Equity volatility could rise once again 

Investment Policy, April 2019

Equity volatility could rise once again

The world’s key central banks, including now the ECB, have recently reaffirmed their intention to support the global economy through its current period of weakness with more monetary liquidity – the oxygen of the financial markets. The decision by the Federal Reserve (Fed) to suspend its rate-hiking cycle for the time being remains the key reason for the unusually strong stockmarket rally since the beginning of the year.  This has led to a situation in which equity markets are technically overbought, with valuations now some 13% higher. The economic data should therefore offset declining corporate earnings, though profit-taking and a resurgence in volatility would not come as a surprise. 

The majority of indicators around the globe continue to point to an economic slowdown. Yet just as the days start to get warmer, so too could the first economic "green shoots of spring" appear. Consensus expectations of corporate earnings have declined sharply since the start of the year. This much is evident from the downgrades of economic growth predictions for 2019 issued by numerous institutions, ranging from the International Monetary Fund to the ECB. On the one hand, if expectations are lower there is a greater likelihood of their being exceeded. On the other hand, market volatilities – i.e. anticipated market fluctuations – have experienced a very pronounced decline. This is also attributable to the fact that almost no market observers are now expecting any interest rate rises in 2019, following Jerome Powell's confirmation of the Fed’s latest stance on 20 March. As a result, equities have enjoyed a well above-average start to the year. 

How has the environment changed compared to the beginning of January? We can see significantly greater monetary support from central banks, but also a clear trend of declining corporate earnings forecasts. In addition, the still-slowing Chinese economy is receiving stimulus from the government, albeit to a much lesser extent than it did in 2016. 

The decline of implied volatility in many equity markets highlights the greater optimism of market participants generally. In particular, the markets are anticipating a positive outcome to the trade dispute negotiations between the US and China, but this is in no way a given. Accordingly, a resurgence in market volatility – which is low by historical standards – would come as no surprise to us. This could in turn produce a correction among cyclical equities as well as among stocks with higher volatility and beta (i.e. sensitivity to overall market movements). It may therefore make sense from today's standpoint to take profits in those sectors that have enjoyed unusually impressive performance this year – such as biotechnology, for example – and to reinvest the resulting liquidity in equities with lower volatility. 

Partial profit-taking in equities that have strongly outperformed may make sense.

Gérard Piasko, Chief Investment Officer

Since the start of the year, the fixed-income markets have benefited from a rather rare combination of declining yields on government bonds and a reduction of risk premiums for corporate bonds compared to government bonds. This narrowing of so-called "credit spreads" is a sign of burgeoning economic optimism in the financial markets, echoing the rise in spring temperatures. In the event of economic data turning out to be better than expected over the next few months, the higher-yielding segments of global bond markets could enjoy further market support. In Europe, higher-yielding bonds are now more in demand than a few months ago due to the meagre yields available on sovereigns. The pause in interest rate rises initiated by the US central bank – as reiterated by Fed Chair Powell on 20 March – is currently supporting all bond segments generally.

The US central bank's pause in the rate-hiking cycle has resulted in a slight (rather than a pronounced) US dollar weakness. The reason for this restrained reaction can be found in the far superior economic growth of the US compared to the Europe. In addition, the interest rate differential between US bonds and those of the Eurozone in particular has widened in favour of the former since the start of the year. Thirdly, the never-ending Brexit saga is keeping European currencies weak against the greenback. For emerging market currencies, a key question is whether the recent economic weakness of various emerging-market countries compared to the stronger US economy will come to an end. Where EUR/USD is concerned, we are anticipating an increase in the very low current levels of volatility within the resilient existing bandwidth of approximately 1.12–1.18. 

The oil price has been exhibiting an upward trend for quite a few weeks now. It is benefiting from the marked reduction in supply resulting from production cuts on the part of OPEC, particularly Saudi Arabia. For its part, the US is still confronted by the problem of a shortage in pipeline capacity. This is set to continue for several months, thereby preventing global markets tapping into higher US oil supply. In addition, the oil price has now clearly broken out of the (chart-technical) downward trend of the fourth quarter of 2018.

Gold has become susceptible to profit-taking around the technical resistance zone of USD 1300–1350 per ounce. In particular, if the "green shoots of spring" become a reality in a number of economies – i.e. if published economic data turns out to be better than expected – this renowned safe-haven commodity could lose ground against other commodities that are more sensitive to the economic cycle. Gold could also underperform other commodities in the event of a positive conclusion of the trade dispute negotiations.

Gérard Piasko

Gérard Piasko

Gérard Piasko is CIO and head of the investment committee of private bank Maerki Baumann & Co. AG. Before he was for many years CIO of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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This publication is intended for information and marketing purposes only, and is not geared to the conclusion of a contract. It only contains the market and investment commentaries of Maerki Baumann & Co. AG and an assessment of selected financial instruments. Consequently, this publication does not constitute investment advice or a specific individual investment recommendation, and is not an offer for the purchase or sale of investment instruments. Maerki Baumann & Co. AG does not provide legal or tax advice. In addition, Maerki Baumann & Co. AG accepts no liability whatsoever for the content of this document; in particular, it does not accept any liability for losses of any kind, whether direct, indirect or incidental, which may be incurred as a result of using the information contained in this document and/or arising from the risks inherent in the financial markets.

Editorial deadline: 25 March 2019

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