There are a few things occurring in markets that warrant a mention. We are not exactly sure of their immediate significance, but in the big picture, they are warning signs of trouble ahead.
First, implied volatility in G7 FX markets has dropped to levels last seen in June 2007 (see chart above) – just prior to the onset of the financial crisis. Second, 30 year bond yields in the US are at the low point for the year and are down over 50 basis points for the year to date. The US yield curve is flattening quite rapidly – an occurrence we would associate with a tightening cycle (and they say tapering is not tightening!).
Taken together, these events, along with a lower Gold price in the last few weeks, are more deflationary than inflationary. Of course, these markets may well be getting it all wrong, and the US and Global economies may be getting ready to launch into escape velocity. However, despite more than 5 years of unprecedented central bank stimulus, such an economic nirvana is still proving elusive.
In equity land, markets have been buffeted by better than expected corporate results on the one hand and heightened geopolitical risks on the other. We continue to be amazed by how the media and investors buy into Wall Street’s narrative that earnings beat expectations. Individual companies like Apple appeared to have genuinely delivered a positive surprise but, across the broad market, earnings are only better than beaten down expectations. According to Factset data, at the beginning of 2014, consensus expected Q1 earnings to grow by 4.3% year on year. Barely 4 months later, by early April, downgrades had reduced this to a decline of -1.6%. We have not added up this week’s results yet, but what we know that Q1 will barely scrape into positive territory year on year compared to expectations at the start of the quarter of +4.3%. So yes, officially a better than expected results season, but only better than depressed expectations and basically showing no growth year on year. We don't think that is very impressive, especially considering the effort that goes in to crafting earnings via accounting gimmickry and share buy backs.
Of course, so long as market momentum is positive, the market doesn’t care about risks, whether earnings, geopolitical, economic or otherwise. This environment seems to fit hand in glove with the low growth/high liquidity environment we have seen for years now. We continue to watch for signs of whether the low growth/high liquidity environment will change, and if so, try and predict how markets will react. The point is that the current environment could prove to be an unstable equilibrium leading to future volatility. Any change (in either the growth or liquidity mix) could lead to dramatically different market prices concurrent with a pick-up in volatility.
Next week will likely see the FOMC reduce QE by another US$10 billion. We continue to believe that less liquidity is being pumped in really matters and that equity markets are vulnerable if momentum and sentiment shift away from bullishness. Next week will also see the release of US Q1 GDP (consensus at 1% according to Bloomberg) and the April employment report which should show signs of economic improvement for Q2. Although we fully expect a decent pick-up in growth during Q2, any signs that this is not happening could well be taken badly by the equity market, especially the high growth sectors that have recently stumbled.
Equity markets are priced for perfection as indicated in the chart below (courtesy of Smithers & Co) that shows the valuation of the US equity market as measured by q ratio and CAPE.
This interpretation of the q ratio and CAPE shows their value relative to their geometric average. What is clear is that current valuation has only been exceeded at the height of the bubble in 2000 and is consistent with the 1929 bubble peak and other notable peaks, all of which led to extended periods of poor equity market returns. We readily admit that these valuation techniques are far from perfect in predicting short term market moves but their use for long term investors is simply not in question. Given current valuations, the market will produce mediocre (possibly negative) returns over the next 7 to 10 years.
Back to the slate of important data next week. If growth shows a robust pick up, then the recent decline in bond yields will be reversed and the market will again focus on potential rate rises starting next year. Dramatically higher yields may well curtail any strength that better data may encourage in the equity market, but we would expect some short-term strength. If the reverse happens, and the data is poor, then expect downward pressure on yields and greater deflation concerns that should also pressure equities. We also believe that the US Dollar is very sensitive to out of consensus data next week. Indeed, strong data coupled with a weak EU flash CPI number on Wednesday could finally put a strong bid under the Dollar.
Our current message is that the unstable equilibrium of low growth and high liquidity is coming to an end and will result in a step change in market pricing in the months ahead. Equity markets are priced for perfection and we strongly believe that lower prices will result as the current equilibrium changes. Bonds are currently indicating an increasing worry of deflation/recession in the quarters ahead and are therefore vulnerable (perhaps temporarily) if growth rebounds strongly in Q2. Regardless of which event plays out in the short term, we fully expect volatility to increase at some point, and this should be to the benefit of tactical managers rather than buy and hold managers.