May 8, 2015

The last two weeks in financial markets have been somewhat of a rollercoaster, with bonds, stocks and the US Dollar selling off in unison, wiping out several hundred billion dollars off global wealth in a matter of days. European bonds took a severe beating, which, as explained in one of our previous blogs, was inevitable considering that a large proportion of them were trading at prices that guaranteed a loss at maturity.

Panics in financial markets always show up unannounced, which makes it all the more interesting to understand ex-post what triggered these brutal moves. Friends of MONOGRAM have heard us mention many times that in essence, this is all about the US. The US drives capital and sentiment, and are therefore more often than not the culprit behind volatility bouts. All major crises in the last 30 years have started in the United States: the 2008 Lehman debacle, the 2000 Tech bubble, the 1998 LTCM bailout, and the 1987 market crash.

This time around, two factors seem to have been the catalyst behind the coordinated retreat in assets markets. First, a couple of fixed-income investment luminaries, Bill Gross of Janus Capital and Jeffrey Gundlach of DoubleLine Capital (who incidentally are both American), have been vocal about the inflated valuation of European sovereign bonds. Gross going on to call long-dated German bonds “the short of a lifetime”. This means that betting on these bonds going down is effectively almost a sure bet, the closest thing to free money.

Secondly, the US economy is going through a bit of a soft patch. This should in theory be favourable to bonds, and perhaps not so good for equities, but both asset classes have gone down. Why? Mostly because the US Federal Reserve said that this would not change its perception of the overall upwards trajectory of the US economy, and therefore it would not change its plan to tighten monetary conditions by the end of the year.

But perhaps the Federal Reserve is wrong. Perhaps the US, which has been expanding modestly over the last 6 years, is starting to turn the corner for the worst. This of course, would be supportive to bonds, although interest rates are so low that upside here is limited. This would also be a headwind to stock market performance, not only in the US, but also in Europe; and this is even if European economies finally break out of the stagnation world it has been living in for years.

Why is that? Because the US economy actually has a much larger influence on the fate of developed markets than the local economies themselves.  This means that what matters most to the performance of say, UK stocks, is not so much whether the UK is in recession or not, but whether the US is in recession or not.

To show this, we look at the performance of 5 local markets on a quarterly basis, selecting only the quarters when (i) the US was in recession, but not the local markets, and (ii) local economies were in recession, but not the US. Our sample includes France, Germany, Italy, Spain and the UK. Going back to 1992, our findings are crystal clear. The simple average annualised performance of local markets when we observe:

  • Local expansion and US recession is -22.0%
  • Local recession and US expansion is 13.1%.
1992 – 2015 Annualised Local Markets Performance
US recession France expansion -25%
US recession Spain expansion -13%
US recession UK expansion -21%
US recession Germany expansion -30%
US recession Italy expansion -20%
US expansion France recession 21%
US expansion Spain recession -1%
US expansion UK recession 21%
US expansion Germany recession 20%
US expansion Italy recession 5%

In light of these results, it is certainly worth keeping a very close eye on the fundamental US dynamic- and hope that the Federal Reserve is right. As former US President Bill Clinton once famously said- “It is (about) the economy, stupid”. That is right, it is about the economy … of the US.

MONOGRAM CAPITAL MANAGEMENT

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