Multi-Asset: Smackdown

On the Mark – Multi Asset Strategy– May 2022

Summary:

We have a problem

Fed tries to restore credibility

Volatility abounds

The spectre of inflation continues to haunt central banks and investors question whether they have let the genie out of the bottle. It is becoming increasingly evident that the US Fed has got far behind the curve and now needs to tackle the problem with increasing urgency. Indeed, in the May BofA Global Fund Manager Survey (GFMS) a hawkish response to inflation is listed as the biggest tail risk.

The Sticky Price Consumer Price Index (CPI) is calculated from a subset of goods and services included in the CPI that change price relatively infrequently. As these goods and services change price relatively infrequently, they are thought to incorporate expectations about future inflation to a greater degree than prices that change on a more frequent basis. You can see from the chart below (Figure 1.) that this index is now at 4.9% and is approaching levels last seen over 30 years ago. This is a massive concern given its very nature – i.e., it is ‘sticky’ and therefore hard to reverse.   

Figure 1. Atlanta Fed Sticky-Price CPI

Source: Federal Reserve Bank of Atlanta

Another major concern that we have pointed out in several previous notes is wage inflation. As you can see in the chart below (Figure 2.) this is now at levels not seen since the 1990s. This should not come as a surprise given the tightness in the US labour market and employees response to high levels of inflation. Reversing this will be difficult and come with significant costs, but if this inflationary driver becomes embedded in the common psyche, central banks will have a challenge of much greater magnitude.   

Figure 2. Atlanta Fed Wage Growth Tracker – three month moving average of median wage growth, hourly data

Source: Current Population Survey, Bureau of Labor Statistics and authors calculations, Federal Reserve Bank of Atlanta

Few, if any, foresaw a Ukrainian war, which would ignite many commodity prices, further disrupt supply chains, and intensify inflationary pressures. Many of these price increases will not be directly combatted by the Fed raising rates. But nevertheless, central banks have to convince investors of their inflation fighting credentials.

At the last Fed meeting on 22 May 2022 the FOMC raised interest rates 50bp to a target range of 75 to 100bp in line with consensus market expectations. Fed speakers came out as one to give investors the message that inflation is their number one threat and that they will take the necessary actions to reverse the current positive momentum and subdue it in line with their 2% target.

Roll forward a week and Kansas City Fed Governor, Esther George, gave an interview to CNBC. She made it clear that the Fed is looking to tighten financial conditions, of which equity markets are a component, in an effort to tamp down price increases running at their fastest pace in more than 40 years.

George went on to say, “I think what we’re looking for is the transmission of our policy through markets’ understanding, and that tightening should be expected … So, it’s not aimed at the equity markets in particular, but I think it is one of the avenues through which tighter financial conditions will emerge.” In other words, the Fed sees lower equity prices in the future as part of the programme to bring down inflation. Full commentary and video replay can be found at:  https://www.cnbc.com/2022/05/19/fed-isnt-focused-on-impact-of-rates-on-stocks-esther-george-says.html?&qsearchterm=esther%20george

In summary, inflation is much higher than the Fed expected; they are behind the curve, they are now trying to catch up with more aggressive policy action and investors see this as a major risk. Let us just take a moment to reflect what all of the Fed’s action or inactions have done to the market pricing of volatility.

The ICE BofA MOVE Index is a yield curve weighted index of the normalised implied volatility on 1-month Treasury options. In simple terms, it is a measure of implied US bond volatility. As can be seen in Figure 3 below volatility is now around levels only seen twice in the last decade. Firstly, in 2013 during the ‘Taper Tantrum’ when the yield on 10-year U.S. Treasuries rose from around 2% in May 2013 to around 3% in December. Secondly, during the COVID panic of 2020 when the yield on 10-year U.S. Treasuries fell from close to 2% at the start of the year to 0.54% in early March, only to rise back to 1.2% by 18th March, before falling close to all-time lows once again.

Figure 3. ICE BofA MOVE Index

Source:  Bloomberg

The VIX Index is a financial benchmark designed to be an up-to-the-minute market estimate of the expected volatility of the S&P 500 Index and is calculated by using the midpoint of real-time S&P 500 Index (SPX) option bid/ask quotes. We can see in Figure 4 that implied equity volatility remained relatively subdued and low by historic standards from 2012 until the COVID threat in 2020, when volatility exploded upwards. However, recently we can see that it has once again started to seesaw higher and averaged levels closer to historic norms around 20. 

Figure 4. VIX index

Source: Bloomberg

CVIX is the Deutsche Bank Currency Volatility Index. which measures the implied volatility of currency markets. Thus, it is a measure of the market's expectation of future currency volatility. Given the highly uncertain economic backdrop, speed of response by central banks to tackling inflation and consequent move in the US Dollar it should come as no surprise that this measure is close to previous highs in the last decade as can be seen in Figure 5.

Figure 5. CVIX Index

Source:  Bloomberg

Last, but not least, we take a look at commodity volatility. We have had to be a little more creative as there is not a well-recognised implied volatility index. As a result, we have graphed the implied volatility of a 3-month option on the Bloomberg Commodity Index (BCOM). This index is calculated on an excess return basis and reflects commodity futures price movements.  As can be seen in Figure 6 this has now exploded upwards as result of the Ukrainian war.

Figure 6. Implied Volatility on 3-month Bloomberg Commodity index option.

Source: Bloomberg

I hear you say, and I get it, the market pricing of volatility in all asset classes is elevated and, in some cases, close to highs of the last decade. So what?  We have two observations: 

Firstly, that the current pricing of volatility reflects the environment and central banks’ ability to clearly communicate and navigate a successful path.

The BofA GFMS shows a chart of its Financial Market Stability Risks indicator at a record high! (Figure 7.) Whilst BofA make it clear that this indicator is an indicative metric only, it comments that it shows “elevated levels of risk aversion comparable to prior crisis moments (GFC, COVID shock). The high perceived risk to financial market stability also points to a further decline in equity prices.”.

Figure 7. Financial Market Stability Risks Indicator (reversed) continues to rise…equities lower

Source: BofA Global Fund Manager Survey, BofA Global Research   

Secondly, this in today’s Bloomberg Opinion, Points of Return by John Authers “the most interesting finding of the Draaisma research is that the other way to prosper under inflation is through trend-following. Equity trend-followers, which might otherwise be called dedicated followers of momentum, do almost as well under inflation (8%) as they do the rest of the time (11%); momentum strategies applied across all asset classes do much better (averaging 25% in inflationary regimes, against 16% the rest of the time). This therefore looks like it should be the time for macro or trend-following hedge funds to start delivering”.

In conclusion, if you are concerned about the outlook, you may just want to talk to our in-house trend following fund manager.

Mark Harris
Fund Manager, Multi Asset