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Summary: This past year was one long roller-coaster ride for equities with the highs and the lows punctuated by a mishmash of mixed messages, misinterpreted signals and even – wait for it – what could be a gargantuan policy misstep.
As planets orbiting stars, financial markets have gone full circle from a year ago. The headlines of late 2017 and early 2018 headlines were replete with bullish noises about how great the economy had become and how animal spirits had been let loose. From early November 2017 to late January 2018 the S&P 500 gained around 11% as logic was left outside in the cold. We didn't buy the hype and our Q1 2018 Equity Outlook was coined “The most important year since 2008” and our main point was:
“For Q1 we acknowledge the strong price momentum and upbeat expectations together with what will likely become a strong earnings season reflecting past events. This is causing us to believe equities can push higher very short-term but that in the second half of Q1 macro data will begin to disappoint against expectations causing an equity correction above 7%, something we have not seen since Brexit.” (Q1 2018 Quarterly Outlook)
The word “synchronous” was the buzzword of 2018 as Quartz so eloquently put in on 31 January 2018. While S&P 500 was already down 1.7% from the peak the editors of Quartz had likely not anticipated the next event.
In the first seven days of February the US equity market plunged 10.3% reminding everyone that markets are not and have never been normal. They may be what the Polish-born polymath Benoit Mandelbrot calls “wild randomness” following a Lorentz distribution which is a headache because this distribution has no modes such as mean and variance. At any time, one new observation can arrive and change the whole picture.
On 6 February 2018 the front-end VIX futures made a sigma 21 move which was three times the daily move the day after the Brexit referendum, itself at that time the biggest single-day move since March 2004. The violent move caused a 93% single-day drop in the XIV (short VIX future ETN) and the ETN provider Credit Suisse later liquidated the fund. Because of the catastrophic February, the XIV had delivered 566% in return since February 2016, which had attracted all sorts of investors betting on short volatility strategies; essentially it was the most crowded trade on Wall Street.
So 2018 started crazily with the best January in decades and then swung into mayhem in February. What came next was even more surprising. The US equity market came back with lightning speed, erasing more than half of the losses and looked solid until mid-March when the market sold off again, touching the lows from February. Panic was in the air, but things stabilised and US equities managed to stage a new all-time-high in September despite growing tensions between the US and China over trade, intellectual property rights and market access. Investors had become used to Trump's wild temperament on Twitter and were paying him less attention. Strong earnings growth and a confident Fed were bolstering sentiment.
However, under the surface cracks were spreading in emerging markets as China’s equities slipped into bear market territory and the stronger USD and oil price hammered the consumer in emerging markets. Europe was going nowhere and saw its leading indicators getting worse and worse on top of a financial sector that was looking very fragile. Then came the now famous words “a long way” from the Fed Chairman Jerome Powell on 3 October 2018. While many factors obviously played a role in the following months this stands as one of the catalysts. Literally the day after equities sold off and interest rates went higher.
Sentiment accelerated to the downside taking down the S&P 500 by 10.7% at the low point. Trump’s aggressive stance against China also played its part in souring sentiment. After much volatility and nervousness over the US-China relationship investors got in late November what we thought were early Christmas presents as Powell flipped on his earlier remarks and the G20 meeting looked like a road to a deal between US-China.
A few days into December a lot of questions were flying around about what was actually agreed between the US and China at the G20 meeting. It seemed from the two countries’ statements that they had different views. That kick-started renewed nervousness and new leading indicators were sending worse and worse signals on the market. Credit was deteriorating, housing was clearly slowing, stocks in cyclical industries were being slammed and the Fed Funds Futures were beginning to price an increasing likelihood of a no-rate hike decision on 19 December 2018.
However, the Federal Open Market Committee meeting in December turned out to be historic as it’s likely that the Fed made a policy mistake. Investors were not pleased about two things: 1) The autopilot on quantitative tightening, and 2) the high weight on economic data/models.
QT is currently on autopilot, which the Fed chairman noted was sensible, but it’s withdrawing $50bn of liquidity from the financial system every month. To make things worse, this monetary tightening of the balance sheet will coincide with the US budget deficit becoming bigger in 2019 creating an ugly supply/demand situation for US Treasuries. In the press conference the Fed Chairman constantly talked about economic indicators such as GDP, employment, fixed investment etc., but all these economic indicators are either lagging or coincident.
We would argue that late into a business cycle a central bank should put more weight on market signals than coincident economic indicators. The financialisation of our economy also means that the feedback loop from markets into the economy is larger than ever and as a result, ignoring market signals 10 years into an expansion might be an almighty policy mistake that the Fed will regret in 2019. The reaction was swift with US equities extending their declines being down 6% for the year as of 21 December 2018.
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