The end of the summer season is coming to an end. August traditionally the quietest month in major markets finishes with investors returning to markets not looking much different from when they left. “Broadly the earnings season has been positive, perhaps most surprisingly in the US although much of that reflected the weaker dollar impact on overseas earnings”, summarizes Mark Tinker, head of AXA IM Framlington Equities Asia. “The dollar of course was supposed to be strong and interest rates were supposed to be rising this year, when in fact the complete opposite has happened. This has helped support US indices, but also dollar linked countries such as much of Asia,” he adds.
The market had several attempts to unwind the low volatility trade, leading to some choppy trading. The fact that equity markets recovered is actually quite encouraging on the basis that it was contagion and portfolio insurance unwinds that represented the biggest threat. According to AXA’s analyst Mark Tinker:
If this is letting the air out rather than bursting a balloon then that is a good thing. If I am a bit more relaxed on equity, I am still nervous that the low volatility trade has extended to other markets, notably the traded prices markets of currencies and commodities. The reality is that there are no long term buy and hold natural buyers of these traded prices markets, only traders and speculators. Despite some attempts to classify them as such, currencies and commodities are not really asset classes and thus a shift in speculation can trigger a sharp spike in volatility. Given the leverage in these markets, a short volatility position could become extremely painful extremely quickly.
The question is that not only should we not take everything for granted (complacency) but we need to look at the world from other investors’ viewpoint as well. For example, it is all very well to say that bond yields should rise because inflation is picking up, but for a manager with a fixed income mandate the question is ‘where?’ they are in the market, no ‘if?’ Equally, it’s easy to say that ‘equities are expensive’, but an equity manager is also simply deciding where not if. Moreover, if it is a tracker fund it is not even making that decision. Asset allocation dominates investor discretion and valuation is only relevant in so far as it changes that (slow moving) decision. The fact that the people claiming that equities are expensive or that bond yields have to rise have been saying so almost continuously for 30 years makes it difficult to decide when ‘the market’ is going to believe them.
As Tinker explains, this touches upon an important phenomenon in markets that our historical/econometric models struggle to cope with: the shifting structure of market ownership.
When equity markets are dominated by US mutual funds, or bond markets by European insurance companies, or currency markets by hedge funds, then the ‘rules of engagement’ can be observed, modelled and hopefully predicted. Much chartism is based on price signals giving us a clue to the rules of any particular market at any particular time. Index funds for example will tend to enhance momentum and their market cap weighting will tend to push liquidity into larger stocks, while driving correlations up sharply. On the other hand, ETFs and thematic investors can lead to increased stock volatility as relatively illiquid stocks get hit with large orders on both sides. Here in Asia we are observing an important phenomenon in terms of individual investors, particularly but not exclusively, via the private banks. Unlike insurance companies and mature pension funds, they are less concerned with asset liability matching in a mechanical sense and obviously have no regulator determining what assets they can hold.
Moreover, as long term investors looking for growth they are far more interested in growth stocks and hence diversified portfolios of thematic growth equities than in holding fixed income. The behaviour looks and feels very similar to that of the US nifty fifty era of growth stocks and mutual funds – suggesting a new set of rules of engagement need to be added back to our modelling.