As part of the macro forecast in his just released 2018 Credit Outlook (more on that in a subsequent post), DB's Jim Reid first looks back at the almost concluded 2017 and muses that "whichever way you cut it, it’s likely that 2017 will go down as one of, if not the least, volatile year ever for the vast majority of asset classes. The recent sell-off in early/mid November has been a bit of a wake-up call but overall this remains a blip." In fact, it makes him wonder if 2017 was "the most boring year ever?"
To make the argument , Reid presents figures 10 and 11 to show vol measures for equities and treasuries respectively, and notes that "realised volatility on the S&P 500 has recently been the lowest since 1995 and close to the lowest in the 90 year history of the data, the VIX has been at the lowest since data started in 1990 and the MOVE index in November 2017 traded at the lowest since the data started in 1988."
Reid then notes that given the close correlation between major asset volatility levels and credit spreads, the latter are not particularly stretched in valuation terms given the external volatility environment is so suppressed, something Fasanara capital has been focusing on, by highlighting the flood of vol sellers but cautioning that stability itself breeds instability. In any case, Reid notes that the recent sell-off is a blip on these longer-term charts, and in Figure 12 shows the relationship between credit spreads in Europe versus a regression model of where spreads should be given volatility in European equity and rates markets and global FX vol.
Deutsche also shows the same for USD credit in Figure 13 but based on US equity and rates volatility as well as global FX volatility.
Reid joins countless other strategists opining on the lack of vol in the past year, asking "why has volatility been so low and can it continue?" His answer is that the most likely reason for volatility being so low is a combination of:
- Synchronised and firm global growth;
- Inflation that has consistently been in the ‘Goldilocks’ range and not accelerating as much as expected in 2017, and;
- Global central bank liquidity which in 2017 has still been close to peak levels.
On global growth we’ve now had eight years of growth and six years of very steady almost predictable levels of output relative to expectations. Indeed the IMF forecast for the globe has ranged from 3.3% (2012) to 3.7% (2014) based on forecasts made around the start of each calendar year and in each year the outcome has not been too far away from these numbers. In this environment investors have been confident enough in the stability to push vol lower. The slight beat at a global level in 2017 (without inflation – see below) has only helped this.
For inflation, Reid notes that "we’ve continued to see a sweet spot of prices picking up enough from the 2015/16 lows to discount deflation risk that many felt possible at the time, but not enough to really convince investors that the central bank put is dead. For financial markets the soft inflation readings in 2017 without any deflation fears couldn’t really have been much better."
In other words, or just one word: "goldilocks", although as Goldman stated last week, "goldilocks is unlikely to continue into 2018."
Which brings us to Reid's key point, and perhaps the most important of all, namely "that we have also had a year of incredibly accommodative monetary policy even with slowing reinvestments and tapering. The combined size of the Fed, ECB, BoJ and BoE balance sheets has expanded to around $14.9tn which represents an increase of $1.8tn relative to the end of 2016."
However as we look forward it’s almost certain that 2018 will represent a changing of the guard for ultra-easy policy. As of October 2017 the Fed has begun (albeit gradually) the process of unwinding its balance sheet, the ECB has announced that it will further taper the growth of its balance sheet in January (although the impact of reinvestments will somewhat buffer this move), the BoE recently raised its benchmark interest rate for the first time in a decade and the BoJ is purchasing less now given its focus on controlling the yield curve rather than targeting a set monthly amount.
Finally, putting these observations in practice for the equity market means that if the S&P 500 can hold on to complete its 13th successive positive total return month - with November currently running at just under +1.5% - it'll be the first time ever in the c.90 years we have monthly returns data that we've seen such a run. We've also never seen every month in the year experience a positive total return. Whether November might create the first of these new records might depend on where we go on the expected Senate vote on tax reform later this week...