Market volatility is here to stay, said Sonja Laud, head of equities, Fidelity International, and added that the fundamental backdrop in 2017 was very strong and there was strong synchronized global growth along with benign inflation.
"At the start of 2018, as well the fundamental backdrop was strong, but then there were fears that if inflation would remain benign and that fear came true by the end of January," Laud said.
When asked if we were at a point, when we should start fretting about recessionary conditions because in the past, the inverted nature of the yield curve has been a telltale sign of some kind of recessionary condition.
Q: It’s been a volatile start to 2018. Do you expect more by way of volatility?
A: The short answer is yes but it’s worth highlighting why we actually believe that volatility is here to stay. If you consider 2017, it has been an extraordinary year not only because equity market have had a very-very good run, it was very calm, very little volatility but obviously the fundamental backdrop was very-very strong as well and in the kind of jargon that we like to use – we call it goldilocks because it was very strong global growth synchronized as such and inflation has been very benign.
Now when we enter 2018, we still had a very strong backdrop in terms of the growth picture but what we started to discuss whether inflation really could stay as benign as it has been all throughout 2017 and as it turned out at the end of January, it was the upside surprise print in the labour market data in the US that caused the initial kind of trigger for the first selloff.
Now ever since market had to digest that actually some of the growth indicators seem to have softened particularly in the developed world and as such there is a bit of a question mark – is that a start of the end of the cycle, is that a start to a more severe slowdown and as such we have seen a lot of activity, a lot of noise but if you look at year-to-date performance actually markets haven’t moved in any direction. The same applies to the bond market and I think this phase of reassessing whether this is now the final part of the cycle or we can assume that it is just a kind of mid-term pause, is something that will be here to stay and to my mind will really move markets. We might end up with very little real kind of movement in absolute terms but there will be a lot of noise and volatility that accompanies this.
Q: Which side are you on? Are you more scared of inflation coming back and further powering on the bond yield beyond 3 percent or are you in the camp which believes that growth will begin to slip off now?
A: I think we have to look at the more short-term and the longer term picture because short-term clearly, I think, we probably have had a bit of a too strong global growth backdrop and it is particularly clear when you look at in some of the developed markets, we are growing well above trend growth which leads me to a longer term picture because if we look realistically what the headwind are then demographics, the debt overhang and the lack of productivity growth are formidable headwinds that will put a lid on global growth and as such you can consider that inflation is not very likely to overshoot either and in that respect it is very interesting that you mentioned the 10-year treasury because it obviously was at the center of attention over the past couple of weeks, it seems such up psychological mark and market paid a lot of attention on what has been going on there but yet, if you consider what I have just said on the longer term picture, it is clear that yes, there will be volatility but can we really see bond yields moving way beyond the current levels given the headwinds we are facing. So I think actually that tactically the fixed income space probably looks really attractive right now and I would consider that you know, whatever is happening here is more volatility than really a fundamental move away from the levels we are seeing.
Q: Would you go as far as to say that it is easier to see the yield back off to 2.5 percent or do you think the path to 3.5 percent is a path of easier resistance?
A: It seems that at least for now we have finally settled above the 3 percent hurdle which as you know that the first attempt failed, it was only one day phenomenon and then it moved back below and so I think that might to some extent depend on a more short-term data and whether there are any signs that either inflation or growth is moving in adverse direction. If not then there might be a few trading ranges but then I would think that the path towards 3.5 is not as clear-cut although I would then assume that we stay at current levels most likely.
Q: But even equity investors such as yourself or equity specialist such as yourself must be getting to that point where they start fretting about the inverted nature of the yield curve because in the past it has been a telltale sign of some kind of a recessionary condition. Are we at that point where you start fretting about it?
A: First of all I agree with you that it has been a very strong sign in the past. I would question whether the signal is as strong as it used to be just because we still have heard or we still experiencing very strong influence of a rather price insensitive buyer in the form of central banks. We have had this influence or past ten years and as such although I do not want to take away of the nature of this signal, I am wondering whether the strength is still the same today as it used to be when we had less kind of artificial influence on the kind of input factors because if you look at the other signals within the market yes, they have been slowing to some extent but not to an extent that would point to an immediate correlation with the flattening of the yield curve although it’s true that it is very strong and we definitely should not ignore it, but I would probably put it more in context with other signals this time around.
Q: Since you mentioned the central bank. Everybody dreams of a very smooth transition away from this tightening into a tightening phase. Do you think it will be as uneventful as equity markets believe or lot of equity participants hope for?
A: I would doubt that just simply because we should be aware of the magnitude of the experiment that has unfolded over the past ten years and my fear is that we have grown accustomed to the fact that they are just there and they are part of the day-to-day market activity. So taking them away, to my mind, naturally has to have some implications. The magnitude of this implications, we all do not know and it depends on how quickly they are implemented, but I cannot subscribe to the idea that we have all signed up for positive implication why they were there on the way in that is providing all the liquidity to markets and then assume at the same time that we take all this positive support away, it does not have any consequences and will have a neutral impact on market but to my mind it is more about the awareness that this might not necessarily be a neutral market even because for the time being we do not know. The only think we know is that from a communication standpoint central banks clearly are willing to be very cautious and trade very carefully and as such it might be a very slow kind of event that is unfolding before our eye but as I said to me it the awareness that – let’s just make sure that we understand that ten years of extraordinary monetary support will probably have a consequence if it’s no longer there.
Q: Do you think market were quite complacent about this and maybe the realization is sunk in which is which is why we are seeing this volatility if 2018?
A: Yes, to some extent although to mind it is the potential change in the fundamentals that has lead to initial reaction function and for most participants the idea still is okay it’s only the Fed so far that is raising rates and let’s face it, none of the central bank really has started to work on the balance sheet question and it’s the European Central Bank (ECB) that only just now tries to reduce the monthly purchasing programme. So we are not really there yet that we could say that we are at a proper tightening phase although to my mind, I agree with you, it’s important enough that we stop the liquidity that is we have this transition phase from quant of easing towards quant of tightening and we clearly have to be aware on the potential implications because if you look at market, market valuation level then clearly we as equity investors have benefited dramatically from the bond yields and the lower bond yields because as we know equity risk premia are related to the inverse nature of the bond yield and ever lower bond yields had a very positive impact on the way we look at equities and it had a very positive impact on multiples as well because we were willing to pay higher multiples for exactly the same earning stream just because the bond yield has had such a big impact on this.
Q: Do you fear though that if we do not have such a smooth transition there might be massive reset in asset prices as the world gets to live with much less liquidity?
A: It is a good question because to my mind it will depend a lot whether this might coincide with a recession because let’s face it, if the cycle were to come to an end and we obviously could think hypothetically around a situation where a potential trade war between the US and China could accelerate the downturn and as such then we would enter a recession with the central bank literally still in very much an easing mode and where to ease from there, where is the support coming from other than yet more quantitative easing. So that is an interesting kind of scenario where you then wonder whether asset prices probably would face one-off reset which you wonder maybe it would be a healthy development which at least would allow to come back to much more normal price discovery mechanism that is less distorted and we might find kind of more normal cross asset correlation relationships that we were used to in the past.
Q: What percentage probability would you assign to this outcome that you just mentioned?
A: For the time being it seems unlikely and I probably can come up with a better probability post the mid-term elections.
Q: But not impossible?
A: No, not impossible because I wouldn’t rule out that a trade war is still something that we have to consider. We should not forget the tactical element because there is the mid-term elections coming up in the United States and I am pretty sure President Trump is very well aware of the kind of headlines he would produce if he were to force China into stricter negotiations.
Q: Where does all this leave the US dollar because in the emerging market spectrum everybody keeps his eye peeled on that? Of late there has been a bit of strength. How would you map that going forward?
A: We have seen the bigger part of that move already and you are right to point out that particularly from emerging market’s point of view this is very-very important and I thought actually it was very interesting to see that although we have been arguing that emerging markets look a lot stronger if you look at the developments that have happened on the ground and you look at the fundamentals, yet again when the dollar started rising, we have seen first jitters emerging particularly within the fixed income space and the local government bond space. So looking at all the moving parts it is clear that it was particular the interest rate differential that has been the leading indicator for the dollar move but if you map this against this then it seems be have seen the majority of the positive dollar move already and it’s much more inline now with the interest rate differential that has led to it and so it seems that from here we have to wait and see what other data points we are getting but the historic correlation between the interest rate differential still is the most important factor and has been right again this time around that the dollar had to move to catchup with this.
Q: Earlier in the chat you mentioned the possibility of the cycle coming to an end and everybody stresses about that. Where are we in the cycle? Do you think it is a matter of time before the cycle ends or will this be a more elongated cycle, any thoughts on that?
A: If you just were to look at fundamentals then you could see this cycle continuing for a while and easily up to 24 months or so. If you look at the data, there is nothing really that would worry us other than probably a bit of normalisation towards trend growth.
In terms of consumption, capex spending, this all kind of seems to just trod along quite nicely. Hence it will come down to more kind of external factors that might add to either deceleration or acceleration.
Interestingly there are two elements, one are the more negative ones around protectionism, potential trade war which again looking at any historic precedent, it is clear that it is growth negative and it could clearly add to acceleration towards the end.
Other areas that we are watching are the credit cycle and here particularly in China because we should not underestimate how strongly the China credit cycle has actually helped the global growth cycle. If we look back to 2017 and the acceleration into the second half of 2017 then you find a very strong co-relation with the credit stimulus provided by China.
So, this is an area we are looking for because if you look at the global growth dynamics then China is such a key part, whatever the policy maker's next steps are in China, it will have an impact on the global growth dynamics. So, that is literally the two areas we are watching very carefully because within the underlying data there is nothing at this point that really worries us. So, it is more about finding out what are the lead indicators to watch to make sure we are capturing the starting point.
Q: You speak of external triggers, what worries you most? The trade war is on the table now, could there be something in the corporate bond market in the US if yields continue to rise, could it be an accident in emerging markets like maybe Turkey or something defaults on debt, where is the trigger likely to come from?
A: The corporate bond market and particularly the high yield space, obviously is priced to a default level that is not very realistic with the expectation for the end of this cycle. So, you wonder whether we would see the kind of lead indicator coming from widening spreads, not necessarily across the board to start with but within the pockets where obviously leverage has been rising the most and as such we have the highest vulnerability towards higher interest rates and hence higher default rates.
It is interesting because in aggregate it still seems okay in the US but the aggregate level is not really telling us where the pressure points and the stress points are. It is something which we are watching very carefully and so far there is nothing that worries us dramatically but we know that back in 2007-2008, it was the credit market that was the lead indicator of worse things to come, so we better have learnt our lesson and pay attention to what has been happening there.
Emerging market bond space is interesting and Argentina was the one that was in the spotlight more recently. What I do find very interesting and that comes back to the point around complacency, it is not long ago that they issued their 100 year bond at yield levels that we even back then wondered whether that really compensates for the risk you are taking and yet just a couple of months later the government has to call the IMF back in. It shows us how fickle investor sentiment is because the sell-off we have seen in the currency and in the bonds has been quite dramatic. Whereas just a couple of months ago we were willing to pay quite healthy prices for 100 year issuance for a country that has defaulted on a rather regular basis.
This brings me back to the idea around central banks and central bank liquidity and the potential complacency around this idea that what happens if that support stops? Because what quantitative easing did is, it has pushed us out of the risk curve and this is why countries like Argentina were able to issue 100 year bonds because there was ample liquidity to pick up these issuances. However with sensitives around higher bond yields, higher interest rates already are kind of reflected in investor reactions like the one around Argentina, then you wonder whether a misstep around Turkey or further developments there whether it would force a similar reaction function.
Q: Having seen so many cycles over the years, what are your thoughts on being able to predict when the slowdown is coming or when the cycle is turning? Does it usually give you so much time and notice to be able to react or usually over the last few cycles we have seen something external precipitating it and you have to react really quickly?
A: The difficulty again is that we are not quite sure yet where the potential turning point is coming from and what we are trying to do really is just look at the risk framework on how to judge the macroeconomic environment. The components clearly are that we try to really assess individually macro-economic data. What is the growth and inflation outlook? Is there anything in the data that worries us, that would be lead indicator for things to come?
Second is Central Bank policy liquidity. Again, obviously related to some extent to the earlier point is there anything in the data that would change the reaction or function of the central banks that obviously then would have implication for markets. Then you add market valuation and sentiment levels, whether your starting point provides you with some margin of safety or not and clearly this is where some warning signals are because most assets classes are priced to an extent that there is no margin of safety. Then you add obviously, political events to it because they are the most difficult to predict, yet can play quite a significant role to determine what then the market implication is of all of these.
For us it is important to break those down into those four components because only then you can detect where the sensitivities are which obviously in combination will have the impact on markets, on where we are heading. Warning signs I think most of them we have highlighted already, what we are watching and they can be either fundamentally indicators or market related indicators. As I said within the fixed income market, spread levels widening in some areas, and I guess that really is the only way to be prepared then for potential changes and as such we try to apply this framework and be kind of humble enough to make sure that we can look at those data points on a regular basis to make sure that we are aware of any changes that is happening.
Q: Speaking of cycle what about the emerging market cycle because that is not 8 or 9 years old. We have had a rough time, so maybe a two years in to that cycle in emerging markets. How do you juxtapose the two I mean developed market cycle versus the emerging market cycle that we are witnessing now?
A: The emerging markets obviously have taken longer to kind of see the recovery starting across the board. The adjustment processes did take longer than in the developed world. Yet again looking at my risk framework, I think I still can tick the box in terms of the fundamental data because you are absolutely right that in terms of the growth momentum emerging markets particularly ex China still look pretty strong and still look to accelerate. Yet I cannot obviously ignore that there is an external influence not only from central bank policy around the world, but in terms of market valuation and sentiment and here I think would include the dollar because although this has no immediate influence on the fundamentals on the ground it has an influence on markets.
Hence for emerging markets you always have to balance what is the strength of the fundamental data and you might then even have a sell off as we are experiencing right now, providing an opportunity to re-engage. So again same principles - look at the risk framework, assess them individually to make a case whether volatility and the market setback provides an opportunity or whether it should worry us and we dis-engage.
I think very important for us here is and you have to do this for each of the countries individually they are no longer a very kind of homogenous group that you have to look at as one. You have to look at them individually and I think the cases around Argentina and Turkey make this very clear that what is going on there has nothing to do with the emerging market complex. It is a very kind of country by country case and its problems that are home made from these two countries.
Q: Where does India fit into that picture? As you look at it individually what are your thoughts on where we stand?
A: India is interesting because in terms of their growth profile it definitely ticks the box and looks very positive. Again obviously the oil price does play a big role for India and the stock market. What we would say in general is that the current backdrop and the increased volatility is the backdrop for active stock selection. If you look across our emerging markets range and clearly what you are finding is it is much more the stock specific story that derives the stock selection rather than country and the country proposition. Yet we obviously - if you have a country like Argentina normally it does not payoff to engage even with individual stocks because the country risk will outweigh the stock specific opportunities but for India in particular it really comes down to the stock specific areas and it seems that from a growth angle here the support of the two components is very attractive.
First Published: IST