Valentine’s Day Massacre?

One of my favourite sayings from The Warren is that it’s only when the tide goes out that you find out who is swimming naked.

Well, whether you want to describe recent events as the volatility tide going out or more of a volatility tsunami, either way we got an ugly eyeful of short-volatility players in their birthday suits. Leveraged inverse VIX notes (essentially instruments betting on lower volatility) collapsed, taking with them the shirts off both institutional and (sadly possibly more) retail backs. This was not an unknown risk – and one highlighted last year by the excellent David Mortlock, of Berenberg. Stories of amateur day-traders making ‘easy money’ in the short volatility market is usually something of a warning sign!

We have highlighted for a while now that, as central banks start to unwind quantitative easing (QE) and tighten interest rates, a pickup in volatility was likely, both in equities and bonds. This phenomenon began this year as the US 10-year treasury yield rose sharply through January, and then shifted to equities, with stock markets sinking abruptly lower last week.

Equities and bond yields had been rising steadily over the past few months due to a mixture of better growth prospects and higher expectations of inflation. Company earnings have largely been strong, with tax cuts helping to boost forward earnings. However, casting its shadow over this sharp drawdown is that grim raven of yesteryear: “good news is bad news.” Back in the early years of US quantitative easing, risk assets were driven higher by a flood of Federal Reserve-driven liquidity – beyond what could be justified by earnings. Because of that, we had a topsy-turvy few years where any threat to QE purchases – i.e. stronger economic data and higher inflation – was met by a wave of selling. Over time, continued earnings growth helped justify higher prices and this phenomenon seemed to fade into the background.

And then, this year Main Street got a pay rise: in January, US wages were 2.9% higher than a year earlier. That was 30bps greater than expected and the highest rate since 2009. Albeit somewhat glossed over was the fact that hours worked actually fell. But it was enough to concern some investors that higher inflation was finally coming down the pipe, which would mean faster interest rate hikes by the Fed. Higher assumptions of future interest rates means cash flow in coming years is worth less, and so share prices adjusted. This appears to have been amplified by the squeeze on investors who were short volatility (highlighted above), and then as markets sold off people (and machines) sold because other people (and machines) were selling and the market tripped over itself in a flurry of worry.

Part of this appears to have been exacerbated by target volatility funds, which target a specific level of volatility by allocating between equities and cash. As volatility spikes, they are required to sell risk assets (i.e. equities) to readjust their levels of volatility. Questions remain about whether the reallocation from these funds has passed or whether there could be more to come, creating continued selling pressure on the market. Either way, this reinforces why we believe having a relative volatility target for our funds is so important, and ensures we are not forced sellers into illiquid markets. We try to keep our funds’ volatility at within certain proportions of global equity movements – not at specific absolute percentages (say, portfolio volatility of 12%). This is a crucial difference.

Volatility is always bracing, but given the move up in equities and length of time we have had since a material pullback, any correction was always likely to be fast and of reasonable magnitude, and as ever impossible to time. To keep things in perspective, the S&P 500 is now only back to November levels (as I write).

It was however a rude welcome for new Federal Reserve Chair Jerome Powell, whose first day was the Monday of the 4% sell-off in America. Many investors will be watching to see how he responds, and we will get an early peek this week with an inflation print due on Valentine’s Day. US CPI has been hovering around 2.1% for several months, if it breaks significantly higher investors may get worried once again.

We think February’s ructions were a foretaste of more volatility ahead as investors come to terms with the Fed’s normalisation of interest rates. The exaggerated market movements caused by quantitative traders and passive flows should create opportunities for longer-term investors who buy on fundamental value. We have used some of the cash to add to  equities on this sell-off and will continue to do so in a careful and disciplined manner should we see further drawdowns in equities or higher yields on bonds.

Happy Valentine’s to you all. Sadly the Fed inflation print will be the highlight of my Wednesday …