A liquidity lull

As uncertainty in Europe eases, investors appear fairly calm about the near-term outlook for equities.

PORTFOLIO POINT: Recent data suggests investors are calm about the near term outlook for equities, although caution remains due to the risks around growth.

After watching last week’s events unfold, it seems that the central bank printing presses could cool off for a while. That’s one conclusion to draw from the events of February 29. The ECB’s 3-year long-term refinancing operation (LTRO) auction was roughly in line with expectations – €530 billion in gross amount, €323 billion net after existing borrowing was rolled into the new 3-year. The apparent success that the LTRO has had in reducing tail risks, at least in the near term, means that further ECB liquidity injections don’t appear likely any time soon. If this doesn’t come as a surprise to most investors, perhaps Chairman Bernanke’s testimony before Congress did. The market interpreted his acknowledgement that recent employment data has gotten better as a signal that QE3 is now less likely. The ripple effect of no QE by both the Fed and ECB could mean less easing in other regions.

Our economics team still very much believes that the GME2 (Global Monetary Easing) thesis – and, to be clear, less central bank balance-sheet expansion than expected – are in no way tantamount to tightening. But since it’s changes at the margin that matter most for investors, any indication of less easing over the near term could be enough for markets to start correcting, or at least make them more vulnerable to a pullback. That, of course, depends on what investors were actually expecting and what the markets were pricing. The market reaction to the LTRO was relatively muted, indicative of an in-line result. In contrast, the initial price reactions across asset classes to Bernanke’s comments were consistent with the markets pricing potentially no QE3: gold dropped sharply, the USD was higher, and rates rose, but after immediately selling off, equities bounced back.

The prospect of less monetary easing puts an even greater focus on growth. Our view has been that growth, not QE, was the primary driver of risk assets over the past few years, and the modest market reaction to the diminished prospects of more QE supports that. That direct relationship between growth and the markets should only be stronger if more QE is on hold. But growth also matters indirectly because it drives Fed action. Given the bullish sentiment of most investors, the market could continue to grind higher on a “heads we win, tails you lose” mentality regarding growth: the market rises with good data, but it also rises with bad data because the Fed (and ECB) will open up the liquidity spigot as needed. Nothing like having your cake and eating it too!
Alas, this sanguine view isn’t supported by the growth data sending a strong risk-on signal. Indeed, US data continues to be mixed, with labour market improvement offset by weakness in personal spending and income. Most confusing is that we saw a sizable drop in our US 1Q GDP tracking estimate to 1% this week, down from 2.2% in late January, at the same time that Chairman Bernanke acknowledged the stronger data.

Now with the price of oil rising on Middle East tensions, and gasoline prices potentially reaching demand-destructive levels during the summer driving season, the risks to growth can’t be downplayed.

Is just being highly accommodative enough?

All told, monetary policy is at least marginally less accommodative than was the case only a couple of weeks ago. For the US, Europe, and the rest of the world, we consider what monetary policy could look like and why.

US/Fed: Chairman Bernanke’s comments did not change Vincent Reinhart’s assessment that the probability of Fed action in 1H12 is 75%, with a 50% chance of QE3 by June and a 25% chance of extending Operation Twist (OT2) by early 2Q. The Fed’s desire to move sooner rather than later is motivated by the political calendar, as well as a desire to nurture the ongoing expansion. What has changed over the past few weeks is the increasing likelihood of OT2 at the expense of QE3. While this could still achieve the Fed’s objective (and it’s easier to continue an existing program than start a new one), OT2 is also not as expansionary as QE3. The market may have already begun pricing in the shift from QE3 to OT2, given that the 2y Treasury yield rose from about 20bps to 30bps in February (see graph 1). This rise could also, however, reflect expectations of the Fed raising rates sooner than its end-of-2014 timeline.

Europe/ECB: With sovereign spreads continuing to come down and strong demand for post-LTRO peripheral debt auctions, further liquidity injections by the ECB look unlikely at this juncture. Indeed, our Europe economist Elga Bartsch now expects fewer refi rate cuts in 2Q, only 25bps not 50bps, and no longer expects QE sometime in 2H12. To us cynics, the ironic perversity is that the unbridled success of the 3-year LTRO removes the prospect of further outright ECB balance sheet expansion in the near term. Furthermore, in between the LTRO and QE debate, an important turn of events not so quietly took place – ECB altering the game on private sector involvement. To us, the fact that the ECB unilaterally swapped out its Greek bond holding into “new” bonds in order to avoid the imposed haircut set a clear precedent that private investors will be subordinated in the future. The unintended consequence of this act is that it likely diminishes the market benefit to future ECB sovereign bond purchases, either through outright QE, or through the existing securities markets programme (SMP). In addition, while lower funding stress is certainly a positive, it also alleviates the pressure on politicians in the euro periphery to undertake fiscal and structural reforms. The news that Spain relaxed its deficit reduction target is a case in point. Once again, European officials may have snatched defeat from the jaws of victory by relaxing too early.

Source: ECB, Morgan Stanley Research

ROW/Emerging Markets: If the Fed and ECB both pass on the QE front, it will have knock-on effects for other central banks. For instance, the BoJ may not follow up on its recently announced $130 billion asset purchase plan with additional easing, especially with the JPY weakening. In emerging markets, the net effect of less developed markets easing should be more easing. Without the Fed and ECB supplying liquidity, emerging economies receive less implicit easing through capital flows. The monetary playbook suggests that if emerging market growth momentum continues to moderate, further easing is necessary. However, the complexity relative to the so-called playbook for emerging markets is the inflation risks posed by a rising oil price. While rate hikes are rather unlikely, if oil and commodity prices generally maintain their upward trend, then further easing could be off the table. While many emerging markets are better equipped to handle the current energy price level than they were a year ago, it nonetheless is a binding constraint around monetary policy options.

Grinding Higher or Tactical Correction?

The economic data is providing a bounty for investors and strategists alike: there is something for everyone to justify their view. Bulls can point to the improving labour market conditions, while bears can emphasise weak income growth, persistently high leverage, or looming fiscal tightening. Thus, there is ammunition to argue both that markets can continue to grind higher and that a tactical correction is likely. Putting aside these subjective economic assessments, the price action also provides context for assessing the potential near-term market outcomes. For starters, volatility for all asset classes has fallen significantly over the past few months, returning to the lows prior to last summer’s sell-off, with credit being the exception (see graph 2).

Source: Bloomberg, Quantitative and Derivative Strategies Group, Morgan Stanley Research

Focusing specifically on equities, three aspects of volatility tell the story of current investor thinking. First, realised volatility has fallen to exceptionally low levels (graph 3). This reflects the slow steady grind higher, as well as the Fed effectively crushing volatility. However, since this is also occurring at low volumes, it suggests caution and complacency to some degree. Second, the implied volatility term structure is once again steep (its normal condition), which is a complete reversal from last August. Back then, the risks appeared to be front-loaded after the US credit rating downgrade, and on fears of a double dip recession and sovereign stress in Europe. The current low short-term volume speaks to the fact that investors are fairly calm about the near term. However, the third aspect of volatility, the steep skew, implies that both tails are relatively fat, with investors willing to pay for downside and upside protection.

Putting this all together, it suggests a market in which investors are fairly comfortable with the view that risk assets can continue to grind higher in the near term, but they’re also fearful of the other shoe dropping, whether on growth, Europe, or something else. And the interest in both tails is consistent with different interpretations of the growth data.

Source: Bloomberg, Quantitative and Derivative Strategies Group, Morgan Stanley Research

The combination of bullish sentiment, underappreciated risks, and 'tranquil' markets justifies a cautious asset allocation, in our view.

*This is an edited version of a research note from Morgan Stanley.

Gerard Minack is head of global developed market strategy at Morgan Stanley.