Volatility in the equity market has come alive, with the volatility Index 7.3% above the 200-week moving average and looking ominously poised to close above this average – a feat it hasn’t managed since December 2012, although it has tried on at least six occasions since. A close above 17.48% tonight could therefore be fairly telling.
This potential closing break would be important because so many trade structures have been put in place to take advantage of low volatility and positively-trending equity markets. With the S&P 500 ominously poised to close below its November 2012 uptrend (at 1956), the combination of shaky price action and higher volatility is causing income-based strategies to be unwound and a more aggressive style of trading to take over. The combination not only impacts trading style, but has big negative implications for assets like dividend stocks, emerging markets and the AUD.
The question, then, is this: If we know that trading style and asset preference should be altered, is there a reason why volatility has actually increased?
Volatility creates strong disagreement among traders and investors by its very nature – a fear of the unknown that could be driven by a major shift in the fundamental backdrop. It’s hard to definitively say whether anything has structurally changed in any significant way, but there is a strange feeling about the global economy that seems to be taking hold.
Energy prices in freefall
What’s more, we have seen the Federal Reserve increase its balance sheet to $4 trillion through three bouts of quantitative easing, and the Bank of Japan has amassed assets equivalent to 60% of GDP. This comes at a time when rates have been cut below the level of inflation (ie negative real rates) in so many developed countries that investors have had to increase risk profiles and chase real returns. Yet inflation expectations are falling and growth (notably in Europe and Japan) is so poor. Does this mean we are losing faith in monetary policy? It seems so.
Mario Draghi has said time and time again that the ECB can only do so much. This is also true of many other economies, but can we rely on European governments to do what is really needed to increase competiveness; ie undertake structural reform? Again, the answer seems to be ‘no’ and we will need to see some fairly dark economic conditions for this to take hold.
The sell-off in the US equity market was attributed to concerns around German growth, with some also looking at growing ease about Ebola. I think we need to look at comments from St Louis Fed president James Bullard as well, as he explained that he thought inflation was increasing and wasn’t worried about the role of the USD on inflation. When you add in comments from Fed members Stanley Fischer and Jeffery Lacker yesterday, the end result is that perhaps Wednesday’s FOMC minutes rally was totally unjustified.
What’s most important, though, is the major change in interest rate expectations this week, with the market now pricing in the first increase in the funds rate in September. Bear in mind this was set to July last Friday. The Fed funds futures have fallen in response, and are now pricing the Fed funds rate at 58 basis points by December 2015, down from 74 basis points last week.
Vulnerabilities in the US and global economy
Some would say that the falling expectations on tightening is news positive for equities. However, I would argue that this is occurring due to concern around the vulnerabilities of the US and global economy. Recall history has shown that rate hikes in the US have actually been positive for US stocks, but it was because the economy was deemed robust enough to handle them.
Asia has naturally followed the US lead, with a strong underperformance from the ASX 200. The bulls will focus on the fact the index has seen buyers around the 5200 level, but that seems a small mercy and there is a pronounced downtrend in place – it seems that the path of least resistance is lower. Brent prices have fallen another 2%, and this could be a reason why S&P futures have pulled back modestly. European markets face the prospect of a weak open and the bulls will hope for improvement in French and Italian industrial production today. One suspects the negative news low will continue.
Keep an eye on the DAX, with the index trading at what looks like a critical level. As you can see from the weekly chart, today’s cash session looks key, and where the index closes out the week could be important from a technical point of view. Similar to the S&P 500, the index looks set to close below its long-term trend. Bear in mind that there will be further Fed speakers over the weekend at the IMF’s annual meeting and the highlight will be Stanley Fischer’s address on the global economy. Gapping risk for Monday’s open remains elevated.