Summary: Market volatility appears to be heading lower, which is normally a bullish signal. A Greek exit from the eurozone is seen as a low probability, the global economy is continuing to improve and there are few headwinds. From a corporate perspective, a number of factors are earnings positive.
Key take-out: We should expect both property and equities to boom. The worst case scenario is that stocks temporarily cheapen on the back of Fed rate hikes.
Key beneficiaries: General investors. Category: Shares.
Notwithstanding price action over the last few sessions, equities have had another good run over the year. Admittedly most of that has been over the last month or two for Aussie and European stocks – perhaps playing catch up with US markets. But the point still stands that they’ve had a very good run.
Now what’s interesting about this, is that Aussie stocks had their run at a time when global fear was a little elevated. That is fear as measured by the VIX index (chart 1). Just as a quick reminder, the VIX index is a measure of implied volatility of S&P500 index options. It’s regarded as a fear index because whenever markets are fearful or uncertain, volatility shoots up.
Anyway, and noting the lift in the VIX index overnight – more generally, market volatility indicators now appear to be headed back down to historical lows. We’re not quite there yet, but fear is low and the trajectory is down. Indeed since reaching a peak in January (following the election of a radical leftist coalition in Greece), the VIX index has declined quite sharply – down around 30 per cent. It’s a similar situation for the Aussie VIX as well.
Now this is normally a very bullish signal. The fact is that when the VIX index drops down to these levels – and stays there – it’s normally during a very strong multi-year rally. That’s what we saw during the period from 2004-2008 and again from the mid-90s. Theoretically a low VIX index shouldn’t act as a precursor to a strong rally. This is because if investors expected a large upside move, the VIX index would be high as well. In practice though – and investors being the risk averse bunch they are – when there is a lot of uncertainty, investors dump stocks. And vice versa.
Chart 1: Market volatility is low
This raises the question as to whether markets are being a little too complacent. Central banks obviously think they are. Yet – and in all seriousness – what are the headwinds? There would appear to be very few.
Searching for headwinds
Notwithstanding daily price fluctuations, chart 2 below shows that commodity prices appear to have stabilised thus far in 2015. Now commodities are a great uncertainty that is true, and no one could have a precise expectation. Yet given the current expectation that a supply glut is driving prices lower, and little in the way that could change that, a rally is unlikely. You need a story-line, a narrative, in a market which the Bank for International Settlements acknowledges isn’t often driven by fundamentals.
Chart 2: Commodity markets have stabilised (CRB index)
Then think of the broader market narrative. There is no fear factor out there at the moment. Greece is it – and the market is very much taking things in its stride here. A Grexit is viewed as a low probability at the end of the day – and even if one were to eventuate, the likelihood of contagion into Italy or Spain is low. So it’s unlikely that this would be the cause of a sustained correction.
More broadly, the global economy continues to improve although there is a bit of volatility around the place. Yet we needn’t worry too much – the latest data out of the US confirms that US consumer spending continues to accelerate, jobs growth remains strong and GDP itself is growing at a decent clip. In the eurozone, recession has past and while growth is weak, the talk now is of stabilisation. The ECB chief Mario Draghi said just this week that the eurozone economy had turned a corner and was on the path to recovery. Over in China, and while growth is strong – those who think it’s weak even talk of a stabilisation rather than a hard landing.
So what does that leave us with?...Not a lot in the way of headwinds.
An “earnings positive” landscape
From a corporate perspective you’ve got the lowest borrowing rates in a generation – on record in some cases. Then think of the earnings environment. Input costs are very low: commodity prices have slumped, wage growth is low and unit labour costs have done little since the GFC. Up about 2 per cent in about six years. This is all very earnings positive.
Global imbalances – whether balance of payments, investment or what have you – otherwise seem contained. Against that backdrop the decline in volatility – in market fear – looks entirely justified.
Normally when volatility is this low you do seem to get a strong rally – that’s what history tells us. But we’ve had that already and many question how much more momentum there can be. Just look at the recent headlines: A lot of the talk and a lot of the advice from money managers is to get prepared for the correction. I’m not saying that’s not going to happen and stocks have been smashed in two of the last three sessions. The problem is that this low volatility, following an already very strong multi-year rally is unusual - and we’re in unchartered waters there is no doubt about that.
Think of our current circumstances as an inflection point if you will: Where the market’s true risk appetite will be tested. If we break through this point, then the market’s rally could gain much more momentum – testing what are already, in the view of some, very stretched valuations. Remember, cash rates are low, so what are the investment alternatives? Nothing really. Property and equities are it – we should expect both to boom and bubbles to form.
Ironically, the stand out catalyst for a correction is the strong US economy at this point. Just look at how the market reacted to the strong US jobs report on Friday night – and subsequently. US equites were smashed, falling by about 1.5% for the session and again last night. I was surprised by that move to be honest, as it had seemed the market was otherwise at peace with the prospect of Fed rate hikes. Indeed the tightening cycle is probably fully priced – at least into the USD index already. And in any case, Fed funds futures themselves expect only two rate hikes later this year – rising to only 1.25 per cent (so another three rate hikes) by the end of 2016. That’s a very gentle tightening cycle and Fed policy is in no way a threat to the equity market rally over the medium term.
The worst case scenario, with that backdrop, is that stocks temporarily cheapen on the back of Fed rate hikes – maybe we are going through that now (see Robert Gottliebsen's article today: Wall Street rules the ASX).
Yet Fed rate hikes can only delay further stock gains – they don’t prevent them – because the Fed will be hiking into a strengthening economy. A strengthening economy is earnings positive – and it’s not a bad position for investors.