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The Big Conversation

Episode 124: A silent seller stalks markets

This week Real Vision’s Roger Hirst uses Refinitiv’s best-in-class data to look at the recent weakness across stocks and bonds. If retail investors are buying the dips and institutions have liquidated few of their positions, then who is behind this weakness? One of the clues could be in the higher volatility across bond and currency markets and how that affects the dynamics of the rules-based funds that were the constant buyers over much of the last decade.

  • Roger [00:00:00] Although this has been the second worst start to a year in history, the S&P 500 has not yet entered a bear market and activity across many stocks suggest that retail investors continue to buy the dip. So who are the silent sellers who have confounded the contrarian expectations? Welcome to the big conversation.

    Roger [00:00:23] For some sections of the stock landscape, this has already been a vicious bear market. The NASDAQ has fallen over 25%, but even that disguises the incredible dispersion within the index, with some of the old darlings of the pandemic, such as Peloton, now down by over 90%.

    Roger [00:00:41] The Dow Jones Industrial average on the other hand has only just fallen over 10%. Investors have fallen out of love with all but the highest quality tech names, whilst consensus has shifted towards owning raw materials and energy names...as well as defensive sectors.

    Roger [00:00:54] But if we are headed toward a recession, then we should expect the broader markets to also catch down.

    Roger [00:01:00] During most recessionary bear markets, the S&P falls between 35 and 40%, and the average duration of those bear markets would take us into Q4 of this year, if this was to play out along average lines.

    Roger [00:01:13] And the equity market appears to be leading the economy.

    Roger [00:01:16] The year on year change of the S&P suggests that the ISM Manufacturing index should fall below 50, the threshold of expansion and contraction...and even towards 45, which has been a recessionary indicator over the last 30 years.

    Roger [00:01:31] But, inflation is obviously key here.

    Roger [00:01:34] Back in the 1970s, the economy often entered recession with the ISM well above the threshold and on one occasion was closer to 60. The point here being that many indicators such as the ISM and yield curves give different signals during times of inflation versus times of moderation.

    Roger [00:01:51] In fact, all the recessions since 1965 saw a spike in inflation during or just before the recession (apart from 2020). Whilst we don't know if inflation has peaked for a while, regardless of the outcome of US CPI which was released after we recorded this film, it's probably a decent bet that we are getting close.

    Roger [00:02:11] But perhaps the real carnage this time around has been in the bond market. Indeed, more than that, it's the combined performance of bonds and equities which is one of the worst on record for any time period.

    Roger [00:02:24] And bond volatility is one of the potential sources of cross asset selling that we're seeing today. Since 2015, there's been a flow of assets from active to these passive mandates, and that's been gathering pace. However, many of these flows were actually into multi-asset mandates that used passive instruments. And these were those rules-based funds such as risk parity. And many of these funds use volatility as a major investment factor. If volatility is low and steady, they can max out their allocations to things like bonds and stocks. But when volatility rises, they then have to reduce their exposure.

    Roger [00:03:01] And during that period between 2015 and 2022, markets generally rallied and when we did have those explosions of volatility, such as 2018 and 2020, the Fed were quick to step in and support markets, helping to cap volatility. And this was part of their mandate to support growth.

    Roger [00:03:19] Even in 2020, the Fed was swift to act when it was clear that there was a sudden de-leveraging event taking place across these funds.

    Roger [00:03:27] Today, however, the Fed is attempting to cap price via higher interest rates, rather than protect growth through QE and rate cuts. This has seen volatility across asset classes rising. Bond and FX volatility are now much closer to their 2020 peaks than is in fact equity volatility.

    Roger [00:03:45] And combine these effects with higher interest rate expectations and we're probably in the midst of a lengthy reduction in exposure from these funds.

    Roger [00:03:52] But this is not the sudden shock of deleveraging, but an ongoing unwind. And we can see this in the volatility of volatility on the S&P 500, which remains incredibly subdued considering the moves we've seen so far.

    Roger [00:04:07] And these rules-based funds are dispassionate, and they don't do sentiment surveys. So, whilst individual investors and many institutions have become extremely bearish, their positions are probably dwarfed by the rules-based funds which are now unwinding.

    Roger [00:04:21] Now, policymakers may not have the resolve to fully re-anchor inflation, but it's unlikely that they will reverse course until there's an obvious slowdown in the economy. And a slowdown on Main Street May 1st require more pain on Wall Street.

    Roger [00:04:35] So what can people do? Well, the sell-off in equities in 2018 occurred during the old era of moderation, BUT yields started to fall before equities finished selling off. A reversal in yields could be the first port of call in today's environment.

    Roger [00:04:51] And during all previous inflationary periods, bond yields finished the ensuing recession at lower levels than they began the recession in all but one case, which was 1974. Bond yields have also fallen during all recessions since that inflationary period.

    Roger [00:05:06] And the TLT has already sold off dramatically. Ideally, it would still fall further to fulfil the head and shoulders formation that has been playing out, but call spreads, because volatility is relatively high, may be attractive.

    Roger [00:05:21] So we have extreme levels of bearishness, but we've not yet seen retail liquidations to match. The selling we are getting is probably dispassionate in nature from those rules-based funds. And recession risk has increased, but if that is the case, then bond markets are usually the first to reverse, and that's what some investors are now starting to position for.

    Roger [00:05:44] And if you've got any questions about this episode, financial markets or the economy, please put them in the comments section or send them to fmt@lseg.com