Last week, Goldman brought you “the bear necessities” – basically a manifesto-ish piece on the inevitability of a downturn.
In that note, the bank warned that the “bear market risk indicator” (a composite of five other “famous” indicators) is flashing yellow.
They went on to catalogue, based on historical precedent, what you can expect going forward.
There were a lot of takeaways from that piece, but generally speaking, the conclusion was simple: eventually this will turn. Self-evident, yes. But investors have recently demonstrated a remarkable propensity to ignore things that are self-evident. So you can’t blame Goldman for broaching the subject.
Well on Tuesday evening, the bank was back revisiting the same subject in yet another sweeping note with another “cute” title: “Goldilocks still escaping the bears.” How fun is that, right? Here’s “Goldilocks”:
The ‘Goldilocks scenario’ of strong growth but little inflation pressure has broadly continued, if not become more favourable, since our last asset allocation update on July 19. As a result, the low vol regime across assets has prevailed, despite shocks from North Korea and US hurricanes. Performance across assets has been strong YTD with risky assets rallying alongside “safe havens”, boosted by lower bond yields.
So “what could go wrong” (we’re rolling out the cliches early on Wednesday)? For one thing, a rapid rise in rates could trigger a tantrum. We got a preview of that in late June/ early July after Draghi’s Sintra “hiccup.” Here’s Goldman:
Some risky assets have already showed signs of indigestion during the periods of higher yields in June when there was the bond sell-off post the Sintra speech by ECB president Draghi. Equities have been negatively correlated with bond yields throughout the year while credit spreads tightened alongside lower bond yields – this is typical during ‘Goldilocks scenarios’ when risky assets and bonds can rally alongside each other. As a result, while not our base case, there is a risk higher rates can weigh more on risky assets on the flipside, especially if they rise fast and are not accompanied by better growth. With most ‘safe havens’ being rate-sensitive, this can increase the risk of drawdowns in multi-asset portfolios.
That’s key. Recall this yesterday from BofAML:
With the Fed’s balance sheet poised to contract and financial conditions set to tighten either steadily or abruptly, we fear gold, fixed income, and equity asset prices may suffer a sudden drop.
And then there are of course concerns about the durability of the low vol. regime which faces threats not only from DM central bank normalization, but also from seasonality and of course, from geopolitical headwinds. Here’s Goldman again:
As a result of the persistent Goldilocks scenario, despite looming growth shocks from North Korea and US hurricanes during the summer, the low volatility regime has prevailed. In fact, S&P 500 1-month realised volatility made a new low this cycle at 4% on August 8, below the previous low of 4.8% in December 2014 and close to the all-time low of 3.6% since 1928. Since then, volatility has picked up temporarily in equities but is now back at the lows. The same has been somewhat true across assets – although rates and FX volatility has picked up more recently.
Uncertainty on both growth and inflation is likely to increase through year-end, which could drive again a temporary pick-up in volatility. Historically, there is a statistically strong seasonality in S&P 500 volatility with October generally showing a pick-up. And indeed, there are several catalysts that could drive larger market moves – the most immediate is the Fed meeting. Also, at their September meeting, the ECB announced that they will make the bulk of the tapering decisions in October.
Political uncertainty remains elevated – President Trump’s fiscal deal delays the debt limit and government shutdown risk until Q1 2018 but newsflow might pick-up towards year-end. German elections on September 20 seem unlikely to drive volatility but the run-up to the Italian elections next year and the ongoing Brexit negotiations could create more uncertainty. Also on October 18, there will be China’s National People’s Congress – while we do not expect any major policy moves as this is mainly about the leadership reshuffle, it could increase focus on China imbalances again. And last but not least, North Korea sanctions, which were passed by the UN last week, might increase tensions between the US and North Korea again.
The bottom line from the bank: “While we do not think that there has to be a bad ending for the ‘Goldilocks scenario’ we have been in since the beginning of the year, the bears could catch up into year-end.”
There’s a bear chasing you. “Run, Forrest. Run.”
