Can equities still climb the wall of worry?

Yvan Berthoux - 16 August 2018

After the early 2018 equity markets shake-out, equity markets have encountered increasing scepticism under threat of a trade war and related geopolitical concerns. Yet, implied spot volatility in S&P options (the VIX) has retraced impressively, now flirting with the psychological 10 per cent barrier. These are reflected in the lessening of long VIX positions and the increasing of short VIX positions. As a result, global equities have slowly recovered from the February shock and beg the question: are we heading towards new all-time highs?

According to a series of leading indicators, this optimistic take looks vulnerable to an array of negative forces. The current low levels of spot volatility offer a good opportunity for investors to hedge themselves ahead of a new potential sell-off due to the lack of liquidity and the elevated uncertainty haunting the financial markets. For instance, the Economic Policy Uncertainty (EPU) index developed by Bloom, Baker and Davies (2016) has continued to rise in 2018 and displays a much higher risk level than would be inferred from the options market. It is true that the two times series can diverge from each other for quite a while; however, it is important to look at what other indicators tell us about the ‘fundamental’ volatility.

Figure 1

Data source: CFTC, Eikon Reuters, Bloom et al. (2016)

Two other important charts to consider as proxies of market health indicators are the annual change in China’s Total Social Financing (figure 2, left frame) and the major central banks’ assets (figure 2, right frame - G4 stands for Fed, ECB, BoE and BoJ). While the market has been largely focusing on the Yuan depreciation over the past few months in the context of the escalating trade war, China’s credit impulse has been shrinking and currently stands at its lowest level in the past 2 years. In addition, after 9 years of zero or negative interest rate policies (ZIRP and NIRP) and a US$20tr increment to the collective balance sheet of the world’s largest central banks, we wait with bated breath to gauge the equity market impact of these bearish readings. 

Figure 2

Data source: Eikon Reuters

Our global excess liquidity indicator (figure 3, left frame), computed as the difference between global real M1 and industrial production, is also pricing in lower performance in risky assets in the next 12 months. We think that excess liquidity is a useful indicator of both inflationary pressure – in the widest possible sense – and equity performance at a global level and therefore merits some careful attention as we explore the territory of Quantitative Tightening (QT). Therefore, signs of weakening global liquidity represent a strong headwind to the equity market in the medium term, which could potentially offset the strong forces of equity buybacks and fiscal stimulus.

To conclude, our global 2Y10Y yield curve, which we use as one of the inputs of our leading economic indicators, is also showing foreshadowing equity weakness coming ahead. Even though the predictive power that the yield curve has on the economic outlook has been sharply reduced in this prolonged period of unconventional monetary policy, we still think that a contraction of another 50bps will send a strong signal that the late stage of the business cycle is coming to an end.

Hence, combining all the charts together, we think that equities’ performance may be capped on the upside and looks very vulnerable to another sudden spike in price volatility. We don’t see any dramatic correction in the short term, however these quiet, thin summer months hold the capacity for sudden reversals.

Figure 3

Data source: Eikon Reuters



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