All aboard the risk train

Perhaps to say that there is complacency in the market is too broad a generalisation, it just seems like there are just so many contradictions out there currently. Equities and fixed income markets are saying very different things; while the S+P 500 and VIX are very sanguine, US bonds are rallying which tells of a much more concerning picture, but even here volatility is falling.

As sentiment and expectations continue to gyrate between extremes, the underlying economic data is still playing out in much the way that we had anticipated. I would argue that it is not so much the economic data that have been volatile and unpredictable, but rather the pendulum swings in market moods, coupled with headline grabbing political dramas, which have led to the kind of fake breaks that we saw in May. I have written over the last couple of newsletters about the unwind of the Trumpflation trade, and it seems like this has now been pretty much all priced out.

Nevertheless, these are indeed some very confused times for markets, and to complicate matters further, global growth is not in synch. US data continues to disappoint versus high expectations (set by some very strong soft data prints that I wrote about in previous Newsletters), but more importantly the positive Q1 momentum seen out of EM and Asia has begun to wane (as China’s policy tightening starts to bite).

European and Japanese data look to be on fire, apart from the one indicator that everyone cares about the most, inflation. But the GFC has altered the way that the market perceives the balance of risks (the behavioural finance term is pain memory): we now have a tendency to overestimate long term volatility (“it’s all going to crap”), hence placing a heavier weight on downside risks. Also, with the economic green shoots in Europe and Japan being so green, we don’t know if we can trust them yet, or if they can gather enough momentum to offset the potential drag from China and the US.

In last month’s Newsletter I went very deep into the intricacies of Chinese financial plumbing and we got feedback that I lost a few people on the journey, so this month I wanted to step back and take a big picture view. In this note I aim to pull together our current thoughts on China and, given the growth inflection point looks to be clearly behind us, investigate what they mean for the rest of the world’s economies and markets. Access our newsletter here.