The first quarter of 2023 saw considerable market swings, reflecting high uncertainty on key macro factors: growth, inflation, and central banks in the middle.
We had a rally of everything in January, with hopes of declining price pressures, but a sell-off in February for the exact opposite reason. March was buoyant, as investors realized that stress in the banking sector could temper central banks’ hawkishness. This first quarter was definitely a bumpy ride.
Q2 starts on a very different tone: much quieter. Most asset classes are so far modestly positive in April, but the most striking fact is not their direction. Volatility has plummeted.
The average daily price change of global stocks saw its magnitude divided by 3 compared to the first quarter. So far this month, they only had one daily absolute move of more than 1 per cent, versus 19 in Q1. Implied volatility followed.
The VIX, nicknamed the ‘Fear Index’, which basically measures the cost of hedging US equities, fell from 26 to below 17, its lowest since November 2021. Beyond equity, a comparable gauge for fixed income - the MOVE index - also dropped 40 per cent from its March peak.
Let’s focus on US stocks. The VIX at 17 or below is not historically atypical, at all. But it usually happens in times of confidence and visibility, or when central banks provide full support. Are we taking this direction?
Well, there is some good news. First, the global economy is doing better than expected, tracking an almost booming 4 per cent annualized real growth in Q1. China leads, but resilience is everywhere, and the latest data suggest that momentum is not broken.
Second, central banks are marginally more market-friendly due to the stress in the banking system. They inject liquidity again, and can be less aggressive on rate hikes, as tighter access to credit has a similar effect on the economy.
Q1 results deliver
Finally, the Q1 corporate earnings season starts well as we write: so far, almost 80 per cent of the quarterly earnings that have been reported are better than the relatively conservative expectations from the consensus.
Indeed, the short-term fundamental picture is factually positive. But macro risks have certainly not disappeared for the medium term. The growth/inflation conundrum is not solved, with core CPI unambiguously too high.
Activity should decelerate and inflation moderate, most probably, but when, and at what pace remain open questions, with implications for both earnings and valuation multiples. The current macro picture shows that there is a possibility for an ideal scenario of resilient growth and more accommodative monetary policies.
The issue is that markets take it for granted: they are priced for it, and the declining VIX expresses a material degree of confidence. Confidence is also high when it comes to next week’s Fed decision: a 25-basis points hike as 80 per cent probability. We agree.
After rate hike, what next?
Are future markets right to expect cuts later this year? If they are, does it mean activity will plunge?
If they aren’t, are current valuations sustainable? What about quantitative tightening, the US Federal debt ceiling, geopolitical tensions, the dollar?
There are many unanswered, important questions, from which we believe that both realized and implied volatility are disconnected. This anomaly results from the combination of a temporary relief on the big picture, with an overall cautious positioning from investors.
Technically, the gamma hedging of previous optional protections is compressing the price of options. Behaviorally, while trend-following hedge funds are buying on short-term signals, conservative investors’ fatigue pushes them to go neutral.
Markets taking a pause?
We can understand the current calm, but we can’t fully justify it. It is probably just a pause.
Against this backdrop, we have just decided to materially increase our allocation to money market funds across all our profiles - our largest overweight ever. When volatility rises, cash is king for its downside protection and flexibility.
Cash in 2023 also provides an unmatchable risk-adjusted return on short, tactical horizon. We currently underweight Western equities, but overweight fundamentally compelling emerging stocks.
We have a clear preference for quality over risk within fixed income. Finally, volatility is a long-term investor’s friend: we have to get ready for the next opportunities when the VIX spikes again.