Global Markets Nervous, Investors Still Calm

Stock markets around the world show signs of building anxiety these days. Japan’s Nikkei 225 had its first 6% daily loss in its 63-year history. Actually, this happened twice this year. China's GDP growth has slowed to under 8% and its stock market has declined sharply, along with many emerging markets. Europe is still in recession as the U.S. tries to recover - its still muddling along with a GDP growth rate at 1.8%. Despite a sluggish economy, the U.S. stock market continues in a bullish trend higher and risk seems to be contained, at least for now.

Volatility
As we discussed previously, a measure by the CBOE of the Volatility Index (VIX) is an indication of the level of risk present in the U.S. stock market. From January 2007 until the present time, the has averaged 23.6. On November 20, 2008, the VIX peaked at 80.9, the exact day the S&P 500 reached a temporary bottom... temporary because it hit a post-crisis low on March 9, 2009. In the past three years the VIX has had three major spikes. The first was on May 20, 2010, when it reached 45.8; the second was on August 8, 2011, when it hit 48.0, while the third was on October 11, 2011, when it topped 45.5. Each time, the stock market was falling. In fact, the correlation between the VIX and the S&P 500 for the period January 5, 2004 until the present is -0.59, indicating a strong negative correlation. [Previously, we mentioned in this blog a structured product that takes advantage of this type of trading.] Recently the VIX rose to as high as only 20.5, but has fallen back to 16.9 as of June 27th. Therefore, for now at least, it appears to be calm.

Stocks
Even though the stock market has been trending higher there is an active fight between bulls and bears to decide how much equity growth is due to Fed policy and how much is due to fundamentals. With the near meltdown of the global economy in 2008, stocks fell hard and fast. Possibly, stocks had fallen so far that the rise over the past four years is neither excessive nor alarming. Everyone, however, seems now to agree that the world is in uncharted monetary policy waters as central bankers continually expand their balance sheets. How will these 'Lords of Liquidity' unwind their QE programs without causing severe disruption to the financial markets?

Bonds
Predicting the timing for any US Fed policy reversal has been a legitimate debate, in large part because US employment gains lag and global risks, including China’s economic slowing, persist. A huge surprise came with the velocity of the spike in interest rates recently. Yields on benchmark 10-year US Treasury notes crossed above 2.6% in late June, surging from 1.6% as recently as May. Besides just interest rate risk, we see the risks of leverage (closed-end funds) and bond-market liquidity. Eventually the bond market will lose a big customer when the US Federal Reserve stops slows its quantitative easing. We fully expect some disorder in the corporate-bond market for the next three to six months. Credit and credit spreads will continue to be vulnerable.

Summary
Consumers and businesses learned a great lesson in 2008: excessive debt can bring the house down when bubbles eventually burst. As a result, I suspect they will be more cautious about returning to the same behavior that led to the crisis. However, the profit motive is a strong one and leverage is still a drug of choice for most investors. This could prove to be an interesting ride!

Author: Chris Davies

Posted in: China , Debt , QE , SP 500 , VIX , Volatility