The defining feature of 2017 was the bulletproof character of risk assets in the face of persistent geopolitical headwinds and ongoing policy uncertainty in the United States.
Rather than paraphrase a previous post, I’ll just take the liberty of quoting from “(Black) Swan Lake” (which you should peruse – at your leisure, of course):
Quite a bit of the uncertainty emanated from Donald Trump. Healthcare overhaul failed, the tax cuts and fiscal stimulus were delayed and generally speaking, rates and FX had priced out his entire agenda by August. Then came “fire and fury” and weeks later, the Charlottesville debacle. Those two episodes underscored how truly tenuous the geopolitical landscape was and how fractious domestic politics had become in the U.S., respectively.
In Europe, the threat of populism never truly subsided despite Marine Le Pen’s decisive loss to Emmanuel Macron. AfD’s stronger-than-expected showing in the German elections made it clear that the populist narrative still resonated and would likely continue to haunt the bloc going forward.
Through it all, dips were bought/vol. spikes were sold and the disconnect between news-based measures of uncertainty and market-based measures of volatility widened materially. See: “The Great Disconnect: 5 Reasons Why Volatility Is Detached From ‘Chaotic Uncertainty’”
What accounted for that the persistent suppression of cross-asset volatility in the face of geopolitical/policy uncertainty? Well, abundant liquidity, for one. Additionally, the vaunted “Goldilocks” narrative of synchronous global growth and still-subdued inflation underpinned the low vol. regime by allowing traders to point to upbeat economic indicators while citing well-anchored inflation as a reason to expect central banks to remain accommodative for the foreseeable future.
That dynamic precipitated a self-feeding loop, whereby “buy-the-dip” was transformed from a derisive meme about retail investors into a viable (indeed, an almost infallible) trading “strategy”.
Part and parcel of that was the idea that the central bank put had become self-sustaining – it ran on autopilot. Why wait on dovish forward guidance (or any other signal from the monetary gods) to buy the dip when you knew, with absolute certainty, that in the unlikely event a drawdown proved to be some semblance of sustainable, policymakers would calm markets? Something like this: If you know it’s coming, well then you should buy the dip now.
That became a recursive exercise as everyone tried to frontrun everyone else and before you knew it, dips and vol. spikes were mean reverting at a record pace as the prevailing dynamic optimized around itself.
That seemed to change in February, in the aftermath of the VIX spike. The implosion of the short VIX ETPs and the activation of the “doom loop” shook confidence. The psychology shifted and with it, the regime.
“Longer-term, I do believe this is a genuine regime change, one where you sell-the-rallies rather than buy-the-dips”, Goldman’s co-head of global equities trading, Brian Levine, wrote, in a letter to the bank’s clients back in February.
Of course the VIX quake was hardly the only event that shook market confidence in 2018, a year that began with a furious rally fueled by massive inflows and ebullient sentiment.
There was the inflation scare that ultimately helped precipitate the VIX explosion and subsequent deleveraging by systematic investors. There was the spike in real rates stateside. There was the blowout in LIBOR. There was the turmoil in Italian bonds. There’s the ongoing malaise in emerging markets catalyzed by a combination of Fed tightening and idiosyncratic flareups that prompted the collapse of the Argentine peso and the egregious slide in the Turkish lira. There’s the ongoing bear market in Chinese equities and the near-bear market price action in European autos and banks. And on and on.
That brings us neatly to a couple of excerpts from the most recent note by BofAML’s Barnaby Martin, who on Wednesday characterizes 2018 as a “non-stop event risk cabaret”.
Martin is of course a credit strategist, so his analysis should be viewed through that lens, but this is applicable across assets. “The message [in 2018] is clear: it’s been a relatively messy credit market thus far, and a far cry from the bulletproof backdrop that characterized 2017”, he writes, before asking the following question:
What’s driven such a marked turnaround in the robustness of European credit?
His answer: a series of event risks including some of those mentioned above. To wit:
2018 has undoubtedly had its fair share of left-field events. In fact, it’s felt like a non-stop event risk roller coaster this year: “Vixplosion” in February, US LIBOR surging in March, inflation worries in April, Italy and EM pressure in May and trade fears in June (Chart 1).
Martin goes on to make the same point made here at the outset – namely that 2017 wasn’t exactly a year devoid of event risks. “But 2017 was also fraught with risks – albeit mostly on the election front – and yet the market barely missed a beat,” he reminds you, before coming to the same conclusion as many other folks:
For us, the biggest change in market dynamics recently has been that “buy the dip” behaviour has morphed into a “sell the dip” mindset, leaving markets much more fragile. Chart 2 shows the sell-off and retracement patterns for credit spreads during periods of market turbulence over the last few years.
But the critical point comes when Martin implores you to consider that while this year’s shocks might seem, on the surface, to be “disconnected” events, many of them have one thing in common:
And while these appear like a series of disconnected shocks, a common thread to some of them is that they are a consequence of populism: the protectionist, antagonistic and deglobalization lurch by western leaders.