Market volatility is the result of a lack of liquidity

Since August’s stock market turbulence — sparked by the devaluation of the yuan and the resurgence of fears about the Chinese economy — the financial markets have seen a great deal of volatility. The market participants have read too much into risk factors, particularly those in China. This has translated into these massive movements, which have been exacerbated by the current lack of liquidity on the markets.

During August’s correction, several market indicators were behaving similarly to how they had in the middle of the 2008 crisis. This is the case for the volatility of US equities’ volatility index (the VVIX), which reached a record high when the People’s Bank of China announced that it would liberalise its exchange-rate fixing mechanism. Between August 21 and 24, the Euro Stoxx’s intraday volatility reached the same highs that it had seen between October 3 and 6 2008, when Lehman Brothers collapsed.

Fundamentals and monetary policies

However, given the fundamentals, the markets’ recent extreme reactions don’t really make any sense. Investors have to try to rationally look at the macroeconomic data. Indeed, these data are giving indications about the real direction of global growth: PMI indicators, among others, are showing that developed economies are holding up with decent growth, stronger than emerging market economies, which are currently slowing down. This divergence shows that growth dynamics are being redistributed. In China, growth is not collapsing, but it has been slowing down for several years now. The Chinese economy’s situation is not new; there’s nothing in current macroeconomic data that justifies greater fears about the consequences of the slowdown in the Chinese economy. The high-frequency statistics are even pointing to a rebound in Chinese activity from the beginning of 2016.

In the United States, the economic recovery remains strong, with growth close to 2.5 per cent for this year and the job market having improved significantly. Nonetheless, wage inflation is still weak, which explained the Federal Reserve’s choice in September to leave interest rates where they were. The Fed didn’t want to run the risk of destabilising the markets. The lack of inflation gives it some breathing room, and on top of this, the Fed can already rely on the appreciation of the dollar, which is contributing to the natural tightening of financial conditions. The greenback’s movement is therefore forming part of the Fed’s efforts to normalise monetary policy, I would like to point out.

On the other side of the Atlantic, as far as the ECB’s policy is concerned, inflation expectations are guaranteeing that the central bank’s asset-purchasing programme remains flexible. With five-year five-year forward inflation close to 1.6 per cent, Mario Draghi is prepared to speed up the quantitative easing efforts if necessary. The impact of the ECB’s policy can be seen clearly in investor sentiment; Draghi doesn’t want to give the impression that he’s giving up in the face of weak inflation expectations.

I believe that all this information is giving investors some reference points to be able to understand what’s going on the markets a bit more calmly.

Fixed-income strategy: defensive positioning that favours liquidity

UBP’s fixed-income team is continuing to put an exposure to US-dollar-denominated, investment-grade corporate debt at the heart of its portfolio. At the moment, the yield on investment-grade US corporate debt is identical to its average over the last five years, i.e. close to 2.8 per cent. The spread component that goes to make up this return is still offering a comfortable cushion, being in the order of 150 basis points. In terms of maturities, we are overweighting the 3- to 5-year bonds in this universe, which are attractive thanks to their carry, and especially because of the roll-down that they allow.

In contrast, we are steering clear of the euro-denominated, investment-grade segment, whose risk/return profile is felt to be unattractive. We think that with a return of only 1%, the risk on this segment is poorly rewarded. This cautiousness also applies to emerging-market bonds (the major capitalisations). Whilst these bonds have only corrected slightly in the last few weeks, there’s a risk that their ratings will be downgraded, as happened to the peripheral European issuers a few years back. This risk has not yet been priced in.

We like two other classes of asset: on the one hand, high-yield corporate debt invested via CDS indices earns a yield above 6 per cent with negligible interest-rate risk and greater liquidity. The use of CDS rather than investing directly in fixed-income assets themselves means that we’re free of the capacity constraints that are particular to the fixed-income universe. And in contrast to bonds, CDS don’t bear any prepayment risk, which preserves their performance potential.

Furthermore, European CoCo bonds have had a good ride since the beginning of the year, outperforming the Euro Aggregate Index by more than 5 per cent. The segment is maturing, with $130 billion of debt already out there, to which USD 30 billion has been added since 1 January. From the issuers’ perspective, lights are green. Banks have carried out the necessary rationalisations to restore their pre-crisis profitability levels and to vastly improve their core equity.

Christel Rendu de Lint is UBP’s Head of Fixed Income and Absolute Return