Normal or systemic markets?

In “The Crucible” Arthur Miller wrote “until an hour before the Devil fell, God thought him beautiful in Heaven”. Granted, equity markets have not exactly suffered Lucifer-like de-ratings lately. Nonetheless, the price action in stock markets around the world is looking less and less healthy by the day. Let us explain: when examining the performance of a given index over a very long period of time, one typically finds that, like most things in life, the distribution of daily returns starts to form a bell-shaped curve. If an equity index has a volatility of 16%, then we generally find that the daily returns fall between -1% and +1% for roughly two thirds of the time. For the remaining one third of the time. These patterns matter tremendously for investors. In a ‘normal’ equity environment, individual equities will be driven by a multitude of idiosyncratic risks. For example, Exxon’s share price will be propelled by changes in the oil price, Goldman Sachs by changes in the yield curve, Amazon by its uncanny ability not to turn a profit, and so on. However, move to the tails and, all of sudden, this dispersion in stock price performance disappears. Instead correlations go through the roof as individual stocks increasingly get driven by a single common factor.

As mentioned in a recent comment on “The Rise in Volatility”, an increasing number of markets have now moved out of the comfortable centre of this Gaussian curve and into the more troubling ‘red zones’ (China, the Philippines and the Czech Republic are the only equity markets still signalling that conditions are ‘normal’ on the behavioral finance grids). So what lies behind this rapid deterioration in the behaviour of global equity markets? Unfortunately, at this stage, it is hard to pinpoint one culprit, but possibilities include: - The obvious fact that we have moved from a bearish to a bullish US dollar trend. Given the existing stock of US dollar borrowing out there, every move higher in the US dollar must trigger some margin calls somewhere (just imagine the poor Russian oligarch who used his ruble assets to borrow US dollars in order to buy up trophy assets around the world). - The accelerating downtrend in commodities, especially in energy prices, which could be either the result of increased supply or the simple fact that China has, over the past year, managed to transform itself from a ‘price-taker’ into a ‘pricesetter’. Of course, the drop in energy prices is positive in that it will increase disposable incomes across Europe and Asia. But the more immediate impact might be that Middle Eastern and Norwegian sovereign wealth funds, or Russian oligarchs, have less capital to recycle into (mostly European) asset markets. - The growing nervousness about central bank activity. A few weeks ago, the overwhelming perception was that although the US Federal Reserve would soon stop injecting liquidity into the system, the baton would be picked up by the European Central Bank which would expand its balance sheet for as far as the eye could see. However, the ECB has lived up to its reputation of always being a day late and a euro short, and as a result the market’s perception of the ECB has now changed. The days when the ECB got given the benefit of the doubt are behind us. Instead, each ECB announcement is now followed by a sell-off in risk assets rather than a rally. This pattern of the market acting like a spoilt child denied more candies by its central bank nanny is increasingly prevalent not just in Europe but also in Japan (where the Nikkei sold off after Bank of Japan governor Haruhiko Kuroda’s latest speech) and now in the US as well (the S&P 500 initially rallied on ‘dovish’ Fed minutes, then sold off when investors decided the minutes weren’t so ‘dovish’ after all). - The weak global growth data. European and Japanese growth have massively disappointed, China’s growth rate is now firmly embarked on a structural downtrend, and commodity producers (Argentina, Brazil, Australia, South Africa and Russia) are facing a number of disappointing quarters. With a third of S&P 500 earnings coming from abroad, it makes sense for equity markets in the US and elsewhere to react negatively to the strong US dollar and weak global growth news that keeps piling up. More alarming for equity markets might be the question of what policymakers around the world do next to combat this weakness. In China, the answer is simple: embrace financial sector deregulation... but can this be achieved if Hong Kong grinds itself to a political stand-still? In Europe, the solution is to embrace quantitative easing... but how much will that really help? In Japan, the answer must be to continue to devalue the yen... even at the cost of killing the domestic consumer. In short, global growth is weak and possibly getting weaker, but the next policy moves are neither obvious nor easy.

The rise in volatility and the behavioral drift towards the ‘red zone’ in most global equity markets could be the result of any, or even all, of the factors above. For now, it is enough to say that we are in a much more challenging environment-one in which deploying capital into risk assets only makes sense if either the given assets’ valuation or momentum are strong enough to justify embracing markets that are increasingly becoming systemic. We tend to believe that the combination of attractive valuations, decent momentum, and markets still acting ‘normally’ can be found today in Chinese equities. But otherwise, we have to acknowledge that there are fewer and fewer places where we can find a positive environment for taking risk.