I promise that I will not do an explainer of the VIX this week. Instead, I will lead with some observations on markets and finish with a war-story from the world of retail investing. The return of equity volatility has engendered two responses. Firstly, it seemed as if investors breathed a sigh of relief on Monday when it became clear that we could peg the swoon to the blow-up of short-vol ETFs and related strategies. It is always scary when markest fall out of bed, and even more if so if we can’t explain why. Blaming excessive risk-taking in short-vol strategies assured that the sell-off, while painful, would be short. Secondly, every strategist note that I have subsequently read—and comments from policymakers—have echoed this sentiment. A sell-off was long overdue and is perfectly normal. There is nothing to worry about, and underlying economic fundamentals for risk assets remain robust. Many have even welcomed the volatility as a sign of healthy markets. I have no particular reason to disagree, but my spider sense tingles when investors and strategists welcome a 10% puke in equities. I understand that macro traders are excited but real money and long-only? The logical response from markets would seem to be: “Oh, so you think you’re tough?”
Read MoreThis essay is full of contradictions and loose ends, so I might as well start with one in the title. This cycle is not over yet, and I am not sure that I have the definitive answer for when it will end. It is, however, well advanced with some themes and narratives. I am writing this in an attempt to make sense of and to explain, a world, which to my despair is increasingly devoid of reason. As a finance geek, I can’t get anywhere without first establishing the state of play in the economy and markets. The most salient feature since the financial crisis has been the unprecedented activism of monetary policy. In 2006, Alan Blinder described central banking in the 21st century. It is a brilliant paper but in dire need of an update given actions taken by policymakers since 2008. Central bankers were first called into action to prevent a collapse. The destruction in markets after Lehman’s failure showed that timidity or firmness in the face of moral hazard risk was impossible. Interbank markets were seizing up, banks were running out of liquidity, and the chaos quickly was spreading to the real economy. Decisive action was needed to avoid the situation spiralling out of control. Central banks had to take their role as lenders of last resort seriously.
Read MoreLast week I warned of a tipping point in financial markets but also contrasted it with potential for a return of the reflation trade. Judging by the price action since, investors have opted to step back from the brink. The dollar finally has found some support—aided by PBoC intervention—bond yields have increased and stocks have rebounded modestly. One week does not make a trend, but the path toward a new reflation trade is simple. The dip in U.S. core inflation is temporary and political uncertainty will fade, prompting investors to focus on the bright side. If so, late-comers to the trend of a weaker dollar and lower yields are in for a rude awakening. By Q1, markets could be looking at a White House pushing through tax cuts; hurricane rebuilding will be underway—perhaps boosted by bipartisan support for infrastructure spending—inflation is rising, and the Fed has re-started its hiking cycle. I am not sure that I believe in this version of the world, but the implications are clear if you do. Bonds should be sold aggressively, the dollar is a buy—in particular against the euro and the yen—and domestic U.S. growth stocks, mainly financials, should be added to global equity portfolios.
Read MoreLast week I said that investors have plenty to worry about, but also that many of the traditional reasons to abandon ship—chiefly extended valuations and political paralysis and risk—perhaps weren't as valid as many think they are. The most convincing argument for not panicking despite extended valuations is that ample global liquidity and low interest rates remain as support for equities and credit markets. I imagine that his idea has been put down on page one of most investors' playbook since the financial crisis. The argument is pretty simple. As long as central banks are on the bid, their purchases of bonds—and other assets—will drive private investors into riskier markets. Known as the portfolio balancing effect, this is recognised to operate via both the stock and flow of central banks' balance sheets. Finally, front-end interest rates that are locked at the zero bound—or slow to rise even as the economy recovers—also translates into higher equity prices and tighter spreads. Low rates mean an increase in the future discounted value of cash flows and also encourages investors to pay a higher multiple for the same level of earnings. It also forces investors to seek out yield in private debt markets to reach their return targets, despite the higher risk profile of corporate bonds.
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