“Black-Monday-light”: Three lessons

On Monday, investors got a rough awakening: Reminiscent of the 1987 Black Monday crash, US equities fell sharply, wiping out all year-to-date gains. Implied volatility, aka. the markets “fear gauge”,  showed the biggest daily increase on record (see figure 1). As a reminder, just a few days ago investor sentiment was close to euphoria. This has turned upside down within a few trading sessions. We see three reasons for this sudden change of mood and some important lessons for the overall market environment in 2018.

  1. The real thing: After years of “lowflation”, there recently have been signs of inflation awakening. Hourly earnings in the US rose to the highest level since the big recession and unit labour costs increased amid weak productivity. In other words, inflation fears are back. Why is this “the real thing”? Because wages are a key driver behind the corporate profit cycle and, therefore, the real economy broadly speaking. Higher wage costs can wipe out corporate margins and force the central bank to (over-)tighten. This normally marks the beginning of the end of the US business cycle and, therefore, the equity bull market.
  2. The pain threshold: As a result of inflation bottoming and central banks tightening, interest rates have risen rapidly in 2018, breaking out of their recent trading ranges. Post-Lehman, low interest rates have been a key driver behind the equity bull market. Naturally, rising rates poses a major risk to markets. The key question nobody is able to answer yet is at which level of rates will equities be hurt in earnest? What we do know is that in previous episodes, a break out of the trend channel in interest rates often spelled trouble for equities (200, 2007, 1990 – see figure 2). Equities were already showing weakness before yesterday’s mini flash-crash, so the pain threshold might be lower than many investors think.
  3. The known unknowns: Market-specific factors are playing out as well. Worth noting is the role of so-called short volatility strategies, making investors able to profit from a continuation of record-low volatility. This investment trend has gained importance over the last few years, which makes it hard to draw lessons from history on their potential market impact. To some extent we are talking about known unknowns, as investors are still very much in the dark when it comes to the impact on overall markets. Investors betting on low volatility were caught wrong-footed. This exacerbated Monday’s volatility, where these strategies took heavy losses (figure 3). On top of this, technical factors come into play during rapid sell-offs, e.g. trend-following strategies, amplifying the moves to the downside.

So what are the lessons learned? First, we are seeing a regime shift away from the low vol environment of recent years. In our view, this is the beginning of a cycle of rising volatility fuelled by monetary tightening (see figure 4), resulting in reduced risk-reward in risk assets going forward. Secondly, while a major top seems unlikely before the second half of 2018, this might be labelled the start of a topping process. Growth is still robust and the inflation fear seems a bit overdone to us. A “big top” in equities would require clearer signs of monetary tightening affecting the real economy. We can take comfort from the fact that the spill-overs to other asset classes have been limited so far. Credit investors are normally one of the first to sniff recession risks, but the moves in credit spreads have been well-behaved compared to what we saw in US equities. Lastly, relatively new investment trends like short volatility strategies are still “known unknowns”, but potentially amplify market volatility in down-phases. Bottom line: Regime shift yes, “big top” not yet.


Figure 1: Biggest jump in volatility on record

image

Figure 2: Interest rates entering dangerous territories

image

 

Figure 3: Short volatility strategies got wiped out

image

Figure 4: Get ready for the coming cycle of rising volatility

image

About Nordea Asset Management
Nordea Asset Management (NAM, AuM 223.6 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 330.4 bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 25.01.2018

Nordea Asset Management is the functional name of the asset management business conducted by the legal entities Nordea Investment Funds S.A. and Nordea Investment Management AB (“the Legal Entities”) and their branches, subsidiaries and representative offices. This document is intended to provide the reader with information on Nordea’s specific capabilities. This document (or any views or opinions expressed in this document) does not amount to an investment advice nor does it constitute a recommendation to invest in any financial product, investment structure or instrument, to enter into or unwind any transaction or to participate in any particular trading strategy. This document is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instruments or to participate to any such trading strategy. Any such offering may be made only by an Offering Memorandum, or any similar contractual arrangement. Consequently, the information contained herein will be superseded in its entirety by such Offering Memorandum or contractual arrangement in its final form. Any investment decision should therefore only be based on the final legal documentation, without limitation and if applicable, Offering Memorandum, contractual arrangement, any relevant prospectus and the latest key investor information document (where applicable) relating to the investment. The appropriateness of an investment or strategy will depend on an investor’s full circumstances and objectives. Nordea Investment Management recommends that investors independently evaluate particular investments and strategies as well as encourages investors to seek the advice of independent financial advisors when deemed relevant by the investor. Any products, securities, instruments or strategies discussed in this document may not be suitable for all investors. This document contains information which has been taken from a number of sources. While the information herein is considered to be correct, no representation or warranty can be given on the ultimate accuracy or completeness of such information and investors may use further sources to form a well-informed investment decision. Prospective investors or counterparties should discuss with their professional tax, legal, accounting and other adviser(s) with regards to the potential effect of any investment that they may enter into, including the possible risks and benefits of such investment. Prospective investors or counterparties should also fully understand the potential investment and ascertain that they have made an independent assessment of the appropriateness of such potential investment, based solely on their own intentions and ambitions. Investments in derivative and foreign exchange related transactions may be subject to significant fluctuations which may affect the value of an investment. Investments in Emerging Markets involve a higher element of risk. The value of the investment can greatly fluctuate and cannot be ensured. Investments in equity and debt instruments issued by banks could bear the risk of being subject to the bail-in mechanism (meaning that equity and debt instruments could be written down in order to ensure that most unsecured creditors of an institution bear appropriate losses) as foreseen in EU Directive 2014/59/EU. Nordea Asset Management has decided to bear the cost for research, i.e. such cost is covered by existing fee arrangements (Management-/Administration-Fee). Published and created by the Legal Entities adherent to Nordea Asset Management. The Legal Entities are licensed and supervised by the Financial Supervisory Authority in Sweden, Finland and Luxembourg respectively. The Legal Entities’ branches, subsidiaries and representative offices are licensed as well as regulated by their local financial supervisory authority in their respective country of domiciliation. Source (unless otherwise stated): Nordea Investment Funds, S.A. Unless otherwise stated, all views expressed are those of the Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and representative offices. This document may not be reproduced or circulated without prior permission. Reference to companies or other investments mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same, but is included for the purpose of illustration. The level of tax benefits and liabilities will depend on individual circumstances and may be subject to change in the future. © The Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and/or representative offices.

Follow our latest posts

3 weeks ago

Returns and Responsibility. It's in our Nordic DNA.

Watch now
8 months ago

2019 Outlook: A Year of Convergence

Watch now