13 septembre 2016

Deleveraging: Has it further to go?

September 13, 2016

On Thursday 8th September and Friday 9th September, financial markets suffered a strong simultaneous decline across asset classes driven by a rise in interest rates. As shown in figure 1, bonds dropped by more than -2.0 standard deviations over the period while equity markets fell between -1.5 and -2.0 standard deviations.

When the dust settled late Friday afternoon, the worst hit equities were the so-called defensive sectors (real estate, utilities, consumer staples) and the materials sector which is the most sensitive to the global economic cycle (figure 2). As a matter of fact, in the US, a minimum variance equity factor has even underperformed the broad-based S&P 500 during the sell-off, thus losing some of the advance it had accumulated since the start of the year 2016 (figure 3).

This coordinated move downward may be a correction of the financial reflation which occurred since the start of the year 2016 and which simultaneously profited equities, bonds and commodities as illustrated in figure 4. The trigger of this correction may have been related to monetary policy. On one hand, markets increasingly worry that ECB president Mario Draghi has run out of ammunition to fight deflation. In addition, the Federal Reserve has sent ambiguous signals as some central bank governors openly considered two rate hikes in 2016 (see Stanley Fisher) while others stated that patience is guaranteed (see Lael Brainard).

Meanwhile, there is no apparent inflation risk as shown by the long-term anticipation of inflation hovering near historical lows (figure 5). Commodities have been the weakest asset class over the last three months, which conveys a poor growth and inflation outlook.

Whatever the Federal Reserve does (or Trump judges about its irresponsibility not to hike rates), interest rates will not rise until the growth and inflation outlook actually improves. As the economist David Beckworth puts it, « interest rates cannot be exogenously pushed up, they have to be endogenously pulled up by a healthy economy. Until this happens, the Fed is trapped in a self-defeating rate hike talk cycle. » Back in 2011, both the Riksbank, Sweden’s central bank, and the ECB learned the hard way that raising rates too early may be hurtful. In the end, long-term rates were driven even further down.

Similar to earlier episodes of deleveraging, as in 2013 and in 2015, financial markets will find some way out of this deleveraging process by overweighting risky assets (either equities or cyclical commodities or emerging assets) under favorable economic conditions or bonds/gold in troubled times.

Figure 1: Move of main assets normalized by the one year rolling standard deviation.

Figure 2: Performance of S&P Level 2 Sectors over the last 5 days. The hardest hit sectors were defensive sectors (real estate, consumer staples and utilities) and commodities producers.

Figure 3: Compared performance of the S&P 500 Total Return and the US Min Variance Total Return.

Figure 4: Performance of a risk balanced strategy since the start of the year allocating equities, sovereign bonds and commodities.

Figure 5: 5 years forward forward inflation swap in the US and in EU, reflecting poor long term anticipation of inflation.

Figure 6: Performance of commodities and base metals since the start of the year 2016.

Figure 7: ECB Main refinancing rate and German 10 years yield.