Current Market Conditions – February 2018

Obviously, volatility has picked up from a historically low level. Some component of this is a function of “risk parity” portfolio construction models, where as statistical risk falls across asset classes, portfolios are expanded in size/leverage. However, what we are seeing is that directional volatility in one asset class (bonds, starting in January) which has been consistently inversely correlated with stocks suddenly becomes very correlated with stocks as risk abatement in one asset class statistically forces risk abatement in others. Most of what’s going on out there are computers and algorithms “going off” in an aggressive fashion.

On a more fundamental basis, I see the clear risk to the whole applecart is statistical inflation actually showing up. Why? An increase in 10-year yields, which broke out of the sub 2.6% range (that they have occupied for the last 4.5 years) to the 2.7-2.8% range is not in and of itself a huge drag on the value of equities, and is consistent with the higher global growth conditions that the stock market has been so elated by. At the margin, there may be some growth at any price valuations imperiled by a slightly higher discount rate, and bond proxies like utilities are easily the worst performers YTD and down 15% since November^*. But if you run that thought a little deeper, what else does that signify? To me the risk is that Central Banks see 2% inflation or something approximating this and begin packing up the quantitative easing (QE) and unconventional monetary policy ‘big top’ that has been parked in financial markets for almost 10 years now. 

Brian Barish provides his take on what's been driving the markets lately.

It’s a post-Global Financial Crisis (GFC) version of the “Greenspan Put” whereby we have been able to reasonably expect financial stress and certainly anything that smells of deflation to be attacked with more QE. However, if the evidence is strongly pointing the other way, I think most Central Bankers want to take their win and clock it so to speak, winding down the QE and the Negative Interest Rate Policy (NIRP) and leave such policy tools available for future stresses. That means no more Permulus (permanent monetary stimulus).

Up to late 2017, I would say nobody expected inflation to do anything other than drag along at <2% in major economies. But… what if after nearly ten years of near 0% interest rates and balance sheet expansions, Central Banks actually caught the white whale they have been chasing? What if statistical inflation picked up as a result of tight labor markets, a raft of minimum wage increases, a lower dollar feeding into commodity prices, inflation in rental-equivalent costs as mortgage rates rise, and a less-pronounced drag from the digitization of the physical economy? We are talking small numbers here: 2.4% inflation would be an epic surprise! But should something that resembles durable real statistical inflation actually happens, the steady but non-volatile retreat from bonds could become rather volatile / has become rather volatile. Equity markets and real estate markets are expensive on a historical basis, and this scenario creates problems for all the asset classes, more or less at the same moment in time.

You have to remove the Permulus calculation from your asset pricing model, basically. I think that is what the markets are doing here. For what it’s worth, the S&P 500 has fallen under 17x 2018 PE as of the morning of February 6, 2018^*, and probably is a reasonable (but far from screaming) buy, if you don’t think yields are going far above 3%. We will see what happens in terms of the “E” part of this, but for the short term, I believe risk needs to be repriced.