From VIX to avocados

This week we highlight seven charts, taking us through the maelstrom of market themes that we take into summer. It is still a hopeful picture, but not as benign as some indices suggest. Liquidity may smooth over a multitude of stresses for some time yet, but some pinch-points are still emerging.

There’s a kind of hush…

We should start with the chart that’s still got everyone perplexed.

VIX May 17

The VIX index measures investors’ expectation of 30-day volatility on the S&P 500.  It’s often referred to as the ‘fear’ index. But, although fear might inspire volatility, lack of volatility doesn’t necessarily imply lack of fear. Once investors put any store by a measure – especially one with derivatives – the measure itself becomes vulnerable to distortion.

So, we shouldn’t take record lows in VIX entirely at face value. But after a brief wobble, global equity markets bounced back very quickly – almost as if they were returning to a default setting. And this is despite US economic surprises moving more to the downside – alongside political concerns

US Citi economic Sup

How have markets become so irrepressible?

Accentuate the positive….

Let’s start with the positive answer: a global economic pick-up.  The Eurozone is the ‘poster-child’ for the global economic revival and PMI® survey data for May showed the fastest growth for six years. This positivity is underlined by record high in German business confidence – which the normally reserved Ifo think-tank described as “euphoric”. Investors are also running the third-highest allocation to Eurozone stocks on record, according to Bank of America Merrill Lynch.

markit EZ PMI

But investors have also found succour in the relatively hard area of corporate earnings. European earnings are set to rise by 10% on average in Q1– albeit reduced to 5% if we take out recovering energy stocks. The UK is a special case – as we’ll see later  – but for those benefiting from exports there are reasons to be cheerful that we’ll take into the summer. But, this isn’t the whole story…

Take a chance on me…

Cracks are appearing in the growth narrative as we go into summer. For instance, if the global recovery is entrenched, why are sovereign yield curves flattening? There are structural reasons for flatter curves per se – including the aging population– but the most recent dip needs a current explanation.  The spread between US two and ten year bonds is now at its lowest since the US election, a trend reflected elsewhere. A fall of this kind would normally suggest falling expectations for interest rates and thus lower economic expectations. It may also suggest that investors are looking for havens.

US bond spreads

No particular place to go…

But, aren’t central banks meant to be on a tightening path and yields rising? The next Fed rise looks set for June. But, the path is murkier after that and policy remains loose and credit conditions accommodating. The ECB – having had its fingers burnt by early moves in the past – doesn’t look close to raising rates any time soon.  The UK economy is barely growing and its monetary path seems unlikely to change radically in 2017 – neither does Japan. Growth is improving, but at a relatively weak pace in a longer context and only with massive help.

To just underline the point on lose policy: central banks bought $1 trillion in assets in the first quarter of 2017. A near-decade of QE has almost normalised this level of support, but we should forget the magnitude of influence it has on capital markets. As Citigroup recently noted:

“the inducement to take greater risk in other asset classes in the absence of apparent and immediate negative catalysts is very strong. Even when central purchases stop, the opportunity cost on those newly created deposits will remain high until rates go up, providing indirect support for risk assets in the absence of obvious negative catalysts for some time.”

Liquidity & S&P

So, if equity markets seem inured to trouble, maybe it’s just because there are few other places to go. The chart from Citi shows how much liquidity matters.

Trouble

Meanwhile, there are still areas of stress emerging. A non-exhaustive list might include –

China…. Moody’s ratings cut is a reminder of its debt issues and difficult economic transformation, although it has an opportunity through the ‘One-Belt-One-Road’ plan to take positive steps and move into trade vacuums.

The US retail sector…..The US economy might be picking up, but wages aren’t and real incomes are weighed down by student loan debt amongst the young and low fixed income returns for the retired. Sub-prime auto-loans are also worrying Wall Street.

S&P500 department stores

The UK economy… The second estimate of UK Q1 GDP has been downgraded from 0.3% to 0.2%, largely due to consumer spending weakness, but there are downturns in manufacturing and construction too. This doesn’t sit exactly square with survey data in manufacturing and the recent pick up in sterling – and the UK weather – may provide some help to retailers; but, overall, it’s an uphill battle for consumer sectors in 2017.

Policy change…According to Reuters, the weakest earnings in Europe in Q1 have come in utilities, where earnings are tracking 30% lower combination of expected or actual increases in the regulatory burden, such as price caps and, in Germany, costs from deconstruction of the nuclear energy infrastructure.

Crisis hangovers…In Europe the Greek saga continues as creditors’ inability to agree on terms for debt relief continues and non-performing loans remain a major concern across Europe.

Everybody’s talking at me

So, as we go into summer, it’s all to play for. There is so much conflicting information that investors seem if not paralysed, then almost inured. But, it’s the abundance of liquidity that seems to be the key to investor rebounds. I’m not really sure what it will take to move investors – the Fed moving quicker than expected perhaps?

This means that companies should continue to benefit from an abundance of capital.

But that doesn’t mean we’ll have quiet summer or that nothing is changing. There is much to be resolved in the US. The sudden drop in the oil price has rattled equity markets. The UK economy is at a pivotal point and looking increasingly differentiated between the domestically and internationally exposed. The recent UK consumer pick up is expected to be short-lived and sterling may struggle to move much beyond $1.30 when the BREXIT talks begin in earnest. The number of column inches covered by rising cost of avocados belies the significant hit to real incomes we expect from more fundamental increases in costs beyond hipster toast-toppings.

avo

But, one of the biggest concern remains how to stop the QE merry-go-round without throwing investors from their horses. It is a subject that central banks that will increasingly address this summer – the ECB and Fed have started to pave the way – and they’ll be very keen for investors to pick up on their increasing signals.


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