2022 market scorecard: butterfly 1, invisible hand 0
Ash Alankar, Global Head of Asset Allocation, explains how a lack of diversification among stocks and bonds has resulted in chaotic financial markets as investors frantically react to nearly every economic and market development.
8 minute read
- This year’s sell-off in both stocks and bonds has robbed investors of diversification’s benefits with the result being large market moves on any surprise in economic data.
- Chaotic markets are also the consequence of investors reconciling themselves to the reality that central banks will no longer intervene to support asset prices, and that a new era of higher inflation and real interest rates has arrived.
- Investors have the opportunity to earn attractive premiums by capitalizing on price dislocations in securities impacted by market volatility, especially as risk begins to tilt toward the upside.
Financial markets have had a bumpy ride in 2022. Through October 21, the S&P 500® Index already recorded 102 days where its closing price moved greater than 1.0% relative to the previous session. This is almost as much as the level registered for the entirety of the pandemic-stricken 2020 calendar year and is on pace to be the second-highest total in the last half-century, behind only crisis-riddled 2008.
The bumpiness has not been entirely unexpected: the year-to-date average of the forward-looking VIX Index measure of equity market volatility is 26, a third higher than the 2021 average. Bonds have had it even worse, with a gauge of U.S. Treasury market volatility 91% higher than last year. This is not a market for the faint of heart. Behind investor fickleness and the hair-trigger reactions of traders, in our view, is the degree to which market participants hang on every macro development, whether it be a single data point on the labor market or inflation, or what they perceive to be the subtlest shift in tone by a Federal Reserve (Fed) official.
Days in which the S&P 500 Index closed with at least a 1% gain or loss
U.S. equities are on pace to surpass the pandemic year of 2020 in number of days with index moves larger than 1.0%.
Source: Bloomberg, as of 21 October 2022.
We believe an explanation for investors’ convulsive behavior can be found in the research of mathematician and meteorologist Edward Lorenz. In perhaps his most well-known work, Mr. Lorenz posited that a chaotic system is characterized by only the slightest change in initial conditions resulting in much larger differences down the line. He called this phenomenon “The Butterfly Effect.” With such large price swings hinging on what would otherwise be calmly absorbed into the bigger picture, we believe “chaotic” is an apt description for markets in 2022.
Another fitting term is “fragile.” The question is, what is driving market fragility? We believe that the answer is the disappearance of diversification between equities and bonds. As we have often warned, in tail events such as generationally high inflation and aggressive monetary tightening, all asset classes are at risk of materially selling off, thus robbing investors of diversification’s benefits at the precise time they are needed most. Without diversification to dampen losses, investors will grasp at anything – regardless of however previously insignificant – in an attempt to right their portfolios, with the subsequent actions appearing, well, chaotic.
Citi Macro Risk Index
In 2022, this gauge of the market’s sensitivity to macro risk is 71% higher than it was in the preceding five years.
Source: Bloomberg, as of 21 October 2022.
Where are you, Adam Smith?
It’s not supposed to be like this. Many have grown to expect an order to complex systems like the global economy and financial markets, believing that the pricing mechanism – the result of innumerable individual transactions – would guide markets toward a happy equilibrium, and that volatility, while unavoidable, would not typically reach stomach-churning levels as buyers and sellers, driven by their economic interests, seek each other out. This is what Scottish economist Adam Smith described as “the invisible hand” of the market three centuries ago.
But a decade-plus of suppressed interest rates followed by inflation almost touching double digits in advanced economies has left pricing signals in tatters. Artificially low yields on benchmark government bonds failed to reignite productivity-enhancing investment, which has been mired in a decade-long slump. The result has been a misallocation of capital across both the financial and real economy. With respect to inflation, by definition, rapidly rising prices alter the behavior of both consumers and businesses, thus throwing sand in the gears of price discovery.
We expected that the exit from highly accommodative monetary policy would not be without drama. The best hope was that liquidity could be methodically withdrawn as the market again learned to price risk – liquidity, credit, inflation – in the absence of central banks’ maneuverings. That luxury was lost once the Fed’s transitory inflation call proved misplaced. Now all eyes are once again on the U.S. central bank.
The only game in town
To a degree, the current parlor game of “how hawkish will they get?” is the antithesis of the past decade’s Fed put. During that time, the market operated under the assumption that the Fed’s doves would dampen any downdraft in asset prices with additional monetary largesse. Fed Chairman Jerome Powell has since made it clear that he intends to take any steps necessary to bring down inflation. He undoubtedly knows the historical consequences of backing off too soon, which would put the Fed’s all-important credibility at risk. Former Fed Chair Arthur Burns equivocated at the first sign that tighter policy was weighing on economic growth, but was forced to reverse course (again) as inflation continued its ascent. Even Paul Volker sputtered in his first attempt at reining in prices, and only succeeded after raising policy rates to a level that finally tamed that era’s relentless inflation.
This year’s market swings – aside from being chaotic – could also be interpreted as a sign of denial. A surprise in any economic report sparks ruminations that maybe the Fed doesn’t really mean it or that all the hiking is already priced in. That may be the case, but we cannot make that call – nor should anyone else. The answer to the “how hawkish” question depends upon the future path of inflation, especially whether a wage-price spiral has already taken on a life of its own. Inflation has only been exacerbated by continuing supply-chain dislocations and the war in Ukraine. But with the Fed seeking to reestablish credibility after being caught flatfooted, the market needs to realize Mr. Powell and company are no longer an investor’s best friend.
Investors ponder: In with the old?
An alternative to getting whipsawed by volatile markets is to play it cautious until conditions turn more favorable. Holding cash is punitive in an inflationary environment, but we believe it can provide investors sufficient liquidity to capitalize on market dislocations so they can harvest potentially attractive risk premiums once conditions tilt toward the upside. We believe that such an inflection point may not be far off.
Driving our view is the return of real yields to territory we consider consistent with macro theory. Academic research suggests that the real yield –i.e., nominal yield less inflation – on the 10-year U.S. Treasury should match expectations of inflation-adjusted growth for the U.S. economy over the next decade. Otherwise, an arbitrage opportunity would exist, allowing investors to borrow at low rates and invest in the higher-yielding economy. In fact, this has been the case for over 10 years, with the result being a misallocation of capital and mispricing of risk across the economy.
With the Fed raising rates at breakneck pace, this phenomenon may be nearing an end. Consensus is that the U.S. economy should grow at 2.0% annually, in real terms, over the next decade. After having reached a nadir of -1.21%, the real yield on the 10-year note has climbed to as high as 1.74%. Should the real yield continue to march toward 2.0%, we believe risks will become more fairly priced. As this unfolds, investors have the opportunity to capitalize on continued volatility by shifting from cash to assets with strong upside potential.
Composition of 10-year U.S. Treasury yield
After spending most of the pandemic era in negative territory, the real yield on the 10-year Treasury has risen to 1.74%, bringing it closer to the 2.0% level that we would consider in equilibrium with economic growth expectations.
Source: Bloomberg, as of 30 September 2022.
Should the 2.0% Treasury-GDP equilibrium be reestablished, the investment climate would look different than it has over the past nearly 15 years. Foremost, the retirement of the Fed put and quantitative easing would likely result in both volatility and inflation resetting at higher levels. With respect to the latter, the trend toward deglobalization should see to that. Pandemic-era trade dislocations have caused major economies to value control over their own supply chains. The price for this resilience and flexibility is higher inflation, which countries appear willing to pay.
Within markets, we believe investors could face a paradigm shift as value sectors such as banks, industrials, and materials are on the ascendency as the growth-above-all-else trend of the past several years finally concludes. These sectors also tend to exhibit greater cyclicality, which jibes with our view that monetary policy will be less assertive in placing its hands on the scales of the global economy going forward. Markets will always be unpredictable, and the nature of risk is constantly evolving. But as the tumult associated with the shift away from an era of highly accommodative policy distorting price signals dissipates, we think investors can begin to expect more order and less chaos.
S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.
Cboe Volatility Index® or VIX® Index shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500® Index options and is a widely used measure of market risk. The VIX Index methodology is the property of Chicago Board of Options Exchange, which is not affiliated with Janus Henderson.
U.S. Treasury securities are direct debt obligations issued by the U.S. Government. With government bonds, the investor is a creditor of the government. Treasury Bills and U.S. Government Bonds are guaranteed by the full faith and credit of the United States government, are generally considered to be free of credit risk and typically carry lower yields than other securities.
The Fed Put is a belief by financial market participants that the Federal Reserve will step in to buoy markets if the price of markets falls to a certain level.
Quantitative Easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market.