The markets were everything but settled this week. Volatility spiked 100% (see VIX Chart below), as the market swung wildly, especially early in the week. Price movements over the course of a week are not always the concern of long term investors; but during a week such as this one, we must take notice and recognize what is going on in the marketplace. It is during weeks like this that investment strategies are created, revised or abandoned.
Volatility spiked this week, but the VIX “only” managed a level that registered about half of the volatility in the market during the height of the crises, October 2008. Also relevant, on Thursday the market seemed to calm a bit. In the end, markets were unsettled but panic was contained, the VIX dropped from a high approaching 50 to settle the week at 36 and change. Lets take a look at the week that was, and try to make some sense of it all and what it likely means for the future.
We begin with the downgrade. In the eyes of Standard and Poors, one of 3 major ratings agencies, our country lost it’s AAA credit rating and was rated AA+. This event had many “potential” repercussions for markets and left market participants guessing over the weekend as to what the fallout might be. Large banks were in contact with large customers and were manning their trading desks throughout the weekend. Discussions in large trading house’ “war rooms” were intense and worst-case scenarios were presumably the conversation of choice. Would funding costs for our government debt rise? Government funding cost estimates were $100bln annually should this happen. What would be the affect on collateral used by big banks in the repo market? Would growth implode leading to retrenchment and liquidation of assets? The week started with capital preservation as the main concern. The markets opened lower as big players moved to cash and the gold market sky rocketed. We saw money market rates go negative and BNY Mellon announced large depositors would have to pay to hold cash. Preservation of capital was such a priority that firms were willing to accept negative rates, the unknowns were high and worst case scenarios carried the day.
Tuesday, what would Ben Bernanke and the FOMC say or do? Ben pledged to leave fed funds rates at current levels, 0-.25%, for 2 years. In effect, this gave banks confidence that their short term borrowing costs would stay low for 2 more years and they bought yield. Instead of the spike in interest rates we saw in 2008-09 (see chart below) there was a decline or flattening of the yield curve as banks borrowed extremely short term and lent to the market and our government. Banks can borrow $1 overnight and only put down 2.5-4 cents; they then buy longer dated securities with higher yields. This is how Bernanke is re-capitalizing the banks. Ben gave banks the green light, borrowing would be below .25% for the next 2 years, and banks reached for yield. The 5 year treasury dropped .3% for the week from 1.23% to .93%.
Risk on, the market surged over 6% after Tuesday’s announcement.
Wednesday, the market finally seemed convinced that extreme risks were not imminent. Collateral in the repo market would not be subject to a haircut and credit markets did not fracture. The focus turned back to Europe and the re-affirmation of France as a AAA debtor. This decision was likely political as one could hardly argue for investing in France over the US, at least not today. A sigh of relief though as downgrades across peripheral Europe have been causing issues in Euro zone funding markets and this might have been the straw that broke the markets’ back. Investor’s hesitated, but dipped a toe into equities Wednesday.
On Thursday the CME upped the margin requirements to purchase exchange traded gold contracts. A similar move in the silver markets in May caused the white metal to drop 30%, highlighting the speculative nature of such markets. A hike in margin requirements makes it more expensive to speculate thus lowering demand for the product and increasing the risk for investors. Money came out of the gold market and went into equities.
Additionally, one must note that the Chinese currency appreciated throughout the week. This is good news. Allowing their currency to appreciate instead of raising interest rates to curtail inflation provides demand for US/Global assets and is positive for economic activity.
After an 18% drop in equities, strategic portfolios had strayed away from target levels for risk assets. By Wednesday, based on our interpretation of news and markets, we felt comfortable re-balancing portfolios back to target weights. These same interpretations, accompanied by good economic numbers on Thursday, and strong market metrics provided the necessary conviction for a short term adjustment to tactical portfolios late in the week.
This week has convinced us of a few things. The US must get its fiscal house in order. The government needs to alter their current trajectory on spending and provide policy geared toward investment and savings. Negligence will only exacerbate market volatility. The largest structural risks reside in Europe. Catalysts for growth reside primarily in Asia. Uncertainty is still elevated but our outlook was more positive Friday than Monday.