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The omicron variant scared financial markets last Friday. The VIX equity volatility indicator added 10 points to close at 28. The MOVE bond volatility indicator closed around 90. The former moved away from its 30-year average at 19.5. The latter moved exactly towards its 30-year average that sits at 90.75.
As stated last week, investors have been traveling a steep pandemic/endemic learning curve since early 2020. Shocks like the one occurring on Black Friday should not destabilise investors. If anything, it trains us to become accustomed to, on average, higher market volatility. Higher market volatility that aligns with historical episodes when central banks played a less pronounced role. Over a the next 3- to 5-year horizon we should expect monetary policy to make a measured retreat.
One might state that we will observe a mean reverting moment in financial market history across central bank policy, economic indicators (i.e. growth, inflation, unemployment, global trade) and main market valuations (ranging from rates, credit, commodities and equity). Mean reversion stands against momentum. Momentum gave rise to and was instrumental in the asset inflation, across markets, that defined the era post the Great Financial Crisis. I briefly pause on the capacity of indicators and markets to exhibit mean-reverting tendencies.
Most DM central banks will make a well-guided reversal away from asset purchase programs that became dominant in markets by the end of 2014, early 2015. Expect most central bank to revert to a state where not quantitative policies but the qualitative interest rate policy instrument becomes alive again. With longer-term inflation expectations settling at or just above target, DM central banks will call victory. Their communication will zoom in on the requirement to go through a period of above-average inflation in order to make up for below-target inflation over the past decade. Central banks are aware and sense that it is time to revert policy and prepare markets for higher policy rates. FED policy rates might revert towards 1.50-1.75% against the ECB reverting to 0.50%-0.75%. Such levels create space for lower policy rates the moment respective economies face cyclical headwinds. It would also anchor their credibility. At this very moment, monetary authorities want to manage their credibility. Their credibility is at stake, even threatened. Paul Volcker has been the central banker that introduced the credibility factor as a success indicator. Revisit Volcker’s FED presidency, a real treat when you are interested in central bank history.
Expect mean reversion to impact growth, inflation, unemployment as well as global trade. Inclusive, regenerative and circular growth might be slightly below consensus potential growth estimates that prevail today across DM and EM economies. Such is reflected in somehow lower terminal policy rates levels than pencilled in the paragraph above. Inflation and modern central banking, appearing as of 1913 by the creation of the Federal Reserve System, have been going hand in hand. Inflation has been a mean-reverting indicator of choice. Unemployment might revert to below-average levels as populations age. The skills mismatch requires sound and visionary education and training policies across government and corporate policies. The current pandemic has put labour markets in a state of flux. Its future state is still blurred and difficult to assess. The difficulty in defining what constitutes a healthy labour market next to when we get to ‘maximum employment’ will often be used by central banks to explain their patient behaviour and slow reaction function. Momentum in global trade was already topping before the corona crisis. The combined impact of a US inward-looking industrial policy, a confrontational US-China trade policy and a fragilized, ex-UK, EU economic block is transforming and impacting value chains. Global, just-in-time solutions make room for regional or local just-in-case versions. Businesses will need to build thicker buffers against shocks. Effectively, companies will need to become more robust and resilient. They’ll have to mimic our behaviour as investment managers as we build robust portfolios that survive or even thrive under stress (become anti-fragile as explained by Nassim Taleb).
Over the past 7 years, since the ECB joined the global QE bonanza, including a FED hiking cycle, 10-year US rates averaged 1.95%. We deviate about 50bp from this 7-year average. Interestingly, 10-year rates 3-year forward bring us to a 1.95% level. Such a level would still result in a positively sloping US yield curve the moment policy rates adjust to a 1.50%-1.75% range. It’s what goes under the banner: ‘A beautiful outcome’. 10-year French OAT rates averaged +0.42% over the past 7 years. 10-year OAT rates, closing at +0.03%, 3 year forward sit at +0.52%. The ECB and France would for sure sign up for such an outcome.
Investment grade credit spreads in Europe, measured by the Itraxx Main 5-year CDS index, averaged 62bp over the past 7 years. We closed at 57bp on Friday…almost a full mean reversion. As the ECB might call an end to its corporate sector purchase program, one might expect a test above the mean over 2022. High yield spreads in Europe, measured by the Itraxx Crossover 5-year CDS index, averaged 293bp over the past 7 years. We closed at 287bp on Friday…same story as in IG. Exiting corporate QE might again put some stress on HY spreads over 2022 but nothing to become frightened of.
For the commodity complex we can be short. It is the mean reverting asset class by design, as demand-supply processes interact seamlessly with (forced or unforced) episodes of scarcity and glut. Taking our 7-year horizon, the WTI (West Texas Intermediate) price of oil averaged EUR 53. We closed at USD 68 last Friday in one of the most aggressive selloffs in history. The price of WTI 3 years forward prints at USD 59.50.
Equity markets somehow reveal a different profile to overall momentum, sector and company-specific biases in favour of quality/growth companies. This has lifted the equity tide to historic highs. Valuations and multiples are historically high. Yet again, no sectors are impacted, and some are valued around the mean. Fact is that new companies that did not exist 5 or 10 years ago make for spectacular headline news on business model and valuation grounds. We discussed the changing economic fabric in these musings over the past weeks and months, and there is more to come. Moreover, the level of rates might and should better be dismissed as an argument explaining valuations. Across sectors, we have notice intense change and disruption. Corporate capex and green capex are set to accelerate for business models to thrive and prosper. Mean-reverting expectations might be less of a guide in equity markets.
Assessing mean-reverting impulses, especially in times of market stress, soothes the nerves. But nothing goes beyond proper diversification to truly bring peace of mind.