The big fall in global equity markets in May and early June has given investors something to think about. After a rally in markets since October 2002, equities had by June 10 fallen from their peak on May 9 by more than 11%. Since this is more than 10%, technical analysts like to call it a correction.
Japan and Europe fell by 17% and 12%, respectively, much more than the US (down 6%). But it was emerging markets that took the biggest hit, down 20%. Of the sectors, basic resources, industrials and energy were most adversely affected, while more defensive sectors, such as health and utilities, enjoyed relative outperformance.
That indicates that the markets that did best in the four-year rally (Europe and Asia) and also demanded the biggest risk appetite (emerging markets) took the biggest fall.
For some time, I’ve been pushing hard with my clients the thesis that the great rise in asset prices (equities, property and commodities) has been driven above all by monetary forces.
Liquidity is the lifeblood of equity markets and global economies. In the past decade or so, that liquidity has been amplified by the securitization of debt and derivatives. The consequent huge rise in liquidity has driven down the cost of capital and encouraged investors to pump more and more money into riskier assets, convinced not only that strong growth will continue but also that inflation will remain low.
| How the money’s changed |
| US liquidity |
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| Source: US comptroller of the currency, Independent Strategy |
The architecture of global liquidity has shifted to encompass a myriad innovative forms of money dedicated to buying assets. Much of this was due to the creation of new types of derivatives.
This new money does not contract per se when central banks tighten. This is because much of the new money is priced off long(er) term interest rates. It contracts only when long-term interest rates rise in tandem with policy rates or increased fear of inflation. When that happens, asset prices start to fall in earnest. This is what we witnessed in May and June.
In recent months, there were signs that what happened in May was on its way. The cost of capital has been rising and the great carry trade was waning. Most important, credit derivative spreads were beginning to widen significantly. Investment-grade and high-yield CDX spreads narrowed right up to the beginning of May. After that, spreads widened significantly, well before equity markets tumbled. The CDX spread on emerging market debt has acted similarly. Even before the May correction, some Middle Eastern equity markets had burst.
Is the correction over? It might be for a while. But the lasting effect of contracting liquidity multipliers is to increase volatility, not just on the days markets tank but also for as long as liquidity tightens, money costs more and risk appetite stays reduced. This combination simply means that every bit of news has a greater impact on prices because there is less of a liquidity cushion to absorb it. Therefore markets get more volatile in both directions in response to good and bad news.
| Good news and bad |
| CBOE VIX |
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| Source: Datastream |
As a result, going long volatility is in one respect a safer bet for investors than going short equity or commodity markets. This is because being long volatility acknowledges the fact that tighter liquidity will make markets gyrate in both directions without making a forecast of which.
The VIX, the Chicago Board Options Exchange’s volatility index, for example, offers interesting results. The VIX is visually in tune with so many of the end-of-disinflation charts for actual inflation, inflationary expectations and nominal and real interest rates; a long slow swoon to extremely low levels that has only just started to reverse. But think about being long volatility on a six- to 12-month view in whatever way makes sense to you.
David Roche is president of Independent Strategy Ltd, a London-based research firm.www.instrategy.com