Overview
“It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We shall accordingly restrict the term ‘uncertainty’ to cases of the non-quantitative type. It is this ‘true’ uncertainty, and not risk, as has been argued, which forms the basis of a valid theory of profit and accounts for the divergence between actual and theoretical competition.” Frank Knight, Risk, Uncertainty, and Profit, 1921.
During the first quarter of 2018, a number of things have changed and, to some extent, caused a shift in mindset for many investors. The situation in 2017 had been unique. First, from an economic perspective, you do not find many periods of above average synchronised growth that do not come with higher inflation. The Goldilocks environment of last year compares with 2009 in many ways, provided one ignores the severe losses that preceded the 2009 recovery.
The second and yet related anomaly of 2017 was the very low volatility that came with it. The level of uncertainty seemed so low that demand for hedging dropped considerably and the VIX curve remained in a contango position for an extended period, long enough to create an intense degree of complacency among market participants. But these are now things of the past.
The key to Q1 was to navigate investors’ growing awareness of the future path of monetary policy. For Q2, we believe the situation is different. Monetary policy is now better priced across assets and little uncertainty should come from central banks for now. But we also believe that clouds are accumulating, creating a more uncertain environment for investors. This uncertainty clearly differs from the risks we perceived for the previous quarter. Risks can be expected and quantified whereas uncertainty cannot, according to Frank Knight (Risk, Uncertainty, and Profit, 1921). In Knight’s view, not only are future probabilities attached to possibilities more difficult to assess but also the list of these possibilities is harder to draw.
In our view, the present uncertainty comes from a mixture of macro and market elements: economic growth now shows more disparities, while the outlook for inflation is unclear. In a context of higher volatility, market valuations should be questioned as well, while positioning has not changed dramatically. Even if the base case scenario remains that of positive macro and market momentum as the inflation story unfolds, our investment case now incorporates a bit more of ‘Knightian’ uncertainty, for which being nimble enough to dynamically hedge global risks as they come and go will prove crucial.
Strong but slower growth while inflation builds up
What has not changed is our assessment that growth is expected to remain strong. As illustrated in Chart 1a, our world growth Nowcaster – our real-time economic activity indicator that covers 80% of the world’s GDP – is still pointing to above-potential growth. This should be led by developed markets, especially the US, while emerging economies should grow at, or close to, potential.
Chart 1a: World growth Nowcaster points to abovepotential growth
Chart 1b: World growth Nowcaster diffusion index shows a deceleration
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
The difference is the deceleration of our indicator: the diffusion index attached to our growth Nowcaster that measures the percentage of improving underlying data has now dropped to 35%. As shown in Chart 1b, it decelerates in exactly the same way as it did early 2016 when US recession fears started to ignite. Is today a comparable situation? Not quite. The levels reached by the world growth Nowcaster and especially the US Nowcaster are without precedent over the past 15 years and so growth should remain strong in spite of the deceleration.
What is the problem then? The pace of growth is not, but we have recently lost something dear to financial markets: the synchronicity of growth across countries. As highlighted in Chart 2, the gap between the highest and the lowest of our regional Nowcasters has increased materially over the past three months.
Chart 2: Difference between the highest and lowest growth Nowcaster (bar chart) and 6-month moving average (line chart)
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
In terms of the diffusion index, the Eurozone seems to have been particularly affected: a very limited number of indicators increased in the region, especially in relation to consumption and production expectations. Of the more than 900 Eurostat surveys, less than 10% improved in February, a definitive sign of caution. Still, the message of our indicators so far remains that growth is still on track, which may explain the limited talk of recession fears in the industry – a very different to the situation in January 2016. The key change is that the macro outlook now looks a bit more uncertain than in the past, an element markets struggled with recently during the March flight to quality.
The inflation picture remains unchanged for the time being. Our world inflation Nowcaster has reached elevated levels and therefore points to potential surprises to the upside. That said, its momentum looks somewhat uncertain now, as its diffusion index is below 50% (see Chart 3b).
Chart 3a: World inflation Nowcaster points to upside inflation surprises
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
Chart 3b: World inflation Nowcaster diffusion index suggests momentum is slowing
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
A quick summary would be that in the US and Europe, inflation does not look as strong as in the past. Wage growth remains the missing link to the inflation equation, as hard data there is still lacklustre. We remain in the camp of those who believe that the Philipps curve – the relationship that binds a low unemployment rate level with higher inflation – will eventually strike back, leading to additional inflation surprises in the future.
Over the shorter term, however, inflation pressures have somewhat eased, a phenomenon that has not been widely acknowledged by the various surprise indices available to the industry and that is partly why we have started to see a bit more value in bonds recently. Our understanding of the situation is that this slowdown in inflation pressures is temporary, as growth has been excellent over the past two years, production costs are rising and demand remains on track. All the necessary ingredients to fuel surprisingly higher inflation have been gathered and should continue pointing in that direction for the rest of the year.
If wage growth starts to ignite, like many observers have been expecting it to do so in the past, the consequences should be much more significant as they would not only push yields higher but directly eat into companies’ peak level margins. As shown in Chart 4, margin growth has been affected negatively in the past by wage growth.
Chart 4: US corporate profits vs. wage growth
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
We do not expect a large surge in wage growth anytime soon, but it seems to us that market participants are assuming wage growth of close to 0% around the world and we think they are wrong in this respect. We are also doubtful of a large inflation wave but all that matters from an investment perspective is that inflation surprises investors by exceeding the expected 2.3% in the US and 1.4% in the Eurozone. We believe that markets are still overlooking this risk.
Market stress has been repriced
A key development during Q1 was that investors stopped neglecting market stress risk. We have long been highlighting a higher risk of inflation surprises, which was not reflected in asset prices. In early February however, as most assets slipped, we started witnessing a firmer pricing of inflation risk. The normalisation of monetary policy by central banks suddenly seemed more likely to markets, and the tighter liquidity environment that comes with it turned out to be implying a normalised pricing of risk as well. The jump in the VIX is the perfect reflection of this sequence of events, from the materialisation of inflation risk to the rise in risk itself.
As shown in Chart 5a, Libor spreads have increased steadily since July 2017 in the US but nowhere else, as it was in the US where inflation surprises materialised the most. Given the systemic importance of the US, it nonetheless fuelled an increase in implied volatility indices, but not with the same impact for non-US implied volatilities. As Chart 5b shows, the sharpest jump in volatility was seen in the VIX, while the rest of the indices were impacted to a lesser extent. The fact that tightened liquidity conditions in the US did not contaminate the rest of the asset-to-swap spreads and we did not witness a contagion from one interbank market to another suggests that this trend stems from an inflation and market stress risk rather than a recession risk.
Chart 5a: Asset swap spreads have risen in the US
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
Chart 5b: Implied volatility indices
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
Tightened liquidity conditions and higher volatility are key to understanding what did happen in Q1, but also to anticipating the coming quarter. The rise in the VIX came with an increase in its volatility, the ‘volatility of volatility’: the risk of the risk. To a large extent, this parameter can be interpreted as a gauge of uncertainty. Q1 marked the end of the extreme macro visibility and we think that ‘uncertainty’ is likely to become one of the keywords of 2018.
The end of market complacency
As discussed earlier, the market sell-off and spike in the VIX in early February were driven by a realisation that financial assets were mispricing inflation risk. However, what should have been a short-lived episode turned into a longer-lasting event, as the more uncertain macroeconomic picture led market participants to focus on idiosyncratic risks, such as turmoil in the technology sector and political risks. Investors appear to be moving away from a very clear buy mindset to a more cautious one, albeit not yet a sell-on-the-high stance.
Concerns over a potential bubble in the tech sector and the rise in protectionism talks were the two main sources of idiosyncratic risk that appeared in Q1. As shown on Chart 6a, tech stocks in the US lost about 8% from their peak and the Congress hearing of Mark Zuckerberg is clearly not helping. Fundamentally, not much has changed for the sector, but the tremors of risk are nonetheless starting to shake the firm belief in a new industrial revolution.
Chart 6a: Percentage change from 52-week high
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
The second source of noise clearly originates from the White House. The potential escalation of trade barriers undermining the work the WTO has done following the different GATT rounds (the first of which dating back to 1947!) is clearly perceived as a threat. Here, markets are probably more affected by what can be guessed rather than by what is known.
Most of the issues seem to be affecting the commercial relationships between China and the US. As shown in Chart 6b, China has managed to reduce significantly its reliance on world trade over the past 10 years: back in 2004, its gross trade activity represented about 60% of its GDP while now it is in the region of 30%. This reduction does not result from a lower trading activity, even though 2015 was a tough year for world trade, but from a strengthening of the Chinese consumer’s position, which is somewhat good news from a world trade-induced potential recession risk. Unless a significant escalation takes place, this potential trade war looks more like noise than a signal. Still, when looking for excuses to let the bears out, Twitter-based noise comes in handy and has succeeded in adding to the level of uncertainty.
Chart 6b: Gross external trade to GDP ratio
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
Our view that investors’ mindset is changing is supported by the fact that diversification was rewarded very differently in February and March. When markets fell in February, diversification did not work as correlation reversed. In March, however, diversification paid off, with well-balanced, multi-asset solutions achieving a near 0% performance. In our experience, diversification is an interesting remedy to political uncertainty. This supports our view that February’s sell-off was driven by mispriced inflation risk, whereas the turmoil in March was fuelled by uncertainty.
What now? Have equities reached levels low enough for investors to neglect the surrounding uncertainty and enter the market once again? Are bonds yields high enough given the growth and inflation scenario? Looking forward, we believe it will be essential to consider three factors: positioning, intraday patterns and valuations. As Chart 7a clearly shows, this year’s market drop did not discourage investors from keeping their equity exposure, or at least part of it. Hedge funds halved their equity beta but did not turn bearish. Moreover, the recent rally in government bonds did nothing to ease the extreme short bond positioning in futures markets (see Chart 7b).
Chart 7a: Positioning as measured by hedge fund beta
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
Chart 7b: Z-scored combined future positioning on T-notes
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
Investors appear to remain somewhat in the camp of more growth and inflation in the medium term, and yet volatility and the VIX index are still elevated. Another sign that highlights this change in the market sentiment is the ratio between intraday high prices and closing prices. When the ratio goes up, it means that markets are closing in the region of their highest price during the day, which is a definitive sign of bullishness. To a certain extent, it can be regarded as a sign that markets are in a ‘buy on the dip’ type of mindset. From Chart 8, the most recent evolution of such an indicator shows that the extreme bullishness of investors has been washed out since February.
Chart 8: High price to closing price ratio evolution for the S&P500
Sources: Bloomberg, based on Unigestion’s calculations, as at 31.03.2018
Despite the apparent better pricing of the equity market, we believe that valuation is an excellent reason for the continuation of this less optimistic mood across markets.
Our message here is simple: if you believe valuations have now reached a ‘fair’ level, this way of looking at valuations suggests the contrary. We are still of the opinion that market stress stands a good chance of getting the upper hand for short periods of time, but in a repeated fashion that can be particularly harmful for investors.
Conclusion
This first quarter changed a good many things and the table below summarises all those that matter in our view.
Our market outlook itself has not materially changed. We continue to expect very decent growth and a period of higher inflation, which should be costly to bond markets and profitable for growth-oriented assets over the year. We still anticipate regular surges in market stress as the extent of inflation rises could weigh on central banks’ expectations.
We believe that a dynamic approach to risk management makes even more sense this year as the prospects for inflation are hard to anticipate and it is these that will largely impact the pace at which central banks normalise their rates. Overall, our key message this quarter is a word of caution: if the actions of central banks are well priced, inflation and market stress could dominate.
Important information
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