Even beyond the dog days of summer, global capital markets have become boring.
Investor complacency appears to have won the day—at least for the moment. The poster child for this unusual sense of calm has been the CBOE Volatility Index (VIX). The VIX, dubbed the fear gauge, as it measures implied expectations of U.S. market movements by tracking option prices, seems anchored near its all-time low. The message from the options market is that investors are content and not at all interested in buying downside protection.
Market participants have been so quiescent that even the threat of nuclear war with a rogue nation such as North Korea caused only a day’s disruption in the steady march to higher equity prices. During the past quarter, certain global equity markets merrily registered record highs. Meanwhile, inflation remained low, as prices across a variety of goods and services barely had the strength to lift themselves any higher. While there’s been some activity among industrial metals, with price increases for copper, zinc, and certain steel products, this has been offset by decade lows for most agricultural commodities, including corn, wheat, soy, cattle, and hogs. No matter how you measure it, inflation hasn’t risen enough to meet the Fed’s 2% target.
If global capital markets can’t get riled up about rising prospects for nuclear war, then we’ve entered a new regime—boring your way to wealth. Could it be that all the attention being paid by investors to their own lack of anxiety is actually an advanced form of nervousness? If so, then perhaps it represents an adequate level of risk awareness. Regardless, we’re not sure what it’ll take to nudge abnormally low VIX readings higher.
Bitcoin price bubble could shake things up
Bitcoin’s collapse could do the trick. Along with other so-called cryptocurrencies, bitcoin has been bid up to ever-higher levels this year. Cryptocurrencies are finding an eager audience among those wishing to convert government-backed notes into an untraceable, non-U.S. dollar medium of exchange. Apparently, a portion of the financial world has some faith in such new synthetic instruments; some market participants even treat bitcoin as a bona fide asset class. We love diversification and often embrace novel investment ideas—but remain unconvinced here.
Turning to more conventional currency markets, the U.S. dollar, a top consensus trade as recently as the fall of 2016, has turned into a relative loser versus most of its major counterparts this year. Such is the fickle nature of foreign exchange. The good news is that a lower U.S. dollar aids American exports and provides a greater degree of monetary easing throughout the global financial system. The weaker U.S. dollar should boost corporate profits, particularly among megacap multinationals that derive a substantial proportion of their revenues from sales outside of America.
Prospects for U.S. equity and high-yield debt have waned
Market multiples make horrible timing signals, but we know that buying expensive assets leads to disappointment more often than not. While the VIX has been abnormally low, history suggests it's only bound to stay low until it doesn’t. Don’t be surprised by a sudden U.S. equity market correction. At this mature stage of the cycle, the risk of a short-term, garden-variety drawdown remains elevated.
While U.S. equity valuations are indeed high, they’re not necessarily unreasonable relative to bonds. Amid an environment of anemic yields, we’ve long been maintaining light exposure to interest-rate risk while leaning into corporate credit, including allocations to lower-rated issues. At last, after a decade of singing the praises of U.S. high-yield debt, we believe it’s time to begin the process of reducing exposure. In late 2008, junk bonds were uniformly being discarded regardless of their coupons or discounts to par. The asset class was then a value vulture’s dream. Today, with option-adjusted spreads paying only a few percentage points over U.S. Treasuries, and with historical default and recovery rates that might wipe out most of that differential, the risks of holding junk bonds are starting to offset the potential rewards. Staying with our low anxiety theme, we anticipate ample liquidity and low default rates for at least the next couple of years, giving investors plenty of time to trim exposure to this asset class.
International equities—especially in emerging markets—show the most promise
The shrinking value of the U.S. dollar has also boosted the returns of international equities for U.S.-based investors. International developed-market equities are up double digits year to date. We’ve maintained a strong and vocal commitment to the benefits of global diversification, and after an extended period of U.S. equity market leadership, the recent shift in momentum adds a measure of validation to our view. Right now, we’re inclined to allocate the marginal investment dollar to markets outside of the United States. Europe continues to follow the U.S. path with a three- or four-year lag, suggesting more favorable market action across the Atlantic is still to come.
Leading the performance parade in 2017, emerging-market equity continues to be among our favorites. Having underperformed U.S. equity for a decade, it has plenty of relative runway to catch up. Strong earnings momentum and more modest valuations also bode well for stocks in emerging economies, especially within Asia. We believe India deserves special attention, as the country’s market reforms have been nothing short of extraordinary. The Indian government’s commitment to strategically simplify the process for starting a new business, combined with the demonetization initiative and the implementation of a goods and services tax, presents a generational change for this country—akin to the opening of China. Results won’t materialize overnight, but the opportunity set in India is vast.
When it comes to markets, remember that boring can be beautiful. It’s easy to forget investing’s basic principles: Remain calm and let the magnificent power of compounding continue. Stay globally diversified, and use these quiet times to read, reflect, and resist the impulse to trade just for trading’s sake.