In recent months, the market has shown elevated volatility and U.S. equities have given back all gains for the year. On a macro level, even though the economy is doing very well, market worries stem from the tightening of monetary policy, and the trade war between the U.S. and China. On a micro level, even though we are seeing corporations excelling on both the top and bottom lines, there are mounting concerns about the margin pressure from labor, input and freight costs.
The Federal Reserve (Fed) has turned much more dovish in recent weeks. The market is pricing in just over one more rate hike before the end of this cycle. Markets had a sharp rally after the dovish speech from Jerome Powell at The Economic Club of New York, then proceeded to sell off aggressively. This is quite different from early 2016, when a dovish turn of the Fed during the oil meltdown that February reversed the selloff and propelled the risk assets to new highs. Why? I believe the causes are the level of the Fed funds rate and shrinking of the Fed balance sheet. At 2.25%, the Fed funds rate is starting to bite into the real economy. Additionally, the Fed reduces its balance sheet by $50 billion a month – this is a lot of liquidity taken out of the financial system. Quantitative easing was great for asset prices; however, quantitative tightening will depress them.
The meeting between President Trump and President Xi of China at the recent G20 summit gave some hope for a trade-war resolution. Markets rallied last Monday, but then the Huawei news broke, and we ended down 3.5% for the week. Even though both sides want to resolve the trade war, there are two significant barriers. First, the trade war entails much more than trade deficits: It is about dominance in next-generation technology, and how to share influence between an incumbent power and a rising power. This is hard to resolve in 90 days. Second, in the current political climate, a politician not only needs to win, but also make sure his or her constituents know about it. Any compromise by one side would be broadcasted by the other side to augment his or her political capital. This type of behavior makes compromising even more difficult.
Given these headwinds to the market, it is likely that volatility will stay with us for the next 12-18 months. How do we navigate this type of market? First of all, stop being short. The wild daily swing hasn’t been fully priced into the implied volatility. There are technical reasons for it, but essentially the implied volatility hasn’t fully reflected the much higher realized volatility.
Also, this higher-volatility regime will test the robustness of post-2008 new financial products. Volatility-controlled funds, risk parity, smart beta and many varieties of quantitative funds have grown popular post-crisis. The next two years will be a test for these funds, and I would avoid them at this moment.
On the buy list, homebuilders and emerging markets look interesting. The U.S. Dollar Index is likely peaking around current levels. Going into 2019 and 2020, when the Fed stops raising rates, the federal deficit will likely grow significantly and the U.S. economy will slow down as the fiscal stimulus slowly fades away. These are all dollar-negative factors. A weaker dollar will be a boost for emerging market assets. For homebuilders, it is well known that higher mortgage rates and labor costs have significantly slowed down construction. The valuation of homebuilders reflects it, as they are all trading at single digit P/E. If the economy really loses momentum, mortgage rates will come back down and the labor shortage won’t be such a big issue. I can see homebuilders doing well in that environment.
Heightened volatility is here to stay, so don’t rush to buy the dip and don’t be short volatilities. The new-volatility regime will test the financial innovations post-crisis. Emerging market assets and homebuilders look attractive in this macro environment.
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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