Reality check in the markets
Since last Friday the markets have wobbled and it is time to take stock of the situation.
There is no doubt that market participants had talked themselves into the belief that the US Federal Reserve would not hike rates further this year and that the other large central banks will continue to be supportive to asset prices, stocks and bonds alike.
In the real world, representatives of the Federal Reserve all the way up to Fed chief Janet Yellen had been very vocal in saying that the markets were not adequately positioned for the future monetary policy. It is about as clear as it comes when talking about central bankers’ statements.
This market optimism (paired with the only short-lived effect of the British referendum) led to rallies in both bond and stock markets.
In our arsenal of indicators we have observed that our Mean Reversal Indicators pointed to very stretched markets. Bond markets, ever sceptical, had stabilised at high levels of this indicator already in the early summer. Stock markets had continued to get further stretched. The put/call ratio is tending historic levels last seen back in 2011. This ratio simply indicates whether bears (buying puts) or the bulls (buying calls) dominate the US stock market. As it were, volume in the call options was between 4 and 5 times the put volume, indicating an extreme degree of complacency.
Add that US stock market valuations are stressed and the macroeconomics on a global scale are still middling. Finally, one of the sure-fire indicators of trouble ahead, falling economic surprise indices pointed to a situation where the markets were likely to enter into a phase of disappointment.
In other words, there have been strong warning signs that the markets had set themselves up for some kind of correction, and it began on last Friday. Market dynamic in many ways resembling the "taper tandrum" of 2013.
Going forward the question is whether this is “just” a correction reflecting that the markets adjust to US rate hikes arriving earlier than expected or whether something more sinister is afoot. We lean towards the first interpretation, given that central banks outside the US are still indicating that further monetary easing is on the cards. A further US rate hike this year will be small, given the economic background, and designed to give the impression that the policy makers are on track.
We therefore believe that the current episode is best handled with tactical positions rather than a major overhaul of the investment strategy. Our interpretation is still that the post-Brexit rally has been prolonged by some investors feeling driven towards forced short-covering, bringing the primary assets to be stretched on simple technical measures and leaving a setup of vulnerability to “bad” news.
In our systematic approach we have however observed some changes since last optimisation in late August.
The systematic investment process direct investors to allocate risk assets corresponding to the middle of their allocation range:
- Our volatility indicator points to further increases in market volatility
- Our risk allocator, which rose abruptly back in July, has reversed and is now indicating a “risk-neutral” episode after a few weeks of “risk-on” signals
Fixed income continue to avoid the longest duration and increasing preferring alternatives as REITs, TIPS and Cash. Overweights remain centered in the European investment credit segment, at the expense of high-quality global government bonds.
The allocation to stock markets returned to neutral-ish at the latest adjustment early September.