Nor­mal or sys­temic mar­kets?

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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.

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