- Financial market volatility has increased in recent months but still remains relatively low by historical standards.
- While the macroeconomic data continues to point to a strong US economy, we are expecting the US Federal Reserve to be more cautious and data dependent as they approach more neutral interest rate settings.
- While US-China tensions are likely to be a source of volatility as news headlines emerge, we expect that this will ultimately come to a resolution in a way that avoids a full-blown trade war.
A noticeable feature of markets in the ten years since the GFC has been an unusually low amount of market volatility. Buoyed by stimulus from central banks, it has often felt like asset markets have largely marched higher in a straight line, with much less volatility than in normal times. However, in a sign that this phase may finally be coming to an end, equity markets experienced a material pullback in October, following by a rise in two-way volatility across most asset classes in November. That said, implied volatilities from options markets still remain low.
In local fixed interest markets, the first half of the month featured a significant rise in yields following particularly strong employment data, with the unemployment rate coming in at 3.9% vs market expectations of 4.5%. Following a string of strong local economic outturns, including GDP and CPI both above market expectations, the sign of the labour market near full employment appeared to scupper any remaining thoughts of a near-term OCR cut from the RBNZ. It appears that crowded market positioning also exacerbated the move.
In the middle of the month, the focus shifted to a change in tone from the US Federal Reserve. This first came in the form of a message from the new Vice Chair of the Board of Governors, Richard Clarida, who noted that the Fed was approaching a neutral setting for the Fed Funds Rate and should, therefore be more cautious and data-dependent. This was later followed up by Chair, Jay Powell, who noted the policy rate was “just below” estimates of neutral, having previously said they were a “long way” below neutral only a month ago. This provided an impetus for global yields to fall sharply and for equity markets to rally on relief that monetary policy may not be tightened much further.
Later in the month equities were provided a further boost by initial signs of a cooling in US-Chinese trade tensions during the G20 summit. In the last week of November, the S&P 500 rose 4.8% to register its strongest weekly gain in 7 years.
With signs of stronger local data in New Zealand and a more dovish tone from the US Federal Reserve, the NZD/USD appreciated sharply by nearly 4% over the month.
The oil market continued its recent volatility, with Brent Crude down 28% to US$58.7 a barrel.
What to watch
Looking forward, we see three main areas to watch.
First, the upcoming meeting of the US Federal Reserve’s FOMC should provide some clarity on the outlook for US monetary stimulus. At the time of the FOMC’s last projections in September, they were forecasting one additional hike in 2018, followed by 3 hikes in 2019 and another in 2020. While the market is still placing an 80% chance on a hike at the FOMC’s meeting on 19 December, there is only one additional move from the Fed priced into the rest of the yield curve.
The market will be watching for whether recent “Fedspeak” will result in the Federal Reserve lowering their estimate of the long-run neutral Fed Funds Rate or merely signally a more cautious approach as they near the range of possible long-run neutral rates. In our view, while there are no major signs in the US macroeconomic data that the Fed needs to change its course of removing stimulus at this stage, the Fed is likely to become more data-dependent going forward, meaning a constant process of checking back with economic data and financial markets on the ability of the system to cope with less stimulus.
The second focus of markets is likely to be ongoing trade tensions between the US and China. While markets breathed a sigh of relief following the G20 summit when the US decided to delay the imposition of increased tariffs on Chinese goods, this has been short-lived given the scant amount of detail on any temporary agreement and lack of consistent tone in comments made by US and Chinese officials. We expect these trade tensions to linger for some time into the New Year as the US and China to jostle and position themselves for a final deal. While this may be a source of volatility as news headlines emerge on the negotiations, our expectations are that this will ultimately come to a resolution in a way that avoids a full-blown trade war.
Finally, we are watching developments in local credit markets. A weakening in global credit has been evident in global markets for a number of weeks. However, in New Zealand, the move has been belated and modest. Retail appetite for corporate bonds in the secondary market continues to be resilient and this has absorbed selling from professional investors. Narrow credit margins have encouraged issuers to borrow and a handful of deals have come to the market. With institutional investors becoming more cautious, and appetite restrained, we are expecting this to eventually flow through to the secondary market for local credit.
Market outlook and positioning
In fixed interest portfolios, we do not have a strong view about the direction of interest rates from here. We continue to see New Zealand government inflation-indexed linked bonds priced at very attractive valuations, with these bonds providing very cheap protection against inflation rising back to the mid-point of the RBNZ’s inflation target. However, with the strength of NZ dollar and weakness in oil prices likely to soften near-term CPI inflation outruns, we have marginally reduced our holdings in inflation-indexed linked bonds.
In equity portfolios, we observe that companies with strong defensive earnings and stable dividends have outperformed in recent months with the fall in global bond yields in November. Looking forward, we are more comfortable with equity exposure to companies with structural growth opportunities. These companies saw a meaningful contraction in valuations in November despite providing generally solid earnings updates. The risk for equities remains that global financial conditions tighten faster than expected in reaction to creeping inflation and removal of monetary stimulus by the US Federal Reserve.
In our multi-asset portfolios, we have moved to a small overweight in equity markets, buying back into these positions at more attractive valuation levels on equity market weakness.
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