Global macro economic update for the week beginning 12 February, 2018

From

The week ahead from Insight Investment.

Summary

Systematic volatility trading triggered the sharp fall in equity markets as the low-volatility regime was hit.

This week, attention will be focused on a range of inflation reports. The US CPI report on Wednesday will be closely watched given the sell-off in government bonds and the fragility of equities.

Strategy Review

The last week or so has been a stark reminder as to how quickly market dynamics can change. Despite little new information regarding what remains a constructive macro environment, equity markets (in particular) suffered their sharpest drawdowns since the summer of 2015. We are acutely aware that internal market dynamics can create pockets of stress that can become self-fulfilling if leveraged and/or systematic risk-reduction strategies build critical mass, and this week saw this with short-volatility and volatility-targeting strategies causing an extreme market shock. We view this period of stress as providing opportunities to add positions with attractive pay-off profiles, particularly in total return strategies.

Market and economic review

An unprecedented increase in implied volatility

Our assessment of this week’s events is that the sell-off was driven by extreme positioning in the volatility market. Fundamental data releases were limited over the last few days and were generally positive for risk. Moreover, the performance of other risk assets (in currency markets, credit, high yield, emerging market debt or even styles within equity markets) suggests that the stress point was very volatility/equity-index-centric. The VIX index increase of 20 points was the largest absolute or percentage change ever. Rebalancing procedures of exchange-traded volatility products contributed to the sell-off as short-volatility products needed to be hedged. While the risk of a sudden spike in technical selling from volatility-related exchange-traded products (ETPs) is now behind us, there is a risk that the increase in equity volatility leads to more short-term deleveraging from systematic trend-following strategies, or to discretionary managers adjusting their holdings in light of higher volatility. However, volatility spikes of this magnitude tend to reverse quite quickly once systematic selling abates and we note the assets under management of short-volatility ETPs is now less than 10% of their previous size.

As noted above, thus far, contagion to other asset classes has remained relatively limited and we would expect that to be the case given the extent to which the underlying economic data is supportive to risk. Given the recent rise in government bond yields, inflation data is perhaps the most important of the macroeconomic indicators to keep an eye on (see below) and if CPI accelerates then this could lead to greater contagion across markets.

Government bond yields rise

Away from these gyrations driven by volatility products there were a few other things to report. Government bond yields generally moved higher, reflecting solid data and fiscal concerns, rather than equity market weakness. Should the equity market rout deepen, we would expect government bonds to be a diversifying asset, despite that not being the case over the last week.

When the dust settles, we see little in the macroeconomic landscape that has fundamentally changed and, for that reason, we have accepted that it is preferable to absorb some mark-to-market volatility rather than make drastic adjustments in the face of a specific shock. We are mindful, however, that investors are likely to be recalibrating their risk tolerance in light of recent events. Regular readers will be aware that we have been running below-average risk within the total return strategies component of the strategy since early 2017 and the current volatility spike is giving us an opportunity to build positions.

Solid data, US government shutdown averted

In Asia both Japan’s Nikkei composite PMI and China’s January Caixin PMI came in above last month’s readings. Later in the week China’s January trade surplus was less than expected at $20.3bn (consensus was $54.7bn). Behind the trade numbers, a strong rise in imports (36.9% vs 10.6% expected) outpaced export growth of 11.1%. The yuan weakened after the authorities announced measures that would encourage two-way currency flows that may temper the Chinese currency’s recent strength. China’s CPI and PPI prints for January both slowed on the month, but were in line with expectations at 1.5% year-on-year and 4.3% year-on-year respectively. In Europe, the final PMI reports continued to point to strong growth. Chancellor Merkel and the SPD reached an agreement to form the next coalition government in Germany; the European Commission upgraded its GDP growth forecasts for the euro area; and the Bank of England’s governor left the door open for a rate hike as early as May – despite ongoing concerns about the economic consequences of Brexit. In the US, Senate leaders put forward a bipartisan two-year budget to extend government funding until 23 March while the lawmakers refine details on longer-term plans and this was signed off by the president on Friday.

Outlook

Economic data: inflation in focus as US CPI takes centre stage

This week sees a raft of inflation releases, and beyond the carnage caused by the volatility shock, it is the inflation risk associated with the strong and synchronised growth rebound that poses the biggest challenge to markets. To be clear, our current assessment of inflation prints around the world is that they are relatively contained, and with output gaps only just closing, inflation may well be more of a 2019 concern. For now, however, it’s at the forefront of the market’s mind. The pick of the inflation releases will be US CPI on Wednesday. US retail sales will also be reported on that day. At the start of the week, President Trump is due to release details of his 2019 budget, which is expected to focus on defence spending. He is also expected to announce details of a series of major public works in the form of infrastructure upgrades. Towards the end of the week, a range of Asian markets will be shut as Chinese New Year celebrations for the Year of the Dog begin. Chinese mainland markets are closed between 15 and 21 February.

By David Hillier, Portfolio Manager in the Multi-Asset Group

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