The move lower in global equities in August and September caught many investors off guard. The shift in risk sentiment was widespread and relentless. The rally that followed in October was less surprising. It was a pattern we have experienced time and time again over the last 6 years. Following these enormous moves, the same risks remain present with additional uncertainty mounting.
We expect further air pockets of volatility across asset classes. The continued move lower in high yield credit and leveraged loans is concerning. Credit market weakness typically pre-empts equity market weakness. There is also significant volatility underneath the surface. Benchmark indices range from slightly negative to slightly positive, but there have been significant losses in widely held hedge fund names especially in Biotech, Energy, Solar, and Retail. For example, the S&P 500 TR has gained 1.4% YTD (through 11/17), but is down 2.0% excluding the top 10 stocks ranked by attribution.
Following the rally in October, there is minimal risk appetite on the buy side and the dealer community. There have been a number of high profile deals that were unable or struggled to receive financing (eg. Symantec, BioMed Realty). We are also observing this in the equity derivative markets where many desks made their year in August and September, and have zero risk appetite heading into year-end. We have seen quotes on liquid structures meaningfully widened as a result.
Nonetheless, these concerns are anecdotal, and only come to fruition through a catalyst. Our concerns over global growth, a lack of liquidity, and EM weakness are fundamentally warranted, but we do not lose sight of the fact that a hard catalyst is required for the market to reflect these concerns. Catalysts such as balance sheet issues with a high profile investment grade corporate, default concern with an emerging market country, the reemergence of fears regarding slowing growth in China, or weakening economic data in the US. Absent these catalysts, the only real impact is a loss of sleep for our portfolio management team.
Central Banks driving asset prices
Central banks continue to dictate the macroeconomic environment. The ECB’s comments were very dovish and point to additional easing measures in December. The recent actions by the PBOC also provide a supportive environment. The inclusion of the CNY in the SDR will allow China to continue weakening its currency, albeit at a measured pace. The Fed’s comments were more hawkish than expected, but still allow enough leeway to be data dependent. The BoJ is expected to take additional easing measures, but we think these actions will most likely take place in 2016.
All of these actions create a more supportive environment for risk assets with a limiting effect on tail risk, which gives all investors a false sense of complacency. Central banks cannot prevent the catalysts discussed above. These events would have a meaningful impact across asset classes, but the probability of any one event occurring is very low. As a result, we are positioned in a more neutral manner with the goal of being able to capture upside while maintaining convexity in case one these events actually does take place.