Ok it has been a couple of eventful weeks if you were invested in equities be them from developed markets or emerging markets. Clearly the scaremongering of analysts and journalists paid by the line rather than the true profit they generate has somehow fed into the volatility and sudden lack of rationale of markets. We have seen a spike in the VIX and as indicated by a 2-state Markov regime switching model a risk off scenario. As mentioned in my previous post, it is worth bearing in mind that those periods of risk aversion tend to be short and somehow provide good ground for opportunities.
True the sell off somehow pushed most equity markets in the red. But if one take time to look at the moves that unfolded they have not been really out of tune from what could be expected from the median risk of equity markets. By that I mean that if you assume that equity markets have typically an annualised volatility of 20% this means that the monthly move expected under a normal distribution assumption should be tantamount to 20% * 1.6450 /sqrt(12) = +/- 9% . So true enough some of the markets such as Japan and Chile have gone somehow out of this range as shown in the below chart. But I would argue that we are not miles away and that there is no reason to panic because a herd of unknown analysts have come out from the woodworks forecasting the end of the world as we know it…..a loss of nerves is is to be expected every time we have a down move of more than 5%.
In respect of the S&P500 the move we have seen over the last 21 days is indeed pretty much middle of the road as a close neighbour analysis using daily data back to 1980 demonstrates. From there the scenarios are quite varied…
So let’s go back to the catalyst of those financial ripples, the Fed policy an its impact on global liquidity. Well , there is nothing new about the Fed reducing its liquidity supply. We have been told last year what was the plan and you are better getting use to it ! Bottom line is that things are going very well in the US, the data is clearly indicating a strong recovery which is logically feeding into both the housing markets and the equity markets. So it may well be that the liquidity which is smoothly withdrawn by the fed will in fact be replaced by investment flows and a growing trading activity between the developed world and emerging market countries as those economies recover and re-leverage. Perversely this could have a negative effect on the dollar as it will mean more cross border flow toward new international opportunities by US investors and corporates. Also as growth come back and US withdraw some of its liquidity it is likely that some of the EM countries will draw on there reserves which is predominantly made of US$ to stimulate their own economies. Anyhow it is worth looking at the latest batch of data on inflow in US Mutual funds as it now cover the recent period of volatility.
And guess what…. investors are still buying international and domestic equities significantly. Bonds flows have somehow recovered ever so slightly….though my view is that they will probably shift back to negative for the reasons presented in my previous posts…..So I think I ll keep re-investing those dividends in financial equities for a while..
Despite the significance of the flows observed the dent made to the level of investments accumulated in bonds over the years remains modest so far. This is good news for the current rally as therefore there is still much adjustment to take place all being equal. Clearly what we will experience ahead will be dependent on future economic growth. Bearing in mind the track record of accuracy of forecasts made by economists and alike my view of a significant economic growth in the next few years based on the lagged response to the significant stimulus provided by major economies is as good as any. Over a shorter horizon I think it is fair to say that so far governments and financial authorities have done a relatively good job and that the green shoots of recovery are well established. My view is that central banks will be weary of adjusting their monetary policy too fast as they will want to maximise the likelihood of strong economic recovery and job creation. Inflation will definitively become acceptable if accompanied by strong growth. A scenario of higher nominal rates but not necessarily higher real rates should further promote flows toward equities. Lets face it what we are seeing is structural and we probably have another few years of equity beta coming our way.
