Roller-coaster ride lies ahead
Volatility is what markets are about, there is no ‘normal’
THE old financial market maxim “The trend is your friend” has rarely been more appropriate than when applied to recent falls in the oil price, government bond yields and the euro, which have been nothing short of dramatic.
But investors enjoying the ride should make sure their seat belts are fastened. Although the trend might well have a good bit further to run, the risk of sudden reversals is growing by the day.
A look at how equities have performed over the past two years shows that the S&P 500 has risen about 40% on its way to a series of record highs. But there have been 10 swings lower of 4% to 10% in that time.
Since the oil price started tumbling in the middle of last year, however, there’s been barely a single noteworthy snap back of 5% or more.
The fall has been both precipitous and relentless. The picture for the euro and bonds is similar.
But the pullbacks and spikes in volatility that have characterised stock market movements are bound to hit oil, bonds and the euro in time.
“These market moves have very little to do with fundamentals, and could create opportunity,” said Valentijn Nieuwenhuijzen, at ING Investment Management.
“Almost always such moves are opportunities.”
A significant, if unquantifiable, factor behind the rapid acceleration in market momentum recently is automated trading.
Momentum funds and algorithmic computer models are playing a bigger part in financial markets than ever before.
Central to the swings across all financial assets is oil.
Slowing growth in demand and (more pertinently) plentiful supply as producers refuse to cut output pushed Brent crude futures below $50 a barrel this week for the first time since 2009.
That marks a 55% decline in six months and a 40% fall in the past two months alone.
Moves of such magnitude over relatively short periods are often evidence that prices have overshot.
However, the oil market is no stranger to longer-term price swings.
As Reuters Breakingviews columnist Edward Hadas points out, since 2000 the daily price has been on average 18% higher or lower than six months earlier.
If the fall in oil has been eye catching, the move in bond markets has been historic.
The benchmark cost of 10-year government borrowing reached record lows this week in Japan, Germany, France, the Netherlands, Austria, Belgium, Finland, Canada and Australia.
The average 10-year yield in the G3 economic powerhouses of the US, the eurozone and Japan fell below 1% — the lowest on record, according to Steven Englander, global head of currency strategy at Citi.
By this measure, investors are pricing in a world economy that is in a worse state now than it was in the Great Depression of the 1930s or during the global financial crash of 2007-09. Is that really the case? If the answer is “no”, there is a growing risk that massive one-way bets on oil, sovereign bonds and the euro would be vulnerable to a violent reversal, especially as central banks are almost out of ammunition in their fight against deflation and sub-par growth.
Englander said: “What are they going to do for an encore?”
Like most people in currency markets, he expects the euro to remain under pressure. The currency hit a nine-year low of $1.1753 this week, a whisker off its January 1999 launch rate of $1.1747.
Englander and Nieuwenhuijzen agree with the market consensus that corrections and bouts of volatility will not translate into longer-term trend reversals.
The longer-term investment strategy, therefore, would be to sit tight.
Investors with a shorter-term horizon, however, would do well to protect themselves against prospective turbulence.
For example, even if you still believe oil prices are headed lower, you could hedge by buying shares in commodity-related companies that are likely to benefit from continued strength in broader equity indices.
Buying an equity market volatility index such as the VIX at the bottom of recent ranges and selling at the top is another simple way to protect yourself against sharp price moves. —