices so that the financial market won’t hurt economic growth.
But this post-crisis economic environment is changing. The global economy has significantly strengthened in the last 12 months. The U.S. economy is booming right now, and we are getting strong doses of fiscal stimulus at the same time. With the tax cuts and last week’s budget deal, we are looking at a more than $1 trillion annual budget deficit in the next five years. I expect these fiscal stimulus measures should keep the economy growing for the next few years.
So now we have a strong economy plus a highly stimulating fiscal policy. If the economic theory works, we should expect to see higher growth and inflation.
One good analogy for the current economic situation is driving a car up and down a hill. The Federal Reserve (Fed) is the driver, and the economy is the car. Post-crisis, the Fed was driving uphill, the hill was steep and there were bumps along the way. The Fed had to step on the gas hard, even harder when the car hit a bump. This was a tough ride, but the risk of accident was fairly low because the car was not moving fast. As long as the driver stepped on the gas hard enough, the car kept climbing without accident.
Today, we are driving downhill and the speed is picking up. If the driver steps on the brake too hard, the car might crash. If he steps on the brake too slowly, the car might accelerate too fast and lose control.
Back to the market, a few things worth mentioning here:
- The market liquidity was weak when volatility picked up. When I was transacting mini S&P 500 futures during this time, the price I could get would be a few points away from what I saw on the screen. Years of regulation has taken away banks’ risk-taking capacity, and high frequency trading has weakened the market structure. Indexes can move 10 points without much trading. This shows how thin the market is. This low liquidity environment will make the next bear market more violent.
- The mentality of buying the dip is so ingrained in the market now. Recent volatility does feel like it is driven by some mechanical selling from short volatility exchange-traded notes and quant funds. But the call to buy this dip is so widespread, which makes me feel a little uneasy.
- When New York Fed President William Dudley was asked about recent market volatility, he said “I‘d say this is small potatoes.” He believes that the economy is strong enough to navigate this financial volatility now. This is how a strong economy reduces the central bank’s support and increases financial market volatility.
- Last week, the Bank of England’s Governor Mark Carney said this at their February rate meeting: "It will likely be necessary to raise interest rates to a limited degree in a gradual process, but somewhat earlier and to a somewhat greater extent than what we had thought in November." Again, this is a sign that a stronger economy leads to tighter monetary policy, and potentially higher volatility.
Looking at the market, equity is oversold now, so I am mostly in the buying the dip crowd. The treasuries have performed very poorly during this risk-off event. Ten-year rates sold off during the week. I cannot imagine how they will perform if the market quiets down. Higher growth, higher inflation, higher fiscal deficit, less demand from Asian countries and petrodollars are all headwinds for treasuries. I like to own the front end treasuries and short the long end treasuries.Key Takeaway
A booming economy might not be that great for financial assets. Be prepared for a more volatile market. Treasury rates should continue to move higher. The chart this week shows how financial markets have greatly outperformed the economy post-crisis. How this divergence is resolved will be very interesting to watch in the next few years.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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