By: Franklin Templeton
We suggested at the end of last year that when the massive tide of global liquidity injected into markets post-2008 begins to recede, a wave of volatility could follow. It appears as though the wave has arrived.
Market volatility—as measured by the VIX (the so-called “fear index”)—surged 80% in the first quarter of the year. The S&P 500 Index and Dow Jones Industrial Average both declined for the quarter respectively, while the Nasdaq Composite Index managed a modest gain based largely on its sharp rise in January. Nine out of 11 S&P 500 sectors traded lower.
The steepest declines were in telecommunication services, consumer staples and energy. Information technology and consumer discretionary were positive outliers despite selling off broadly in March. The negative quarter for the S&P 500 Index broke a string of nine positive quarters, the longest streak in 20 years. In addition, all of this happened following the nine-year anniversary of the US bull market, which began on March 9, 2009, and 10 years after the bailout of Bear Stearns.
So now what? From our perspective, a reversion from the unprecedented low levels of volatility was to be expected—perhaps even welcomed. In some ways it reflects the resumption of more normalised market behaviour. This is a good thing, in our view.
As we have said in past commentaries, the historic levels of quantitative easing following the global financial crisis—that is the expansion of the Fed’s balance sheet from around US$900 billion to nearly US$4.5 trillion today—was one of the most dominant market-shaping forces over the last decade. In our view, it caused a distortion in prices, a suppression of volatility and a reduced emphasis on corporate fundamentals.
In addition to yields being driven towards record lows and stock markets to record highs, many investors were pushed towards riskier assets while the cost of capital was kept artificially low. While passive investing thrived in such an environment, it could be argued that active management and hedge funds suffered. As this era of quantitative monetary stimulus slowly winds down, we believe an improved environment for active management will emerge.
Reduced central bank support should make stocks more responsive to idiosyncratic factors. The consensus thought seems to be that less-supportive monetary policy will lead to greater price sensitivity from individual company fundamentals, which in turn could lower pair-wise correlations. If this were to occur, we feel this should lead to greater sector dispersion as well, creating a more conducive environment for managers to identify potential winners and losers. As a result, we believe the environment for alpha capture1 for the remainder of 2018 may remain fertile.
Our outlook for the discretionary macro strategy continues to improve. Increased central bank activism and policy divergence, combined with political uncertainty across major economies, have contributed to an increase in volatility across major asset classes. The increase, while modest, is nevertheless indicative of higher uncertainty and potentially better trading opportunities for managers with flexibility to trade across asset classes (most notably in fixed income and currencies, which have traditionally been a core area of focus for discretionary managers).
Long/Short Equity – Europe
The opportunity set in Europe remains favourable for long/short equity managers. European equities continue to trade below their historical average valuation versus the United States, which we believe to be fully valued. Eurozone forward earnings estimates are trading well below their prior peak, providing ample room for further recovery. US forward earnings, by contrast, are well above their 2008 peak.
European economic growth should continue to improve with low rates, resumption in bank lending, and strong external expansion. We believe the fears of a catastrophe following the Brexit decision are beginning to subside, as the issue appears to be reaching an amicable end for both Europe and the United Kingdom. In addition, Europe looks to be positioning itself close to US President Donald Trump’s administration at the trade table, likely putting it in a better position related to China or Japan in terms of any tariff actions by the administration.
Furthermore, the alpha environment appears strong with increased dispersion and decreased correlations2 impacted by varied regional macro developments, European Central Bank meetings and elections.
Relative Value – Fixed Income
With interest rates finally starting to rise, duration3 risk is coming into focus for fixed income investors. Relative value fixed income managers such as long/short credit managers appear well positioned, given their shorter duration portfolios, and, in our view, should be able to generate alpha from rising sector dispersion.
The diverging paths of central banks in the major global economies are expected to present improved directional opportunities. Participation from directional buyers and sellers of bonds should result in greater market inefficiencies between cash bonds and futures, benefitting less directional relative value trading. The strategy is still subject to greater leverage and funding risks, justifying a cautious approach.
By: Franklin Templeton