In our previous memo, we discussed how volatility, as a tool, could be used to maximize risk adjusted returns and how options provide a means of protection to investment portfolios, especially in times of extreme market fluctuations. In this short piece we’d like to take a look at the key themes ahead and how to navigate the choppy waters of the final legs of 2019, amid growing uncertainties in the global geopolitical and macroeconomic environment.
Geopolitical environment
Geopolitical risks are a recurring theme impacting global markets and have been the primary driver in recent times. In an age of globalization, and through the rise of technology and social media, we’ve witnessed the growing reach and immediacy of information especially since President Trump’s election in late 2016. The China-US trade war, as a theme, has been the single biggest driver of markets in 2019. On this front, we stand at the precipice of a truce in hostilities between the two countries and with that have seen an easing of tensions in recent months. Furthermore, with Brexit given an extension to 31 January 2020 - a reversion to a low volatility environment in the near term after a tumultuous August may seem to be in the offing.
When we look at some numbers, they might at first glance support the case: the CBOE Volatility Index currently stands at a 4-month low of 12.8 (versus a YTD high of 28.5 and low of 11.0, see Fig 1). Similarly, the Hang Seng Volatility Index currently reads 15.5 (versus a YTD high of 27.1 and low of 14.0, see Fig 2).
Fig 1: The CBOE Volatility Index (RH Axis, in Blue) v S&P 500 (November 2019 YTD)
Fig 2: The Hang Seng Volatility Index (RH Axis, in Green) vs Hang Seng Index (November 2019 YTD)
However, in the medium term we foresee tail winds which could drive volatility, including a Democratic party-led impeachment probe on President Trump amidst a re-election campaign; the deteriorating political situation in Hong Kong; political instability in Chile and Argentina. More pertinently, investor sentiment on seem increasingly based on frail foundations with any slight impasses causing outsized reactions. Recent examples include Trump’s tweets on trade negotiations throughout August (see Fig 3), culminating in a tariff hike on 23 August which led to an inversion of the US yield curve and a 2% plunge in the S&P 500.
Fig 3: Trade Headlines Hit Stocks
A similar observation can be made in terms of the Brexit negotiations too. To date since 10 October, the Sterling has surged more than 5% against the Dollar, to its highest level since mid-May, and has not seen such levels of volatility since the days following the referendum vote in June 2016 to leave the EU.
Macroeconomic environment
From a Macroeconomic perspective, the financial health of economies individually and globally make for some grim reading too (see Fig 4). Economic figures have of late been in the limelight as we come to terms with stagnant economic growth, easing of monetary policies by central banks across the globe and an over-valued equity market.
Fig 4: Global Softdata Tumbling
The Sustainability of Economic Growth
China’s growth story had been brought into sharp focus in light of its ongoing trade spat with the US. The latest economic figures show cracks in its meteoric rise. The October reading for manufacturing PMI came in at 49.3, the latest indication that China’s domestic economy is slowing down. Analysts polled by Refinitiv had expected the figure to remain flat. This coupled with a GDP growth rate of 6.0% for the third quarter (see Fig 5), which came in below expectations of an already revised down figure of 6.1% earlier in the year, could have cascading effects across a sluggish world economy and increase the risks of a global recession.
Fig 5: Chinese Economic Growth Slows
In the US, corporate margins and revenues are coming under pressure despite borrowing rates being in check. Operating margins amongst US corporations, on average already at a low level, are being driven down – third quarter earnings suggest that these have been squeezed further, by 0.6% YoY.
As a result of the China-US trade spat, the IMF in October downgraded growth forecasts for the global economy to 3.0%, down from 3.2% earlier in the year. Kristalina Georgieva, the newly appointed head of the IMF, noted that the global economy is in a “synchronized slowdown”, with growth in global trade having come to a “near standstill”. She further quoted that as recent as 2 years ago, nearly 75% of the world economy was growing – now, close to 90% is in the midst of decelerating.
Further, with growth slowing almost everywhere, central banks are on the case. Given that there are few signs of inflation, the US Fed, ECB, PBoC and BoJ are all trying to boost economic activity with cheap money. The Big question remains about just how effective these tools will be (see Fig 6) with rates at such a historically low level as it is.
Fig 6: Impact of Fed Interest Rate Moves on Markets
With the US and China seemingly at loggerheads in terms of trade, it certainly begs the question - where else will growth come from in the short term to fuel a continued global upward trajectory?
The Debt Problem
The general problem with debt is that since the global financial crisis, overall debt has largely shifted from private sector banks to the governments that bailed them out. The private credit market has also been of concern.
The issue of Non-Performing Loans (NPLs) in China, especially amongst small and medium sized enterprises, has also been brought into question. The issue resurfaced after the recent slew of closures and crackdowns on peer-to-peer micro finance companies. Outstanding loans made to small firms by China’s 5 largest lenders stood at 2.52 trillion Renminbi by the end of September, up 47.9% from the figure at the end of 2018, according to the China Banking and Insurance Regulatory Commission (CBIRC). When looking at the ratio of non-performing loans (see Fig 7) this is even more stark as current readings are at levels not seen since the global financial crisis.
Fig 7: China Non-Performing Loan Ratio 2009-2019 Q2 YTD
In the US, the deterioration in the corporate credit quality year-to-date highlights a vulnerability in markets, primarily due to ratings downgrades, slack demand, continued deterioration amongst the weakest credits, and a preference from buyers for higher quality issues. Leveraged loans, for example, are one corner of the market showing cracks, with corporate income growth now expected to be negative, marking the first time since 2016, while debt levels are high, particularly among weaker credits. Lower-rated high-yield bonds are showing similar pressures. Furthermore, these companies that geared up on cheap and abundant debt in the past decade will face their first significant hurdle of the cycle as $4 trillion of maturing bonds come due over the next 5 years (see Fig 8).
Fig 8: US Corporate Debt Maturity Wall
Conclusion
With markets hurtling full steam ahead and reaching new highs – it certainly raises the question of whether this upward momentum can be sustained and how long this late-cycle bull run can go on for. In the short term the focus will undoubtedly be on the geopolitics – be it on the latest developments in trade negotiations or the latest swings in opinion polls on the British General Elections. Whereas an eventual refocus and evaluation of the economy and fundamentals is unavoidable.
One thing is certain: volatility is here to stay.
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