While investors are currently trying to discern the fundamental drivers of the increased volatility in the market, what has been even more noticeable to Global Beta has been the intraday volatility of the market. Unlike a typical market sell off compared to what we are seeing now, the major U.S. indexes are experiencing several 100-basis points fluctuations in both directions during a single trading session. Volatility is simply the degree to which prices in the stock market move and one of the most commonly used barometers is the Chicago Board Options Exchange Volatility Index, commonly referred to as “the VIX”. When the price of the VIX moves up, that indicates that volatility is high in the market place. When the price of the VIX moves down, that indicates that volatility has receded in the market.
What is causing this recent spike in volatility? Well, it seems there are quite a few items that are influencing the market: The Federal Open Market Committee (“FOMC”) decision on interest rate hikes, as well as rolling off 50 billion in debt a month from the Federal Reserve (“the Fed”) balance sheet, the pending trade war with China, and algorithm-based trading by large hedge funds. Below, we separately discuss each one of these influences to understand their distinct impact on the market.
The FOMC met to discuss policy on December 18th and 19th. At that time, they announced a 25-basis point rate hike (the 4th hike of the 2018 calendar year) as well as the continuation of the unwinding of the Feds 4 Trillion balance sheet. In 2009, the Feds balance sheet mushroomed during the crisis as the Fed created money to buy certain bonds on the open market. This program was named Quantitative Easing and was a program created by then FOMC Chairman, Ben Bernanke, to increase liquidity in the market by purchasing treasury bonds and mortgage backed securities from the open market place. At the September 2018 meeting, the FOMC “dot plot”, which is a survey of each of the FOMC’s 12 voting members’ projections for the federal funds rate for the calendar year, revealed a projected median rate of 2.4% for 2018. Currently, the federal funds rate is 2.25%, so the 25-basis point rate increase places the funds rate on the target projected in September. Current FOMC chairman, Jerome Powell, announced that the FOMC is now targeting two rate hikes in 2019, instead of three. This comes on the heels of the FOMC recognizing that global growth is slowing, and as a result, their outlook for the funds rate for 2019 has now been adjusted to 2.8%, which is down from their 3% outlook in September. However, many investors are wondering, “is that enough?” On the surface, it appears that Jerome Powell is either out of touch with the market price signals [particularly the bond market] or is he establishing the Feds independence from President Donald Trump’s public dissatisfaction with the FOMC’s path of aggressively raising interest rates. However, the problem runs deeper than just Jerome Powell. The FOMC was created in the legislation of the Bank Act of 1935, which like most current financial regulations, stemmed from the Great Depression. The fundamental reason for the existence of the FOMC is to maintain price stability of goods and services in the economy. While the intention of creating the Fed was a noble one, their track record has some glaring errors. For example, In the late 1920s and early 1930s, The Fed strangled the economy with overly tight money supply, which helped cause the Great Depression. In the early 1970s, the Fed responded too slowly to inflation and it resulted in stagflation. While the FOMC does rely on key economic indicators and surveys, the concentration of power among the voting committee can, at times, lead to misalignment with price signals within the economy. In the current case, this Fed has prescribed rate increases nearly a year in advance of data as well as placing on auto pilot monetary withdrawal with bond selling from the Fed balance sheet. This is problematic because, as history has shown, measurements such as GDP, inflation, and unemployment can be lagging indicators. Currently, the bond market is evolving into an inverted yield curve. This occurs when the 2-year treasury bond yield rises above the 10-year treasury bond yield and is highly correlated with the slowing of or a recession in the economy. According to the Federal Bank of St. Louis, as of 12/19/2018, the 10-year yield was only 14 basis points higher than the 2-year yield (2.77% for the 10-year vs 2.63% for the 2 year). For context, the spread between the 10-year and the 2-year was 54 basis points at the beginning of 2018. As mentioned, the FOMC raised rates four times in 2018, resulting in the spread narrowing to the aforementioned 14 basis points. In theory, a higher short-term interest rate should be attractive to investors, so the demand for the 2-year should offset an increase in rates in a strong economy. However, investors have not felt the same conviction about the current state of the economy that the FOMC has. Therefore, short term rates have continued to climb amidst the rate hikes. Investors have piled into longer duration bonds (such as the 10-year) for fear of a recession brought on by the double tightening of bond selling and raising the discount rate. Again, it must be noted that, as the FOMC increases rates, they are also selling $50 billion in long term treasury bonds and mortgage-backed securities. In summary, investors are seeing price signals indicating a slowing economy while the Fed seems unnaturally aggressive in light of tame inflation and price stability. Many investors are beginning to perceive that the Fed that is expanding its mission. In each and every case where, the Fed has departed from its core mission, the result has been a severe correction in equities. As such, it’s hard to defend a Fed that announces a target interest rate without supporting data and a Fed that puts monetary tightening on auto pilot.
What is the FOMC thinking?
The general thought process from the FOMC to raise rates is to tighten liquidity in the market (i.e.: making it more expensive to borrow money), and thus curb potential inflation in the economy, given the recent strength in the jobs market as well as overall Gross Domestic Product (“GDP) growth. However, raising rates too quickly can be as damaging as inflation. It’s a delicate balance that the FOMC weighs, and one that has led to recessions before. If the FOMC gets too far ahead of inflation with raising rates, that’s when the pattern of an inverted yield curve develops. As mentioned earlier, if the market believes a recession is near, they sell short term assets (such as the 2-year treasury bond) and purchase longer term assets (such as the 10-year treasury bond). The past four recessions (1981, 1991, 2000, and 2008) occurred within 1-2 years after the yield curve first inverted. It’s important to remember that an inverted yield curve is not the cause of a recession but simply a correlated event with an eventual recession. As is the case in markets in general, they are telling us something about the economy. Is this time different? Each recession is like a snowflake. They’re not all the same, but they usually are usually fueled by accelerating inflation that generally stems from asset bubbles.
The Recession of the 1980s
In the case of the recession in the early 1980s, severe inflation began to hit worldwide because strife in the Middle East significantly curbed oil production. Inflation was as high as 14.6% year-over-year in April of 1980. In a misguided attempt to cool down inflation, the FOMC began to raise short term rates but that only contributed to unemployment beginning to rise and GDP beginning to recede. At the beginning of 1980, the 10-year yield vs the 2-year yield was already inverted by over 90 basis points and still the FOMC ignored what the market was signaling and the rate hikes they pushed through ended up exacerbating the inversion to the tune of over 200 basis points and we then saw the U.S. spiral into a recession in the early part of the decade.
The Recession of the 1990s
In the case of 1991, there were a couple of factors. Again, Middle East tensions ballooned into what ended up being the Gulf War and oil prices pushed higher again. In the early part of 1991, inflation hovered around 5% on a year over year basis. The other factor was grossly high interest rates that resulted from the housing boom in the 1980s. The 10-year note was hovering around 8% in the early part of that calendar year, however, the 10-year yield never ended up inverting with the 2-year yield. A previously hot economy began to slow down and these 2 factors parlayed a cooling economy into recession.
The “Tech Bubble” Recession
Then came the technology bubble in the late 1990s. In 1997, Fed Chairman Alan Greenspan responded to a major bull market in technology stocks by commenting it was being driven by “irrational exuberance “. The 10-year yield first inverted with the 2-year yield in June 1998; however, the FOMC had yet to raise interest rates. In August of that year, we experienced the Asian crisis and Long-Term Capital Management – a highly levered, multi-billion-dollar hedge fund — became the first too big to fail financial firm to be bailed out. Part of the issue was that the asset bubble that technology created didn’t generate inflation in the same manner as previous recessions. However, inflation had reached 3.8% in March 2000, despite monetary tightening during 1999. The bubble in technology was a clear mispricing by market participants belief that the retooling globally of both computer software and hardware to avoid the Y2K problem (a software glitch that could not calculate the new century) would last beyond 2000. But growth stalled once the demand for Y2K proof computer systems was met. This bubble apparently created a wealth affect that disrupted prices. The Fed seemed to believe this required tightening. It is not quite clear how effective the Fed was during this time frame. We did end up with a crisis in equites subsequent to 9/11 and repricing of technology. The Fed was required to reverse itself once again as tightening overshot what was necessary.
The Financial Crisis
Most recently was the infamous financial crisis of 2008, which ended up being the worst recession since The Great Depression. Coming out of the “tech bubble” recession, the economy began to expand in the mid 2000s and interest rates slowly began to rise. In the expanding economy, home prices began to rise as demand began to hit a fever pitch. This contributed to inflation rising to over 4% for most of the mid 2000s period. However, unlike previous recessions, the asset class that began to balloon became more systematic as they were being leveraged in investment vehicles. Loose standards for mortgages led to “subprime mortgages”, which were simply high-risk mortgages. Similar to high yield bonds, subprime mortgages provided more attractive yields; however, just like high yield bonds, carried higher default risk. As a result, banks began to bundle these subprime mortgages into Mortgage Backed Securities (“MBS”) with lower risk mortgages and they were vastly sold into the market as a low risk investment with an attractive yield. On the other side of the equation, banks purchased Credit Default Swaps (“CDS”) to protect themselves against default risk on the MBS’ they sold to the market. CDS were simply insurance against mortgage defaults. Banks would pay a premium to the seller of the swaps to insure them in the event there was a default on the mortgage. Thus, the market was flooded on both sides: the market owned several high risk securitized mortgages, and the market also was insuring against the default of those mortgages. The thought process among banks, and even the Market, was that MBS were about as safe as a bet you could make. However, the economy began to start slowing in 2007. In fact, at the end of 2005, the yield curve began to mildly invert. By the 4th quarter of 2006 and through the first quarter of 2007, the yield curve was inverted by an average of nearly 10 basis points. As the economy began to slow by that time period, demand for housing inevitably began to decrease as inflation began to recede. Moreover, with unemployment beginning to rise, not only did that suppress demand in the housing market but it also began to increase mortgage delinquency. The result was default rates going from roughly 2% to 12%. As the defaults came in, it began to trigger the several outstanding CDS’. The 2 largest institutions that underwrote those CDS’ were Lehman Brothers and AIG. Of course, neither institution had the capital to satisfy those obligations, so they had to default. In the case of Lehman, they ended up in Bankruptcy court after the Fed refused to step in to back their liabilities. The domino effect left the counter parties of the MBS’ unable to satisfy their MBS obligations, which then led to asset managers accumulating large losses. This unraveling whipped across the entire financial structure, which led to the Fed introducing the aforementioned Quantitative Easing program to purchase troubled assets, such as MBS’ with subprime mortgages, to provide adequate liquidity to the market and stop the bleeding. In addition to the Quantitative Easing program, the FOMC also reduced the fed funds rate to 0, which represented the most accommodative monetary policy since the great depression. The Quantitative Easing program lasted until the 4th quarter of 2014 and the FOMC did not begin to raise rates from 0 until the 4th quarter of 2015. The result has been the longest running bull market as well as the longest gap without a recession in U.S. history. FOMC critics would say that with the Fed largely sitting on their hands for the better part of the last 10 years, the economy and markets have been stable.
Do the Recent Monetary Policies and Yield Curve Trends Mean Recession in 2019?
While the yield curve itself and the hawkish monetary policies set forth by the FOMC strongly suggest we are facing a recession in the next 12 months, this time does feel different. Unlike the aforementioned previous recessions, there are missing ingredients in the current environment: inflation, high unemployment, lack of wage growth, and slowing GDP. That said, it is imperative that the FOMC does take its foot off the gas pedal in regard to raising rates. While the economy has gained momentum over the past year, there is little evidence of inflation and still a looming trade war with China, which we will breakdown.
China Trade War
The second part of the equation for the current market volatility is the ongoing trade war with China. Although some of the recent rhetoric by both the U.S. and China have pointed towards optimism of both tempering tariffs and potentially working towards a deal, there’s still plenty of ambiguity on what parts remain unsettled and exactly how far apart both sides are on those issues. The market is still trying to weigh that. Perhaps the most significant point for the U.S. is China’s theft of intellectual property from U.S. companies that run commerce in the communist state. While free enterprise is a concept that we take for granted in this country, it is not a principle adopted by the Chinese government. This fundamental issue is a reason why many economists and traders are skeptical that there will ever be an agreement between the two countries. China has shown willingness to narrow the trade deficit between the two countries and has also even shown willingness to neutralize the tariffs between the two as well; however, the issue remains whether a company from a country runs as an independent enterprise can operate similarly in a communist country. At this point, it would seem both sides want an agreement, but it’s very difficult given then two very different economies. One thing is certain: much of the trade war is priced into the market, so, any agreement that is made between both sides would almost certainly rally the market.
As is the case in every industry, companies are constantly looking for ways to commoditize products. It’s no different in the financial services industry. Actively managed strategies are great if you have a really good active manager. Since the beginning of the century, only about 20% of active managers have routinely outperformed the S&P 500 Index. Also, actively managed products can cost investors hundreds of basis points to manage. Finally, you are at the mercy of key man risk with that active manager. Those three factors have led the industry to try and commoditize active management by writing algorithms to run mutual funds and exchange traded funds. While these strategies have revolutionized the investment industry, they’ve also created a warped market. Market volume is now less controlled by investors buying and selling individual names based on fundamentals or news. Large institutional and retail money is heavily invested in many of those algorithm-based strategies. Therefore, when a technical indicator triggers these algorithms, the momentum of trading in that direction goes with it. When volatility increases in the market, the algorithm-based trading exacerbates it now, which is why we not only see day-to-day volatility but also heavy volatility intraday. When this level of volatility hits the market, investors have to be extremely careful about how they trade. There are certainly opportunities that present themselves, but investors must proceed with caution.
What does it mean for your portfolio?
In summary, there are clearly a lot of moving pieces, both in the stock market and the global economy. What’s important for investors to know is to be prudent with their investments. It’s not wise to sell into panic, and it helps to take advantage of opportunities when they present themselves. Global Beta has developed an array of strategies that identify stocks that have attractive valuations relative to their long-term averages and we manage our portfolios to take advantage of those moments in the market. We also screen our portfolios for liquidity. Identifying quality companies is critical to improving your overall return but investors also have to make sure those companies have strong liquidity. Over our vast industry experience, we have seen investors suffer before at the hands of tight liquidity. Investors can’t make money if they’re unable to get in and out of a stock with efficiency, and that’s part of what we keenly identify in our screening process. While we believe that “recession” calls are a bit premature, there is still global risk; however, identifying the right opportunities is what can set you apart from the general market return in 2019.