Will we see more turbulent global asset markets in the rest of 2018? Why are asset prices more volatile this year?
We see a high chance of more turbulent or “volatile” global financial markets in the rest of 2018. Solid returns year-after-year in international equities and bonds have allowed investors in these financial instruments a relatively easy ride since the 2007-09 Global Financial Crisis (“GFC”). As an example of well-followed equity benchmark, the MSCI World Index has returned 178% in the 9 years since end-February 2009 or 12% on average each year. These figures are impressive when compared with nominal global GDP growth, up 25% (2.5% per annum, source: IMF) in that same period of time.
The repairs to the global financial system undertaken since the GFC have taken a very long time. Interest rates were maintained at a zero bound (minimum of 0%) in the US for 7 years to the end of 2015 and remain today at an effective zero bound in the Eurozone, Japan and Switzerland. In Europe, only the UK (one interest rate hike) and the Czech Republic (three hikes) have moved interest rates away from the zero bound since last August. Faced with what appeared to be a weak economic recovery in 2009-11, Central Banks went further, embarking on programmes of “quantitative easing” (“QE”), the printing of money in an effort to stimulate economies back to health.
Rather than acting to bring global economic growth back to healthy levels, these QE programmes in our opinion not only inflated the price of financial assets, including bonds, credit and equities but also suppressed the degree of movement, or “volatility”, of markets. Central banks, especially the Bank of Japan, the Swiss National Bank and the ECB bought and remain buyers of riskier financial assets. These Central Banks are now substantial holders of these types of assets. Other market participants were and are aware of the intentions of Central Banks, as their overall QE decisions are publicly declared before implementation. Thus, it was a relatively easy decision to hold these assets, knowing that substantial buyers were probably in the marketplace.
The recent sea-change is the decisions by the US Federal Reserve (“the Fed”) to raise interest rates from their zero bound 5 times already and to announce and start to implement their intention to sell their acquired US Treasury bonds in the marketplace. The key consequence of this decision we note is the increase, for example, of US Treasury 10-year bond yields from below 1.5% to nearly 2.9% over the last 18 months. The Fed observes inflation running at its target rate of 2% and very low unemployment rates in the US economy. It sees risks that inflation might rise. The Fed thus is signaling that further interest rate rises are likely.
For US borrowers and market participants globally, this is a disturbance to those calm waters seen since 2009. US interest rates and especially US bond yields are used as benchmarks by borrowers worldwide. It was a fear that these rises are actually going to happen that saw sharp falls in equity (and some credit) markets in early February and a pronounced increase, sustained somewhat since, of measures of the movement, or volatility of these asset classes (such as the widely-followed US S&P “VIX Index”).
In recent weeks, the Bank of Japan and the ECB have made more obvious their desire to reduce their own “QE” efforts, even though their inflation rates are below the set targets. Their intentions are perhaps an admission that the policies have had a limited positive effect, merely more a protection against a deep recession.
We believe that if some or even all of the major Central Banks are moving in the direction of tightening policy, then market conditions with violent movements (“volatility”) will persist. And price corrections may ensue.
Anecdotal surveys such as by pricing provider Bloomberg suggest just over half of asset managers active in London, Paris and New York have less than 10 years’ experience. This implies they have thus never experienced large-scale tightening of monetary policy by Central Banks. Given the record levels of personal, corporate and government debt across the world economy, these higher interest rates may well make the waters ahead very turbulent.