Revisiting the 2014-2016 sell-off in risk assets

After the end of a volatile and tumultuous Q1 2018 for risk assets, this felt like an opportune time to recall the last risk-off period that started midway through 2014 and ended in Q1 2016.  The purpose of doing so is in large part to determine whether today's financial and economic backdrop is similar to that one.  Although the 2014-2016 volatility in US equities did not result in a major cyclical disruption, financial market price trends suggested that the US and global economy had come perilously close to a possible downturn.

1.)  Nominal GDP growth topped out in Q3 2014.

• In Q3 2014, nominal GDP (total domestic spending) growth hit a high of 5.2% before sliding to as low as 2.45% in Q2 2016.
• Unlike that two year period, nominal GDP is currently experiencing an upswing with the latest Q4 reading coming in at 4.49%.  In fact, aggregate domestic demand growth has reaccelerated after a temporary dip in Q2 2017.
• Importantly, during much of 2014-2015 the Fed embarked on passive tightening as officials talked up the first rate hike that occurred in December 2015.   Given that nominal GDP growth was slowing at that time, it is the opinion of this blog that the Fed's monetary policy was too tight considering those circumstances.  Although it would be preferable for the Fed to hold off on further rate increases & balance sheet normalization so as to allow NGDP to rise further (especially with persistently sub 2% inflation), today's monetary stance isn't as restrictive as it was then.  

2.)  Between the summer of 2014 & Q1 2016, the US dollar experienced its biggest surge since the Great Recession.

• During that roughly 18 month uptrend, the USD appreciated by 23%.
• Despite the recent dollar rebound that began in January 2018, the greenback has depreciated by 8.5% during its current downtrend.
• Due to the dollar's role as the anchor currency for the global financial system, dollar depreciation is a sign that global risk taking has been improving as market participants have bid up currencies and risk assets in the rest of the world.  Therefore unlike during 2015-2016, the dollar has recently been a tailwind for global growth.  

3.)  US long term treasury rates hit a cyclical low in July 2016.  

• By the summer of 2016, the 10-year treasury yield had declined by 54% after hitting a high of 3.04% in December 2013.
• In contrast, as of today the 10-year rate has about doubled since the July 2016 low of 1.37%
• Unsurprisingly, the trend in the 10-year has been following the progress made by NGDP as market participants have priced in improving growth and inflation expectations.

4.)  High yield credit spreads had reached a post-crisis high by February 2016.

• Much like the USD, high yield credit spreads surged in the 18 months following the beginning of July 2014.  During that time, spreads widened by over 220%.
• Conversely, credit spreads have since gone on to reverse nearly the entirety of that rise.  Despite a volatile first quarter, spreads have barely budged in 2018.

5.)  Crude oil prices & inflation expectations had collapsed by Q1 2016. 

• Crude oil's downtrend saw its price fall by 75% in roughly 18 months!  As expected, inflation expectations followed lower.  Moreover, similar trends were visible in other parts of the commodities and metals complex. 
• On the other hand, as of the close of the most recent quarter crude is currently in an uptrend.  Along with the 150% rise in the price of oil, inflation expectations have also rebounded.
• The overinvestment, overproduction, and excessive speculation that saw prices collapse throughout the commodities space served as a headwind to global growth during 2014-2016.  Unlike then, the global economy has either been in the process of or has completely worked though the downturn in commodities. 

6.)  In January 2016, the US equity indices experienced a bearish monthly moving average crossover for the first time since the global crisis.  

• The major US equity indices traded roughly flat for two years between the summers of 2014 and 2016.*  This trendless volatility caused a bearish moving average crossover to occur as the 10-month moving average fell below the 20-month average.
• Given that the two prior bearish crossovers in 2001 and 2008 proved to be a harbinger for much greater losses, this is not a signal that is easily ignored especially in the presence of the other red flags listed above.
• Fortunately, this condition reversed by June 2016.  Since the bullish cross, the S&P 500 has gained 25% even after the recent two month sell-off.  Until further developments,** the price action in US equities appears to be a correction/pause in an ongoing upswing rather than the beginning of a bear market.  With that said, prudent attentiveness is warranted until new highs are made.**

Concluding Remarks:

Starting midway through 2014 and lasting until 2016, nominal GDP growth was decelerating (a sign that monetary policy was too tight).  Meanwhile, the dollar and high yield credit spreads were surging while long-term treasury yields, commodities, and inflation expectations were falling precipitously.  During this period, equities were volatile and trendless.  By the first quarter of 2016, it certainly felt as if the global economy was on the brink of another relapse.  Luckily, policymakers responded*** and the global economy has since experienced a growth rebound.  

The wild swings of the first quarter of this year have certainly marked a difference compared to a 2017 that exhibited nearly zero volatility.  Unlike 2016, none of the warnings signs that typically preceded recessions and bear markets are present today****.  The greenback is currently rebounding but doing so in the context of a downtrend.  Treasury yields remain near multi-year highs while high yield credit spreads are still compressed.  Commodities and inflation expectations have rebounded.  The equity upswing remains intact (bullish crossover).  Most importantly, as of Q4 2017, nominal GDP has yet to show material signs of slowing.  In other words, the context of today's volatility is completely different to that of 2015-2016.  Without further signs of deterioration in these aforementioned trends, there isn't nearly enough reason yet to believe that a recession or market top are on the immediate horizon.

*Even though the major US equity averages were trendless, a considerable percentage of individual US stocks along with emerging market indices had experienced bear market like declines of over 20% by 2016. 

**The philosophy of this blog is that planning and reacting are a better strategy than predicting/forecasting because the future is so unknowable with any degree of precision.  Although important, being attentive is not a substitute for proper risk management.  

***The Fed followed through on their promise to delay rate hikes (the 2nd policy rate increase didn't take place until Dec 2016) while the ECB and BOJ expanded the scope of their monetary accommodations.  Chinese authorities also relaxed domestic credit restrictions.

****One of the major red flags that typically triggers before recessions that did not transpire in 2016 is the infamous yield curve inversion.