What a change a few months makes post the Trump hype and reflation trade shenanigans. Q1’17 has completely unwound the “reflation” thesis across various stocks, sectors, and foreign currency markets, essentially the long dollar trade. However, Equities are still strong as an asset class with the US S&P500 and Eurostoxx 50 up 8% and 9% respectively year to date. So what gives? What may seem boring on the surface has been rather exciting when one drills down into the various sectors and stocks. The market has been rotating violently quarter on quarter whilst keeping the overall index level positive.
This may be starting to annoy passive investors, especially since they have been waving the flag for the last seven years as passive flows have outpaced active flows given the performance of markets in general. There is a school of thought that this is about to come to an end, or atleast one starts to see a revival in “active” money management. This could be the year when active funds come back into vogue and start outperforming. If markets continue in this “boring” state it may be the case as generic market indices and ETFs lack in performance whereas true alpha funds could outperform generating return for their investors.
After all the last seven years have seen incredibly accommodative monetary conditions across most developed countries with central banks pumping as much money as possible into the system to stimulate growth keeping rates artificially low, in some cases even negative. But this is all about to change. We are now entering a brave new world. A world where central banks are thinking of ways to de-lever their balance sheets, and raise rates slowly. Can investors handle markets that do not rely on a constant opiate fix from central banks? Do they even know how to?
Volatility in the markets has been falling continuously. Most investors/Hedge Funds are long volatility as “protection” on their portfolio. Every month that passes, this protection insurance seems a waste of premium paid as the market correction never comes. It has gotten to a point where we are now packaging retail products for speculators (punters) to play the collapse of volatility via an inverse exchange traded product with the ticker XIV Equity. Can you blame them, after all year to date XIV is up 70% (up almost 700% over five years)! It is now one of the most heavily traded ETFs. Momentum chasing aside, do these retail investors know exactly what they are buying? This seems strikingly similar to when retail were buying heaps of ABS (asset backed securities) and MBS (mortgage backed securities) products, as they thought there was only one way, up! Then the financial crisis hit and we know how that unwound.
When one buys the XIV, one is essentially betting that the market will continue to rally and there should be no risk premium, in effect selling portfolio insurance. Does the average Joe really want to be short “protection” here? One little market hiccup from premature central bank tightening, a stale US recovery, or potentially deflationary data could set the markets back a few percent, but this XIV could fall ten fold in a matter of minutes! For example: XIV fell by 20% on back of Trump potential impeachment risk. #Ouch!
The debate between “soft” data and “hard” data continues. The “soft” data shows a heightened optimism in the state of the economy and its growth prospects via stimulus, tax cuts, and increased capital spending expectations. The problem is that the economy is not listening to them. The actual economic data that is hitting the tape recently points to a rather muted growth scenario, in some cases an even weakening one, with the Treasury markets pointing to much lower yields going forward.
Are the Equities right or the Bonds? The convergence could be a painful trade. Something’s gotta give….