Head of Saxo Strats
Summary: The Fed's latest rate hike seems ill-judged but what does this mean for equities? We've crunched the numbers, found huge variance and concluded that great caution is warranted.
The VIX Index remains elevated at around 28.6 and US equities are down 0.5% before the cash market opens. US equities are down 16% from the peak in September and the smell of panic is spreading. The big discussion is whether the Fed made a policy mistake two days ago. The SaxoStrats team is of the view that it was most likely a policy mistake. The rate hike would have been justifiable, mostly to send a signal that the Fed is independent, but maintaining quantitative tightening on autopilot and putting too much weight on lagging economic data series were the two things that scared investors. As it is, the bleeding continues and frighteningly into a thin liquidity holiday period. So what can we expect from here? Well we have been crunching the numbers and here are our answers to confused and panicking investors.
It can get much worse
For analysis we broke daily VIX Index levels into deciles since 2 January 1990. We then isolated all the historic dates were the VIX Index was at the same level as the current decile. With the VIX Index at 28.6 it is currently in the ninth decile [24.1 – 28.6]. We then extracted the future returns 63 trading days into the future from that day. Aggregating all these returns provide us with historical sample returns. In order to compute the distribution of future paths we bootstrap* (with replacement) from the historical sample returns series future paths 63 trading days into the future. In total we simulate 50,000 paths.
The chart below shows the median (dark blue line) of these 50,000 paths and the ribbon spans the worst-to-best cumulative return in % at any given future time. It is clear that the potential outcome 3-month into the future from our current level in the S&P 500 is enormous. In the best possible scenario based on historical data we could be up 60% or down 39% (roughly the same log return).
The density of the terminal values (cumulative return in % after 63 trading days) are as shown in the chart below. The distribution has a positive skew which should not be a big surprise.
As we highlighted in our live presentation two days ago we would favour being tactically long equities (global) if the Fed could deliver, which they didn’t, and China would announce another round of stimulus. The Chinese government may soon come to the rescue as the CSI 300 Index futures broke down today to new lows for the year and cycle, adding further pressure. The stabilisation phase in global equities could come soon from China and then if things go smoothly Fed governors will increase their dovish language in speeches during January.
Even when equity markets are quiet things can go wrong
We believe few investors understand the actual risks they are taking in equities. 2017 was the ultimate year of compressed volatility in equities. In these times, and especially a long bull market, investors can be lulled to sleep. But again running 50,000 simulations on historical returns from a starting point with very low VIX Index (first decile [9.1 – 11.9]) we get a large range in terminal cumulative returns after 63 trading days. When things are very calm investors should realise that there is a 5% probability that equities will decline by more than 6% (worst case 18.7%). In other words expect the unexpected when trading or investing in equities.
2024: The wasted year
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
