Data Source: Bloomberg
Market Volatility Stabilizes as We Head into Year-End
Markets Push Higher as Volatility Declines
The holidays came early for U.S. equities, primarily U.S. large cap growth technology, as investors pushed 2019’s market leaders ever higher. Much of the angst we wrote about in October (“ October 2019 Market Commentary: Tearing at the Seams”), such as 1) renewed tensions in U.S. / China trade discussions, 2) Hong Kong protests, 3) ongoing global manufacturing malaise, and 4) emerging weakness in U.S. corporate credit, did not translate into November volatility as global developed equity markets advanced higher led by U.S. large cap stocks. Emerging markets have not benefited as much from the holiday rally as the fallout from the U.S. / China trade conflict spreads across Asia from worsening credit conditions cropping up across China’s banking system to a steep drop in local retail sales resulting from Hong Kong protests.
The last few weeks of November saw U.S. growth stocks follow a stable upward path of appreciation that also helped drive down U.S. market volatility to near-term lows (Figure 1). So far, the drop in realized volatility has not been met with a corresponding drop in implied volatility (or expected volatility that is priced into S&P index options), suggesting that the options market is less complacent versus equity investors and is expecting a pickup in volatility over the next few months.
Figure 1 – Realized Volatility Drops as Investor ‘Worry’ Gets Priced Out of the Market
Speculative (non-commercial) investors are betting on a further drop in volatility (or at least stable volatility) as non-commercial short interest in volatility (VIX) futures has reached near peak levels (Figure 2).
Figure 2 – Short Interest in VIX Futures Reaches Near-Term Highs as Investors Seek Nickels in Front of Steamrollers
Those short volatility via VIX Futures can earn a roll-down term premium between the 2nd / 3rd month futures versus the current front-month (Figure 3) as long as market volatility remains well behaved. Overall market volatility has come down, but investors seem to be betting on further drops.
Figure 3 – Those Short Volatility Are Enjoying a Steep Term (Roll-Down) Premium at the Front-End as Long as Market Risk Remains Well Behaved (Chart as of 11/30/2019)
A strong case can be made that equity investors are becoming more complacent, but a further drop in implied volatility priced into options and volatility futures would help confirm this complacency.
U.S. Markets Continue Their Advance Over Rosy Growth Expectations Heading into 2020 and a Fed Policy Supportive of Loose Financial Conditions
Regardless, expectations of robust U.S. holiday sales (goosed by earnings surprises from big box retailers) combined with liquidity support from the U.S. Federal Reserve (via balance sheet expansion driven by the Fed’s intervention in the repurchase markets) have helped give U.S. equities another leg up, which has pushed the forward earnings multiple to 17.8x over next 12-month earnings (Figure 4). Equity investors also seem to be looking past this year’s macro headline tail risks such as U.S. / China trade disputes and U.K. Brexit.
Figure 4 – U.S. Market Valuations Approaching 2017 Peak Levels as Rest of the World Continues to Lag the U.S.
Investors have largely written off earnings growth for 2019 (flat earnings according to the 11/22/2019 edition of Factset Earnings Insight as opposed to ~10% growth for 2019 that was expected around this time last year). Most of this year’s appreciation in U.S. stocks has come via multiple expansion (14.5x at the beginning of the year versus 17.8x currently). Wall Street analysts now expect 9.9% earnings growth / 5.5% revenue growth for S&P 500 companies in 2020, with much of the growth expected to be generated by 2019 sector winners, namely consumer discretionary and technology, both trading at over 20x forward earnings. Earnings estimates for next year are trending positively for both U.S. markets as well as Europe while flat or trending down for Japan and Emerging Markets (Figure 5).
Figure 5 – Earnings Estimates (White Lines) Trending Positive for U.S. and Europe While Trending Flat or Down for Japan and Emerging Markets
‘Long duration’ plays that have defined 2019 (long maturity bonds, corporate credit, premium growth stocks, low volatility equities) are gaining momentum as investors seek to catch up with this year’s popular trades. Investors don’t expect the U.S. Federal Reserve to upset the apple cart like it did in 2018 when the Fed hiked rates and pared back its balance sheet. In addition to capitulating on the pursuit of rate normalization by cutting rates three times in 2019, the Fed has reversed its balance sheet contraction via repurchase (repo) market support (Figure 6).
As more information surfaces on the Fed’s repo market intervention, large U.S. banks do not appear to be the culprit for overnight funding stress, unlike 2008 when the large repo players helped bring down Lehman Brothers as Lehman was effectively cut off from short-term lending. Rather, it appears that smaller banks (particularly, non-U.S. banks heavily involved in leverage loans via collateral loan obligations over CLOs) and non-bank lenders (i.e. specialized brokers who lend to leveraged hedge funds) appear to be the source of the funding stresses. The Fed may face criticism that it is helping to prop up the weaker areas of the credit markets, such as leveraged loans, but they would rather do that than have to clean up the mess that could occur without the Fed’s intervention.
Figure 6 – Renewed Growth in U.S. Fed Balance Sheet Resulting from Repo Market Intervention (Comments Courtesy of the Bear Traps Report 12/2/19)
Source: Bloomberg and Bear Traps Report
Fed funds futures are pricing in one more rate cut in 2020, likely before the November elections (Figure 7). Outside of some troubled pockets within corporate credit (energy, consumer discretionary), investors seem to be more at ease in receiving smaller compensation for investing in riskier segments of the credit markets even as corporate credit decouples from U.S. leading economic indicactors (Figure 8). The Fed has effectively sidelined itself on monetary normalization; current Fed policy will likely not serve as the prime contributor for the next spike in market volatility.
Figure 7 – Fed Funds Futures Pricing One More 0.25% Rate Cut by 3Q2020
Figure 8 – Credit Spreads Remain Narrow in the Face of Declining U.S. Leading Indicators (Black Line Inverted)
Despite the September/October outperformance of ex-U.S. markets versus the U.S, U.S. assets and the U.S. dollar have retained their 2019 dominance as investors see fewer reasons to invest beyond the U.S. markets. European and Japanese central bank officials are indicating the limits of negative interest rates and have strongly hinted for government fiscal stimulus to pick up the growth slack – not exactly a vote of confidence for near-term growth outlooks. Benchmark German and Japanese bond yields (Figure 9) have risen suggesting a lower threshold for negative interest rates has been reached, yet the U.S. dollar continues to appreciate as investors have not entirely discounted an economic contraction outside the U.S.
Figure 9 – German and Japan Government Bond Yields Have Risen from Their August Depths
Figure 10 – The U.S. Dollar Recovers Much of the Value It Lost in September/October
Price seems to matter little under a ‘long duration’ regime of low nominal economic growth and negative real interest rates. Since ‘growth’ is perceived as scarce under this regime, investors are willing to pay up for extra ‘carry’ such as long duration corporate bonds and premium growth stocks as the ‘terminal value’ (future growth discounted at very low cost of capital rates) comprises the bulk of overall equity value. Until, the macro outlook shifts towards one of more synchronized global growth, investors will likely flock to the ‘sure’ thing which appears to be U.S. large cap growth and long duration bonds.
November 2019 Market Review
Global stocks posted positive returns (MSCI All-Country World Index or ACWI up 2.4%), primarily driven by the U.S. (S&P 500 +3.6%). Europe, Japan, and Emerging Markets (up 1.5%, 0.6%, and -0.1%, respectively) could not keep up with the U.S. (Figure 11). Emerging Markets and the broader Asian region continue to suffer from the knock-on effects of the U.S. / China trade conflict and increased signs of financial stress within the Chinese banking system.
Figure 11 – U.S. Led Major Market Regions While Emerging Markets Lagged
Within the U.S. markets, U.S. small caps underperformed large caps and value underperformed growth (Figure 12); much of this outperformance occurred towards the end of the month. S&P Small Cap returned 3.1% vs. 3.6% for the S&P 500 while S&P Pure Value returned 3.8% vs. 4.2% for Pure Growth.
Figure 12 – U.S. Small Cap and Value Narrowly Outperform Large and Growth
Technology, financial, and healthcare stocks led sector performers while defensive and interest-rate sensitive sectors such as staples, real estate and utilities lagged.
Figure 13 – Healthcare, Technology, and Communication Services Led Major Sectors
Among factors, High Quality and Momentum outperformed Value, High Dividend, and Minimum Volatility (Figure 14). Once again, High Quality seems to be benefiting from an earnings/profitability scarcity as investors flock to companies deemed to have strong competitive positioning. Minimum Volatility continued its underperformance from September as this factor suffered alongside the sell-off in the bond market earlier in the month.
Figure 14 – High Quality the Only U.S. Factor to Outperform the S&P 500
Fixed income was marginally down in November as the 10-Year Treasury Yield settled at 1.78% (down from an intramonth peak of 1.94%), slightly up from the beginning of the month. The U.S. Bloomberg/Barclays Aggregate Index returned -0.1% in November (Figure 15). High yield posted another positive month as corporate credit spreads remained stable despite the continued sell-off in the weakest and most leveraged segments of the credit markets. Emerging market debt underperformed alongside equities.
Figure 15 – Slightly Down Month for U.S. Investment Grade Fixed Income
Commodities were up for most of the month (Figure 16) but then finished flat as oil prices sold off due to higher than expected U.S. inventories as well as populist pressures arising across the Middle East that could test OPEC’s resolve to limit production. 1-month spot oil ended November at $55.18/barrel, up from $54.17/barrel at the beginning of the month. Real estate and Precious Metals posted losses earlier in the month following sell-off in U.S. Treasuries that saw the 10-year yield rise to 1.94%; real estate recovered as the 10-year rate settled down to 1.78% but precious metals performed sideways.
Figure 16 – Commodities Gave Up Early Month Gains at the End of November
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