2022 has been a volatile year for foreign exchange, interest rates, credit, and equity markets. The relentless tightening of financial conditions by central banks catapulted participants into a new reality. Fair enough, we lack historical experience on how above markets might evolve when confronted with the combined impact of both balance sheet run-off and policy rate hiking. Nevertheless, our visibility grows on the contours of a different financial market system. The ecosystem we detect exhibits the following characteristics.
First, from a controlled, low-volatility condition we transition into an uncontrolled, uncomfortably, high-volatility environment. Volatility is kept at high levels by sustained geopolitical uncertainty that is multi-polar instead of bi-polar. Markets adjust to sanction-heavy investment decisions. This condition will keep demand for far out-of-the-money options across rate, credit, equity, and foreign exchange markets, and the distribution of outcomes across respective markets will exhibit fat tails over the next decade. Volatility will feed on fiscal imbalances that become persistent. That reality will spur the intensity of the debate on debt sustainability. Debt sustainability headlines is a recipe that fosters risk-off strategies. Restructurings will become part of the solution set instead of a QE policy that shields, protects indiscriminately. The volatility dampening QE – large scale asset purchasing – instrument will not make a comeback anytime soon as central banks have reclaimed control of their interest rate policy instrument. Remember that QE only becomes relevant when policy rates sit at the zero-bound frontier. Over an 8-year stretch between end of 1996 to 2004, the VIX equity volatility index averaged 23.3, while the S&P 500 total return index posted an annualized return of over 8% over the same period. The MOVE index, which measures US rate volatility, averaged 103 over the same period. Last Friday, the VIX closed just below 23, while the MOVE index was at 113. This suggests that we will need to get accustomed to such a high volatility background. Long-term investors will have to reinforce portfolio value when panic dips occur, whilst rotating into quality fixed income sectors the moment relative valuations across credit and equity sectors get stretched. Simplicity in combining attractive fixed income carry per unit of volatility and attractive equity value per unit of volatility is back.
Second, primary markets become less buoyant. The volumes of investment grade and high yield credit are lacklustre or dwindling, respectively. Global equity IPO volumes fell by about 44% in Q3 2022 versus 2021. The US market is on track to record its lowest IPO proceeds since 2003. Clearly, we are morphing into a market condition that challenges the trend that has been prevalent since the Great Financial Crisis (i.e. a disintermediation trend that saw the banking channel taking a back seat). Is traditional bank intermediation staging a comeback? When policy rates are at approximately 5% in the US or 3% in the EU, it begs the question if securitization will thrive. Leveraged loan origination (CLOs) may become challenging as default probabilities at the margin will rise under tight financial conditions. The read-through of less buoyant primary markets is less liquid secondary markets. Risk budgets for secondary market credit trading among sell-side liquidity providers got a serious hit back in March 2020. We observe that even small pops in volatility translate to outsized drops in liquidity provision. Buy-side transaction intensity is at the mercy of sell-side liquidity offering willingness.
Third, regulation by supervisory authorities to protect investor interests is balancing on a fragile frontier. This frontier, if crossed, might be at the detriment of end-investor liquidity but also opportunity. Effectively, public markets might become less interesting for borrowers and entrepreneurs when sourcing funding. The allure of private market funding possibly continues to accelerate from here. Confirming the opposite: public markets might be retracing. Indeed, at the margin and over the long-term, public markets could become less diversified, more concentrated, and potentially more volatile over the long term. When considering the integration of ESG factors and potential bubble-risk that goes along, we become more attentive to the structure and evolution of portfolio compositions. Due diligence on investment processes and resulting portfolio outcomes should attract attention from end-investors and fund selectors alike.
Active quality solutions have potential and can become more appealing than beta solutions. The latter replicate market-cap weighted indices. Let’s repeat. Exposure to the most indebted countries and corporates or the largest equity market caps through passive or ETF solutions can easily translate and lead to less optimal investment outcomes.
As we exit COVID-related volatility conditions in markets, we are entering a new reality of market challenges conditioned on higher volatility, reduced liquidity, and market drivers that are more prone to regulation.
2022 has been a defining year for the structure of financial markets. Central banks reverted to their historical mean. Fiscal policy is getting stretched and regulatory tensions are omnipresent. All combined we find ourselves morphing into a new era for financial markets. A story we will revisit over 2023 and beyond.
