What a difference a year makes

Over the last twelve to eighteen months, the configuration of the global markets has undergone a drastic shift.  This post seeks to compare the twelve to eight month period immediately preceding 2018 with the market trends that have occurred since the start of that year.  The objective is to understand just how different today's world appears to the one market participants lived through from the 2nd quarter of 2016 until the end of January 2018.  The hope is that by analyzing this shift, we may gain insight as to whether another turn is set to happen again in the year or two ahead.

2016 - January 2018:  A recession scare turns into euphoria

• Following the US nominal GDP slowdown from 2014-206 and Chinese scare, the Fed reacted by holding off from any further tightening for much of 2016.  Simultaneously market participants began to correctly anticipate the Trump fiscal expansion.  
• Furthermore, Chinese policymakers also eased their credit policies after making efforts to wean their economy off of debt dependent growth.  
• This combination enabled inflation and global GDP growth and therefore long term treasury yields to bottom.  Yields would go on to more than double from their July 2016 Brexit lows.

• Despite the prospects for larger fiscal deficits and renewed expectations of easier monetary policy, the USD held on until the very end of 2016.  Eventually this change in policy was too much for dollar bulls and the USD went on to fall for over a year.
• Amid dollar weakness, the global growth scares turned on its head.  The new theme was one of coordinated global expansion.
• The Chinese Yuan repelled off of the 7 level and trended higher along with the Euro.

• Low but rising inflation, coordinated global growth, accommodative monetary, credit, and fiscal policies all over the world and an end to the dollar squeeze launched global risk assets higher.  
• SPX, EEM, HYG (narrowing credit spreads), & commodities etc. all moved up in a relatively low volatility fashion in unison.  2017 in particular became the year everything worked.

• It should come as no surprise that in that global policy, growth, and risk-taking backdrop, measures of market volatility fell and thus volatility related products collapsed in price.  

2018 - Present: Excessive risk-taking dies in volatility with a renewed sense of pessimism

• US economic momentum carried US treasury yields higher for three quarters in 2018 even though global weakness had already started to become evident by then.  That is until this risk aversion finally hit the US in the 4th quarter of last year.  The 10-year yield has since declined by over 30%.  
• Interestingly, unlike Q4 2018 where risk-off and recession fears sent yields lower and global credit spreads wider, 2019's down move coincided with rising global bond prices and narrower credit spreads.  What was once a fear based trade in long US bonds turned into one that was pricing in easier Fed policy and lower inflation. 

• In contrast to 2016-2017, 2018 produced the next leg up in the US dollar.  Both the Euro and Yuan have come under immense selling pressure at times during this phase.  Despite the misleading notion that Chinese policymakers necessarily desire a weaker Yuan, it appears that their goal has been to keep the Yuan from falling below the 7 level as market pressures and capital outflows have pushed their currency in that direction.
• What was once a moderately valued USD to start 2018 has become overvalued judging by traditional currency valuation models.  Will the dollar top in 2019?  Perhaps but as always the trend dictates the narrative.  Overvalued can always become more overvalued.  Dollar bears will want to see the dollar's wedge break to the downside.  TBD!

• Low and falling inflation, gloomy global economic prospects, hawkish policies in the US and abroad, and a strengthening dollar resulted in multiple large percentage drops in US equities and high yield debt in what has been a pattern of messy sideways consolidation after a torrent 2016-2017 uptrend.
• Unlike US stocks, EM equities immediately began to trend lower as soon as the dollar bottomed at the start of 2018.  It may largely depend on the next move in the dollar to know whether EM is in the process of bottom or if support will give way after all is said and done.  In the event that the pessimistic scenario for EM were to occur, would the US be capable of going it alone?
• In a similar fashion to US treasury yields, crude managed to escape its fate until the start of what was a violent 4th quarter of 2018.  Unlike US equities whose secular bull thesis remains in place as long as the December 2018 lows are not taken out, crude has been in a secular bear market that began around 2011-2014.  Until oil begins to show multi-month relative strength to US equities in what would probably constitute a much more inflationary environment, each wave of risk aversion should see oil continue to underperform. 

• Where 2017 was the year everything worked, 2018 saw cash outperformed nearly every other asset class.  Under these circumstances, volatility shot up at least twice with the short volatility complex famously blowing up in early February of last year.
• 2017's stability ultimately proved to be destabilizing for much of 2018.  Will today's volatility eventually resolve itself into a stability that is conducive for revived risk taking?  Time will tell.  Consequentially, bulls will want to see VIXY breakdown below multi-year support much like it did in 2016 for this to happen.  

The Fed was too hawkish in 2018 

Over the last year or so, the financial market environment isn't the only facet to have dramatically changed in nature or course.  Although 2017 saw the Fed raise their policy rate three times, the Fed took additional measures to slow the pace of economic growth in 2018 through a reduction in their balance sheet as well as telegraphing more hikes to come in the year ahead.  It was not long ago where market participants were expecting 3-4 rate increases in 2019.  Market participants can be forgiven seeing as it was only last October where Powell famously uttered,

Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral,” he added. “We may go past neutral, but we’re a long way from neutral at this point, probably.

In the first half of 2018, this overall stance first provoked a leg higher in the dollar due to diverging monetary expectations between US monetary policy relative to the rest of the world.  With the USD serving as a major headwind, emerging markets experienced persistent downtrends for much of 2018.  Off the back of accelerating NGDP and solid earnings, US equities and credits held on the longest before they too both capitulated in Q4 2018.  Unsurprisingly, these dynamics saw inflation and inflation expectations both fall sharply with US nominal GDP decelerating.

The Fed Pivots in 2019

While global markets were falling apart along with inflation expectations, the Powell Fed still went through with a final rate increase in December.  In hindsight, this will likely be seen as a policy mistake if it isn't already.  However, 2018 still serves as a hugely important remind of how powerful monetary policy can be particularly as a break should the goal be to slow economic growth.  As long as the Fed is willing to be aggressive, it has the influence via capital markets and price trends to offset upward economic momentum should inflation actually pose a threat.  Problematically, their decisions to enact a hawkish bias last year came when inflation on average has been below 2% since they formally instituted this as their target in 2012.  Why should market participants treat 2% as a target instead of a ceiling when the Fed's reaction function says otherwise?

Therefore, Powell should be applauded for attempting to correct the institution's mistake by pivoting to a much more accommodative stance.  With that said, given that market trends have yet to firmly confirm that the worst is over, only time will tell whether more aggressive dovish steps will be required to moderate the slowing that is occurring in the US economy.  This major shift in stance is epitomized by the fact that market participants are now pricing in multiple cuts for the remainder of the year when only doing the opposite just one year ago.

To cement this lesson, as has already been mentioned in this blog for years, if the Fed's objective is to increase the level of interest rates throughout the curve in a sustained manner then they must create monetary and financial conditions that will enable the pace of nominal GDP growth to move faster.  The Fed's 2018 attempt to "normalize" failed to do this.  Instead the Fed's rate hikes, balance sheet run-off, and hawkish tone sent long term treasury rates and inflation lower flattening the yield curve in the process.  This episode demonstrates that monetary policy still is very very effective at forcing nominal GDP growth and inflation lower.  What is left to be answered is whether the Fed intentionally wants to put a lid on growth and if so why.  With inflation below target for about a decade, the Fed is risking its credibility should their decisions provoke a recession in the future. 


The good news: Lagging, coincident, and leading indicators are still only pointing to a slowdown in US nominal growth and not a recession

Without laboring on too much and to allow the charts to do the talking, whether one compares the stance of monetary policy using the fed funds rate or 3-month treasury bill rate to the pace of growth in NGDP, retail sales, effective demand, weekly jobless claims, home prices & transactions, the message remains that the US economy should not be expected to head into recession unless something absolutely dramatic/catastrophic were to occur.  Narrow credit spread and a benign yield curve also confirm this.  Anything is certainly possible.  However, by taking a weight of the evidence approach, it would require that at least most if not all of the below trends to slow much further before calling a recession becomes appropriate.  As long as monetary and fiscal policy are forceful any unwanted deceleration can be offset.  Policymakers have no excuse not to offset an unwanted growth scare especially considering that the excesses of the bubble era are not present today. 

Conclusion:

The complacent excessive risk appetite which characterized much of 2016-2017 that led to the turbulence in global markets that began in 2018 and still linger are not with us today.  If anything, the current market configuration is the exact opposite to that of 2016-2017 and appear to be more similar to 2014-2016.  Unlike a Q4 2016 through Q1 2018 that saw US long term treasuries and the dollar persistently trend low, both continue to move higher today (for now) with signs of slowing momentum only just materializing.  Unsurprisingly, these major trend changes in US long term bonds and the USD marked the end of the 2016-2017 global equity, credit, and commodity market rallies.  Although US equities have held up the best, all three have since experienced violent declines along with forceful reversals.  

Which is why the almost two year environment heading into January 2018 can be characterized as a low volatility trending regime whereas the last twelve months of trading have been anything but.  It proves that the lessons of Minsky are still very relevant, stability can be destabilizing.  Market participants during much of 2017 began to grow complacent as they reached for yield and took on excessive risk.  This culminated in a parabolic spike in global equities to start 2018 that was born out of euphoria.  Instead of fearing a reversal, investors were afraid to miss out on further gains and therefore chose to extend themselves to capture them (FOMO).  Calm turned into frenzy and eventually morphed into volatility.  

In obvious ways this description does not fit today's narratives.  Despite an impressive rally off of the December 2018 lows, sentiment for the most part has not been excessively bullish by any means.  The June bottom that has held so far was also accompanied by quite bearish readings.  Note the contrast between a year ago's "Greed" to the "Extreme Fear" at the end of May 2019 not to mention the near zero readings that triggered at the December 2018 panic lows.

Whether or not this current multi-year market regime eventually resolves itself in favor of risk assets remains to be seen.  Should risk assets ultimately fall below their May/June lows and especially if they were to round trip back below the December 2018 bottoms, investors will have been warned to get defensive.

With that said, unlike much of 2018, the necessary conditions for a sustained breakout and uptrend in risk assets are in place today.  The US economy although decelerating is still growing at a healthy pace.  Inflation remains muted which should keep the Fed on hold particularly given the collapse in inflation expectations over the last six months.  This combination along with bearish sentiment and muted returns have in the past been a harbinger for bullish outcomes.

The risk to this view is that emerging markets & international equities are still in the process of bottoming with no guarantees that support levels will hold.  The USD's momentum may be slowing of late, yet the greenback remains in an uptrend.  This has a tendency to weigh on global growth due to the dollar's role in the global financial system.  The Fed may be on pause, but it is not certain whether this stance is enough to offset the negative dynamics in play.  In the event that treasury yields were to continue their decline and credit spreads were to widen materially, this would serve as a major clue that something is not quite right and that the bullish view is in major doubt. 

Which is why, despite the positive conditions for a sustained rally in risky assets being present, market participants are not out of the woods yet.  After dealing with nearly two years of volatility, more patience, discipline, and an open mind are absolutely still required.