By Buttonwood
THERE is a familiar scene in westerns where the cavalry is riding through the mountain pass and the captain says “I don’t like it. It’s quiet. Too quiet.” Seconds later, a soldier gets an arrow in his chest and all hell breaks loose. Some people feel that about markets at the moment. Deutsche Bank reckons the S&P 500 has had 10 out of 11 days with a move of less than 0.2%, the quietest period since 1927. The volatility index, or Vix, fell to a 23-year low after the French election result.
This calmness is in striking contrast to the political turmoil that has followed the election of the Trump administration; the tensions over North Korea, the firing of the FBI director and the trade policies that have pushed Citibank to issue a regular “US protectionism round-up”. Is it all a sign of complacency?
There certainly have been occasions in the past when a low Vix has preceded trouble. The previous low, in December 1993, was followed by a great bond sell-off after the Federal Reserve started to tighten policy in January 1994. But what does the Vix measure? It is the price, as derived from the options market, that investors are willing to pay to insure themselves against a sharp move in asset prices. As Eric Lonergan writes in his Philosophy of Money blog
Implied volatility, as derived by options markets or indices such as the Vix, is predominantly determined by realised volatility. So when people say “markets are complacent because the Vix is low”, it is worth remembering that all they are observing is that prices have not moved very much in the last 30 days or so. There is no “view” embedded in the Vix.
The intellectual battle is between those who believe that the “reflation trade” which preceded, but was much bolstered by, the election of Donald Trump, has still plenty of momentum behind it, and those who believe there is trouble ahead. The latter focus on signs that the tide may have turned. Commodity prices have fallen 7.3% since their recent high in February and that may point to a slowdown in the Chinese economy. Goldman Sachs’s current activity indicator for China slowed to 6.4% annualised in April from 7.6% in March on the back of higher interest rates, and slower growth in credit and the money supply. The risk, as seen before, is that Chinese growth shows up in slower commodity demand (which hits emerging markets) and a weaker currency (which hits manufacturers in developed economies).
But there are plenty of people who take the opposite view. Mark Tinker of Axa investment Managers thinks there has been
a misplaced emphasis on short-term indicators and particularly on measure such as debt to GDP
At UBS, Bhanu Nweja says that, while Chinese depreciation is a serious deflationary risk for the global economy, the autho*ruties seem to have gone to great length to prevent capital from flowing out of the country and triggering a sell-off. And Chetan Ahya at Morgan Stanley points out that, this time, the Chinese are tightening at a time of accelerating global growth.
The key reason why this cycle should be different is that the external demand environment has improved significantly. Indeed, we expect 2017 to be the best year for exports growth for China since 2013
Other sign of growth remain healthy. Capital Economics shows that emerging market export growth reached 13.9% in March, the fastest increase since 2012. While that is largely a value effect, volumes are up 3.2% year-on-year. There is no sign of distress in the corporate bond market which many, including David Ranson of HCWE Economics, see as an early-warning indicator. The global default rate for speculative bonds over the last 12 months fell to 3.6%, according to Moody’s; a year ago, it was 4.3%. In America, the default rate is down to 3.8%, from 5.1% at the end of 2016. The spread or excess interest rate, paid by junk borrowers is 428 basis points, up slightly from 405bp at the start of the year, but a long way below the 805bp of February 2016.
In short, the argument is currently being “won” by the bulls who argue that recent falls in commodity prices are just “noise”—Bloomberg’s commodity index is only back to where it was in September or November 2016. Something more significant has to happen for the bearish case to be strengthened. That may come from Mr Trump’s economics team, which was interviewed by our top editors last week, who found that
Trumponomics is a poor recipe for long-term prosperity. America will end up more indebted and more unequal. It will neglect the real issues, such as how to retrain hardworking people whose skills are becoming redundant. Worse, when the contradictions become apparent, Mr Trump’s economic nationalism may become fiercer, leading to backlashes in other countries—further stoking anger in America. Even if it produces a short-lived burst of growth, Trumponomics offers no lasting remedy for America’s economic ills. It may yet pave the way for something worse.
The danger, if investors are disappointed by Mr Trump, is that valuations are so high—American equities are as dear as they were in 2007, as this column pointed out last week. The fight between the reflation camp and the complacency camp is far from over.
