It has been a turbulent week in markets with the US markets down over 10% from their January high point. It is the US market that has driven the selloff but, as is to be expected, the rest of world has followed suit with the FTSE 100 Index currently down 7% year to date at the time of writing. While rising interest rates may have kicked off the falls, technical factors kicked in on Tuesday making things much more dramatic. We should keep in mind that, whatever the explanation is, the global economy is broadly in a healthy state with low unemployment and companies' earnings continuing to grow. Below is an explanation of what has happened, which may initially seem complicated, but when we look through the noise, companies and economies are generally strong which in the long run supports equity investment.
Since the financial crisis of 2008/9, markets have seen support from central banks who cut rates and then bought bonds to boost economies. Cutting rates in reaction to falling markets was not new following the 1987 crash. Interest rate policy, which had been tightening, reversed but then tightening resumed as the markets recovered. Since the early eighties, interest rates have been cut in response to economic and stock market woes. Each time as markets recovered, rates rose but not as much as they had been cut. With interest rates around the world falling to close to zero, or even negative in some cases, central banks resorted to buying bonds to further stimulate the economy. Markets had come to see this as an effective put option preventing large falls. Over time this has reduced market volatility and some investors began to think that this would carry on for ever.
The US Federal reserve ("Fed") started to raise rates in December 2015. They carefully managed expectations to avoid market disruption, giving guidance well ahead. By the end of 2017, rates had risen five times without any significant equity sell off. Unemployment was falling but wage growth was modest and inflation remained low. At the end of last year, President Trump finally managed to pass his tax reform package. This cut taxes and many companies were seen to be passing this on in bonuses and pay rises to employees. US stock markets took this well and in the first part of January, US equity markets were up over 7%. With easy money, inflation has always been a concern but the deflationary influence of technology, globalisation and an aging population helped keep it low. This January, US bond yields started to rise and the market priced in about three further rate rises in 2018. The Trump boost to an economy that was already doing well raised fears of the economy overheating and rates having to go up faster and further than expected. This caused US equity markets to start to sell off. With interest rates rising, the Fed Put option was no longer seen as a support.
Volatility trading makes it worse
This is the point where things became technical; during the period of low volatility leading up to the sell-off, investors had felt it was safe to sell volatility. They were able do this in a number of ways. They could sell put options and take the premium if the market held up. They could buy structured products that paid a high coupon unless markets fell more than a certain amount, or they could sell volatility by buying an inverse tracker on a volatility index such as the VIX. The VIX index has sometimes been referred to as the 'fear index' because it goes up when markets fall steeply. An option on a market has three main components to its pricing: the length of the option, its strike price relative to the market price and the volatility that can be seen as the probability of a big move. The VIX index is a measure of this last component on the S&P 500 US equity index. If the market is steadily going up, the VIX falls. The index was at record lows last year. There is a futures market on the VIX that the trackers follow. Whilst selling the VIX when it was at record lows may seem to be wrong, because of the structure of the futures market at the time, the carry was high. However, at the end of January, as the market turned, the perceived risk in markets went up and so volatility rose. The issuers of inverse trackers are protected by the terms of issue to prevent them losing money if the index rises so much that the investors capital is in danger of being wiped out. Consequently, as markets fell volatility rose and inverse trackers fell steeply as they are effectively betting against rising volatility. The issuers had to cut positions, buying volatility and indirectly put options, which in turn pushed the market lower. This compounded the effect. These inverse trackers were in effect a short derivative (future) of a derivative (VIX index) of a derivative (options on the S&P) or derivative cubed. After the blow up in credit markets in 2008, investors should have known better.
In short, derivatives cubed made a bad market much worse on Tuesday this week.
Treasury market impact
With tax cuts, rising interest rates and a possible increase in spending, the outlook for US Treasuries was not favourable at the start of the year. Trump's plans were expected to increase supply as the US borrowed more. The Debt ceiling which constrains borrowing needed to be raised or the government would shut down non-essential services. Debt ceiling negotiations between Trump and congress have been held up over immigration restrictions. This has further complicated the situation. After the initial 4% fall on Tuesday, markets had seen a partial recovery when an auction of 10 year and subsequently 30 year US treasuries caused Treasury yields to move up and sent markets back to their lows.
UK market impact
Where the US leads, others follow however the FTSE 100 was in less good shape already. The Bank of England ("BoE") had raised rates in November and Gilt yields were moving higher. Talk of a softer Brexit and these higher yields pushed the pound higher, particularly against the US dollar. With many companies with overseas earnings being impacted by the currency move, the rise in the FTSE was much smaller and the fall more painful than the US market. The BoE Monetary Policy Committee provided little relief with, if anything, a more hawkish stance predicting rates would rise sooner and faster than they expected in November. If economic growth goes on as expected we can expect another rate rise in May. While the FTSE 100 is very international, the bond market is more susceptible to economic changes and these are mired in the fog of Brexit negotiations.
Where do we go from here?
The interest rate rises are a reflection of a strong economy. Company earnings have been robust with 5% sales growth and 12% earnings growth year on year, so far, in the latest US reporting season. When markets fall, one of the buyers of equities may be the companies themselves but when results are due they are prohibited from doing so. With the rapidly approaching mid reporting earnings season, a high proportion of companies are unable to act in this way. The short volatility trackers have been largely wiped out with many fund closings so this will not be repeated. We have Trump's tax cut to come and potential for increased infrastructure spending. On the down side, this may lead to higher inflation and interest rates but the economy is strong. We have a new Fed Chairman whose policies are expected to be similar to Yellen but he approaches the world as a practitioner rather than academic, so it will be very interesting to see his reaction. The next Federal Open Market Committee meeting is on the 21st of March. In the short-term, the next US inflation data release is due on Wednesday next week.
At the moment, markets have given up some of the strong gains from the previous year and the move is unlikely to have much economic impact. However, if it was to fall further then there is a danger that moves on Wall Street spill over into the wider economy. If this were to occur we could see the Fed moving any further rate rises further out. For now, the central bankers here and in the US appear to see this as a healthy correction.
We will continue to monitor developments closely but for now we see this as an opportunity to get money into the market for investors who have been holding cash.
(data source Bloomberg as at 9th Feb AM)
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