Photo: iStockphoto
Photo: iStockphoto

Betting against conventional wisdom

Usually, a flatlining market with higher volatility after a long bull run signals the end of the prevailing bullish trend. However, such heuristics are no longer as reliable in the 'new normal'

The markets have not been generous so far this year to investors, who have been left pondering the right asset allocation strategy as prices across markets flatline or worse and volatility rises. Since the beginning of the year (1), the Indian stock market has lost 3%, 10-year bond yields are broadly unchanged despite the Reserve Bank of India (RBI) rate cuts, and the rupee is down 1%. Foreign markets have not provided much solace either. The S&P500 in the US has returned 1% and the UK’s FTSE100 2%. Even though the quantitative easing (QE)-supported markets of Europe and Japan notched up double-digit gains (Eurostoxx up 10% and Nikkei up 17%), the rising price trend seems to have reversed since May. In conjunction, bond yields have risen (i.e. prices have fallen) with some disconcertingly vertiginous moves in “risk-free" government bonds. The fall in commodity prices (Bloomberg Commodity Index down 4%) has compounded the asset allocation dilemma.

Usually, a flatlining market with higher volatility after a long bull run signals the end of the prevailing bullish trend. However, such heuristics are no longer as reliable in the “new normal". While greater volatility and the tendency for the market to turn on a headline provide short-term trading opportunities, investors need to configure portfolios for the medium to long term. For this, they need to keep an eye out for four main factors that are likely to have a major impact on markets. In most cases, the opportunity lies in betting against conventional wisdom.

The first is the situation in Greece, which has been creating headlines since the start of the year when an anti-austerity government was elected (2). Contrary to conventional wisdom, a Greek default or an 11th-hour miracle deal is likely to only have a short-term limited impact on the markets. The former is largely priced in due to the festering negotiations, and the latter is likely to be another exercise in delaying the inevitable. The main determinant of the future course of European asset markets will be the ex-post impact of default on the Greek economy and employment. While pundits are largely focused on the short-term impact with an economic catastrophe widely expected, the actual result may not be as dramatic given the already severe deterioration of economic fundamentals (rock bottom is pretty close with more than 25% unemployment and 50% youth unemployment and an economy that has lost 30% of its gross domestic product since 2008). Moreover, a case can be made for a fairly quick turnaround in Greek fortunes if the Syriza government uses the resulting fiscal and monetary independence to pursue expansionary economic policy (3). A better-than-expected outcome is likely to embolden anti-austerity movements across other European Union (EU) member-states and weaken the monetary union. This is likely to lead to a resumption of the acute crisis phase, the possibility of which markets seem to be ignoring for the moment.

The second factor that may destabilize markets, especially the commodities markets, is the Chinese economic rebalancing. We have discussed this before. Suffice to add that current data continues to support the view that a hard landing is likely. In contrast, conventional wisdom expects a managed soft landing in China. This is exceedingly unlikely given that no country has managed it yet (4). For example, the fact that almost all of the annual increase in Chinese firm profit was due to income from the stock market6 has echoes of “zaitech" (financial engineering), which Japanese firms undertook to speculatively boost profits during the 1980s Japanese bubble.

The third factor is the eventual “normalization" of interest rates by the US Federal Reserve (Fed), which is likely to impact almost all asset markets as the taper tantrum of 2013 and more recent spike in credit and government bond yields demonstrated. However, given the Fed’s recent history of dovishness, conventional wisdom expects market moves to be limited due to gradual and small rate rises with interest rates remaining well below pre-crisis levels. While true, it ignores the fact that lower interest rates have greatly reduced the extent of post-crisis deleveraging and have even led to releveraging in certain sectors. Consequently, the level of interest rates that can trigger a Minsky moment is much lower. From 1987, when Alan Greenspan took over as Fed chairman, each economic cycle has seen lower absolute level of rates along with an increase in private debt. Therefore, despite the absolute level of rates being lower, every policy tightening in the last three decades has eventually led to selloffs.

The fourth factor is the unseen change in market functioning caused by post-crisis regulatory changes (5). Although not much has changed superficially, the lack of liquidity and more frequent volatility spikes are worrying market participants (for example, in the course of a fortnight in April-May, German bond yields spiked from 0.16% to 0.7%0—a rare occurrence for AAA government bonds). As is usually the case, efforts to reduce and regulate systemic risk have only shifted the risk onto unregulated corners. For example, exchange-traded funds (ETFs) have proliferated across asset classes offering a low-cost way for investors to take exposure. Regulators and investors view them as safe and liquid. However, many underlying ETF assets are illiquid, which may prove the promise of fast and easy redemption illusory. The change in market functioning been exacerbated by the extraordinary monetary support provided to the markets by developed-market central banks. In the search for yield, investors have herded into the same positions increasing volatility and likelihood of disorderly markets.

The four factors have made asset allocation decision more complicated for investors given the greater than normal uncertainty in how events will unfold and the potential large impact that each can have. In each case, a long-established trend looks set to change. Therefore, an unconventional and contrarian approach may be warranted.

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy.

Notes:

1. Until 15 June, the time of writing this article

2: As of this writing, Greece looks set to default with both sides holding fast to their position while asking the other to show the will to compromise

3. Although viewed with alarm by the true believers of current economic dogma, nations that pursued an expansionary fiscal policy climbed out sooner from the Great Depression

4. It’s never different this time

5. Although this impacts mainly western markets, the interconnectedness of the system ensures that the impact is felt even in developing markets like India where foreign institutional investors are such an important constituent

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