Tag Archive: policy

Still a risk-on environment, but option traders remain nervous

Markets globally continue to show strong risk-seeking behavior, a continuation of the broader trend in place for much of the time since late March 2020. That was the point at which monetary and fiscal policy activity surged to produce enormous stimulus in the US and globally.

Recent US legislation that included a total of about $900 billion in new fiscal support is now starting to be felt, and recent political developments have increased the odds of further fiscal support this year. Alongside this persistent fiscal support to counteract the severe economic impacts of COVID-19, monetary policy remains extremely accommodative. Near-zero policy rates and heavy bond buying programs are expected to be maintained for many months if not years, putting both monetary and fiscal policy firmly in the “highly stimulative” category at the same time.

This backdrop has allowed the strong demand for risky assets to continue, as reflected in many measure of market prices. Our chart below shows four such measures:Global Risk Appetite Measures

Top section: The MSCI All-Country World Index (ACWI) is a broad global equity index, and it has been outperforming the total returns generated by the ICE/BofA Merrill Lynch (ML) 10+ Year Treasury Index (measuring returns to Treasury bonds with maturities of 10 years or more). This stock/bond relative return series has recently moved above its pre-COVID peak as bond returns have been weak and stock returns have been very strong.

Second section: Here we plot our own custom index of global high volatility stocks (top decile of global stocks above USD$200 million market cap, ranked by trailing two-year historical return volatility). This index of risky stocks is a useful measure of investor risk appetite. It has posted powerful gains since the March low in equity prices, and continues to make new highs.

Third section: This shows the relative returns of the S&P 500 High Beta index versus the S&P 500 Low Volatility index. The High Beta index reflects the 100 stocks in the S&P 500 with the highest market beta (sensitivity to stock market movements) and is a measure of high-risk stock activity among US large-cap stocks. The Low Volatility index captures the 100 stocks in the S&P 500 with the lowest historical return volatility (both indices are rebalanced quarterly). Their relative return is another measure of risk appetite among investors based on the relative riskiness of stocks within the major US benchmark index. It has been rising sharply again after a pause over the summer and is also making new cycle highs.

Fourth section: Turning to debt markets, this plots the average credit spread on high yield (junk) bonds in the US. The credit spread measures the additional yield investors require over and above the yield on a US Treasury bond of the same maturity to hold the debt of a high-risk borrower (i.e., companies with weaker financial conditions and thus higher default risk). That spread surged in the immediate aftermath of the COVID crisis in March/April of last year, and then has been steadily declining thanks to the Fed’s aggressive support of the corporate bond market. Recently it has continued to make new lows (reflecting greater risk appetite among investors), and is now back to pre-COVID levels despite the ongoing economic turbulence.

So we can confidently say that investors are content to take on greater risk than usual with the expectation that government support for markets and the economy will continue. We also note that the volatility of stock prices recently has dropped back down to very low levels, another condition typically found when risk appetite is high and a bullish trend is well established.

Under these conditions, we would normally expect options traders to react to the low market volatility and favorable backdrop by reducing their expectations of short-term future volatility. This would typically be visible in the CBOE VIX index, which measures the expected level of market volatility over the next month embedded in S&P 500 index options prices.

But right now, we see that the VIX has held at relatively high readings, and allowed a wide gap to open up between implied future volatility and recent realized volatility. We can see in the chart below that normally the VIX and realized volatility move together and are closer than they are now.VIX vs Realized Vol

It appears that options traders do not expect the current stability in equity markets to continue, and are pricing in a significant rebound in volatility (which is typically associated with falling stock prices). Our analysis indicates that this tends to be a favorable contrarian sentiment indicator: when options traders are especially nervous about rising volatility (relative to actual volatility), it suggests that some investors remain unconvinced and underinvested, which can support further near-term gains.

So while some measures of market sentiment are clearly pointing to high optimism among investors (a worrisome sign from a contrarian sentiment standpoint), the VIX is currently providing a supportive sentiment reading in our view. With the market’s trend still strong and the policy backdrop supportive, risk assets could continue to rise at least a little while longer.

Inflation likely to remain moderate even with more fiscal support

The news of Joe Biden winning the US presidency in November has now been joined by news that the US Senate will very likely be under the most narrow control of the Democratic party, along with a narrow majority in the House of Representatives. These developments have led investors to expect more fiscal stimulus and other support than would have been expected under continued Republican control of the Executive branch and Senate.

One of the consensus views that has emerged is that the higher level of expected fiscal support along with the aggressive monetary support from the Federal Reserve (zero policy rates and ongoing bond buying programs, or QE) will provoke accelerating inflation. The view is amplified because the recent stimulus legislation, and expected future fiscal support, have included direct payments to individuals ($600 stimulus checks, possibly becoming larger in the future) along with resumption of enhanced federal unemployment benefits (though smaller than the initial CARES Act amounts), among other programs. The view is that these sorts of direct payments are more likely to be spent on consumer goods and services (to a greater degree than spending on things like health care, infrastructure, or defense), and thus that consumer prices will be forced up by the increased demand.

We are often asked about our view on inflation, particularly in light of these unusual policy conditions. So what is our take? We think the supply side of the equation needs to be considered along with the demand-oriented arguments. Our view is that the economy has a lot of slack still left in it, and thus has capacity to meet increased demand without broad-scale acceleration in inflation. We certainly expect an increase in demand due to the stimulus relative to what it would have been otherwise, but do not expect it to be so extreme that it will push the economy past its potential output limits and produce substantial sustained inflation as a result. This does not mean relative prices will not change, as indeed they already have, but there will continue to be offsetting impacts that keep the overall inflation rate from accelerating.

The chart below shows the historical and projected estimates from the US Congressional Budget Office (CBO) of the “output gap”, or difference between actual real economic output and the estimated potential output the economy could produce without causing accelerating inflation. The grey shaded area indicates forecasted future data from the CBO. At the end of 2020, the economy is operating more than 6% below its estimated capacity, and even after a sharp rebound that is expected in 2021, the economy is still expected to be more than 3% below its potential at the end of this year. The CBO’s projections do not anticipate that the economy will exceed its capacity over the 10-year forecasting horizon (i.e., until 2030 at least). All such long-run forecasts should be viewed with skepticism, but the broad message makes sense given the long-run secular trends in the economy and the lasting damage caused by COVID-19. The inflation data shown in the lower section (using the Fed’s preferred measure of the Personal Consumption Expenditures core price index, i.e., excluding food and energy) corroborate our view that accelerating inflation is very unlikely when the economy is operating below its potential, as has been the case for most of the last 40 years.

Output Gap and Core Inflation

To better understand some of the key drivers of the output gap that argue that there is plenty of spare capacity in the economy, we can review the chart below. It shows the unemployment rate as a measure of labor capacity and the capacity utilization rate as a measure of manufacturing capacity. The unemployment rate remains above the long-run average (dashed line), and far from the low points near 4% where inflation (wage pressure) is more likely to become a concern. The reported (U-3) unemployment rate is also likely a conservative estimate of labor market slack, as it does not measure people who have given up seeking work but would do so under better conditions.

Unemployment and Capacity Utilization

The capacity utilization rate reported monthly by the Federal Reserve also shows a wide gap between the current reading (73%) and the historical average (80%), much less the historical peak levels that would be associated with accelerating inflation. Indeed, the fact that capacity utilization has shown lower peaks and lower troughs over the last three decades helps explain why consumer inflation has also been declining and low for much of that time. If demand can be met by current capacity, broad-based inflation is much less likely.

Long-term structural trends in demographics, debt, and productivity in the US and much of the developed world are generally disinflationary. So it would take an unusually large and persistent effort by fiscal policy makers to generate high inflation in this environment. Naturally, that could happen, but history and current politics suggest it is unlikely, and in our view any increase in consumer demand from additional stimulus can be readily met without broad-based inflation given the slack in the economy.

Going over the fiscal cliff

As we discussed in an earlier blog post (and in our client research), much depends on the path of monetary and fiscal policy, particularly the fiscal stimulus programs put in place in response to the COVID-19 crisis in March and April.

Back in March, hopes were high that by the end of July, the trends in COVID-19 would look better and there would be less need for such aggressive fiscal support. Sadly, that has not been the case, and the markets have clearly come to expect a new fiscal package to maintain support for the still shaky US economy. The concern is that a “fiscal cliff”, i.e., a sudden drop-off in government support before the economy has regained self-sustaining momentum, will lead to a renewed bout of heavy economic weakness.

Unfortunately for the millions of unemployed people who have been relying on a combination of state and federal benefits to get by, the fiscal cliff has already begun. The US Congress has allowed much of the fiscal support provided in the initial rounds of stimulus legislation to expire (or has been used up) and has not yet agreed on what (if anything) will replace it.

US Treasury Unemployment Benefit Expenditures

One of the key supports for the unemployed has been the additional federal unemployment benefit of $600/week (Federal Pandemic Unemployment Compensation, FPUC) that was being added to the regular state unemployment benefits (which average less than $400/week). The Pandemic Unemployment Assistance (PUA) program also made benefits available to those who would not normally be able to claim unemployment (self-employed, gig workers, those caring for a family member, etc.). There were also provisions that provided federal funding for extended unemployment benefits to those who would have exhausted the normal duration of benefits (often 26 weeks) to a total of 52 weeks.

The provision of the extra $600 expired on July 25th and has so far not been replaced (Trump’s recent memoranda on the topic notwithstanding), while other provisions will expire at the end of this year. Congress and the White House continue to debate whether to extend the federal unemployment support and at what level, among many other things. Until they come to an agreement and pass new legislation, the additional federal unemployment benefits will remain unavailable. And even after a bill is signed, state unemployment offices will need time to make changes to their (mostly old and creaky) systems before claimants can receive the benefits, potentially leaving an extended gap in benefits.

The chart above plots data released daily by the US Treasury, which shows the amount disbursed for all federal unemployment benefits. Prior to March of this year, the numbers were normally much smaller but surged to levels of about $5 billion per day, or $25 billion per week, from April to July. Since July 27th, the payments have begun to drop off sharply, with the weekly average already down below $3 billion/day and falling. A drop from the $5 billion/day rate to $2 billion or less (as it looks to be heading toward) equates to removing something like $15 billion per week (~$750 billion annualized), or more, of income support for unemployed people, who have a high average propensity to spend.

If the financial markets, earnings, and investor sentiment have been supported heavily by fiscal stimulus, and that stimulus (and political support for it) is now clearly fading even while COVID-19 continues to spread across the country, it raises questions as to whether the markets will have sufficient tailwinds to continue higher in the coming months.

In case you need a refresher course, it’s all stimulus these days

*with apologies to Irwin M. Fletcher

Much has been made about the divergence between the path of the US (and global) economy and that of the stock and corporate bond markets. Even while economic and earnings growth is historically weak and remains under severe pressure from a rapidly spreading virus, major stock market indices have rallied and are at or near all-time highs. Market valuations based on forecasted earnings over the next 12 months have clearly risen sharply.

While the divergence between financial asset prices and the “real economy” as experienced by many Americans is striking, the reason is not hard to see: enormous levels of stimulus by both fiscal and monetary authorities.

Essentially, the US Congress has voted (in four separate pieces of legislation so far) to drastically increase deficit spending to support individuals and businesses as well as the costs of health care and virus abatement. The trailing 12-month US federal deficit has jumped to about $3 trillion, easily a new record in nominal terms and the largest deficit as a percentage of US GDP since World War II.

As shown in the bottom section of the chart below, the current 12-month deficit is now nearly 14% of nominal GDP, significantly more than the peak following the Great Financial Crisis, and up from the deficit levels of 4-5% of GDP in 2018-19, i.e,. adding roughly 10% of GDP to spending. This has helped fill a huge gap in personal incomes caused by lockdowns associated with COVID-19.

US Monetary and Fiscal Stimulus

And crucially, at the same time, the Federal Reserve has also engaged in an unprecedented level of money creation (“quantitative easing”, or QE) to essentially monetize the increase in Treasury debt. After immediately cutting its fed funds policy target back to zero (0 – 0.25%), the Fed has expanded its balance sheet from around 20% of GDP before COVID-19 hit to over 30% of GDP currently, i.e., adding roughly 10% of GDP to the money supply. This is also far bigger than its balance sheet was after the three previous rounds of QE between 2008 and 2014.

While the Fed has a number of different programs in place to support financial markets and the economy, most of what it is doing is buying up Treasury bonds, mortgage backed securities, and more recently corporate bonds and bond ETFs. It does this with newly created money that can then circulate in the economy. A key effect is to essentially offset the absorption of money caused by the Treasury issuing huge amounts of new bonds, and has drastically expanded the US money supply. And by using newly-granted powers (under the recent CARES Act) to buy corporate debt (including some high-yield or “junk” debt), it has also compressed the credit spreads in the corporate bond market and made it cheaper for companies to borrow than it otherwise would be.

So an extreme oversimplification would be that the Treasury engaged in new spending of something on the order of 10% of GDP, and the Fed printed roughly a similar amount of new money to “pay” for it (a liquidity conversion of the Treasury bonds to cash), with some of that Treasury money being used to allow the Fed to take on corporate credit risk for the first time. That extra ~10% of the economy that has been conjured up by Congress and the Fed was meant to fill some of the hole left by the meteor that hit the global economy in the form of COVID-19.

The key question now is to what degree is additional stimulus needed, and will policy makers provide it to the appropriate degree? Current virus trends, structural economic damage COVID-19 has already caused, and rising debt levels suggest significant further stimulus will be required to bridge the gap until the economic effects of the virus have passed, though that remains a point of debate.

Investors who take the view that the policy response will be sufficient (or possibly even excessive) are likely those who are content to pay the same (or higher) prices for stocks and some bonds than they did in 2019, and assume that earnings will fully recover and stocks will be worth more in the future due to the lack of any competition from near-zero interest rates on safe debt (Fed policy rates are expected to remain near zero for several years at least).

Investors who worry that the policy response will falter may be more cautious, given the potential further weakness in corporate earnings that would also result. And one outcome in particular bears consideration: what if the fiscal response falters (due to Congress being unable to agree on sufficient stimulus legislation), but the Fed continues to intervene heavily in financial markets with quantitative easing and corporate credit spread compression (i.e., printing more money than can readily be spent)? Then financial assets, and unprofitable companies, might continue to hold up and inflation could eventually rise, even while the underlying economy weakens (with implications for income and wealth inequality).

That is arguably not far from what is happening now, as the Fed has adopted a “whatever it takes” approach and has few limits to the amount of monetary support it can provide. The question of further fiscal stimulus is the key question right now, as there reportedly remains a wide gap between Democrats and Republicans in Congress (and the White House) about the size and scope of any additional stimulus. With much of the original stimulus plans now fully utilized or expiring soon, there is a clear danger of a de facto sharp contraction in fiscal policy relative to the current extreme levels of support (the so-called “fiscal cliff”). Congress is scheduled to be in session for only a couple of weeks before going on August recess, and the key $600/week of extra unemployment benefits are due to expire on July 25th. The path of the economy and financial markets may depend on decisions made by Congress in the next few weeks.