From the Sunday Start by Andrew Sheets, Morgan Stanley's chief cross-asset strategist
Every American has their own 4th of July traditions. Mine included the neighbourhood lining up in a field and tossing eggs back and forth, at increasing distance, until only one person remained. Every year, one egg was suspiciously indestructible, impervious to all manner of drops and awkward bounces. Roughly a year ago, that seemed to be a perfect analogy for the market.
A year later, things have a familiar feel. Global markets have withstood all manner of challenges without cracking, from a sharp spike in volatility, to higher US rates, to escalating trade tensions. Once again, summer looms with low implied volatility, tight high yield spreads and persistent leadership by US equities and tech. On the surface, it looks a lot like last summer. It’s not.
Four key elements of this market are very different than a year ago. Back then, we chalked the market’s resilience up to four factors: An unusually happy truce among growth, inflation and rates; a positive skew to policy surprises; rock-solid credit markets; and a large gap between (low) implied and (even lower) realised volatility. All of these have changed.
Let’s start with growth and inflation. Last year, markets enjoyed the unusual combination of rising PMIs with little inflationary pressure. For the last eight years, markets have been supported by the idea that good data would support market normalisation and bad data could bring further policy easing. While not always the case, it was often fine either way. Good and bad were both good.
That’s changed. US headline and core inflation have risen sharply since the start of the year, with core PCE now sitting above the 20-year average and facing a shift to structural upward pressure from healthcare costs (which make up 20% of the index). Unemployment is back down near historical lows. We think that this keeps the Fed hiking, with a forecast of four more hikes between now and December 2019. Better-than-expected data would mean even more tightening, while the strong US growth we’ve already seen in 2Q has led our strategists to raise their USD targets and lower their assessment of EMFX and EM equities. Good could be bad.
Meanwhile, two things have stood out to me at recent meetings and conferences:
- Investors are now more sanguine about how much time they have until the next recession than at any point since 2010. We’re 8 ½ years into an expansion, and many investors finally are finally confident that there is plenty of time left on the clock.
- China is rarely mentioned as a growth concern (after causing angst for much of this period).
Both, in my view, suggest a vulnerability to weaker data, especially given the rise in US inflation and the already dovish stances of the ECB and BoJ. Bad could be bad.
Together, this lack of concern means growth and inflation now need to fit into a much smaller window to avoid rattling markets one way or another.
Second, the change in policy. Last year, there was clear policy catalyst (tax) that the market was far from fully pricing. This year, that seems to have been replaced by a clear policy risk (trade) that the market is far from fully pricing. Our economists and US public policy team remain cautious on the current state of trade negotiations.
Third, credit markets. Last year, nearly every pocket of global credit was strong and stable. This year is very different. While US high yield is back near post-crisis tights, US investment grade, European credit, Asia credit and emerging market credit are all weaker. Libor-OIS spreads are near a nine-year high. No prizes for guessing which one of these we think is most mispriced.
Finally, market volatility itself. Last year it was easy to scoff at investors who were selling volatility at historically low levels. But the irony is that this trade was hugely profitable. Although implied vol was low, realised volatility was even lower, near some of the lowest levels ever recorded.
That’s changed. While implied volatility in DM equities, rates, credit and foreign exchange is back near 10-year lows, realised volatility is often closer to the middle of the 10-year range. Volatility is less expensive to own and less profitable to sell. We think that matters.
What does all this mean? We see a broad-based opportunity to buy volatility across asset classes based on levels and carry. We think US high yield credit is an attractive short via options for the second half of the year, given tight spreads, high gearing and expected outperformance versus other global credit assets. Our FX strategists have revised their USD path upward, given the pressure on the Fed to keep tightening policy despite recent EM weakness. We expect the Treasury curve to keep flattening, and suspect we may have passed the high point for US 10-year yields in this cycle. Within EM, our greatest concern would be with equities, which we think face earnings risk, poor momentum, poor FX-hedged carry and an insufficient valuation premium to other ex-US markets like Europe and Japan. We think EM hard currency debt is preferable to equities, and European stocks are preferable to both.