Quote of the week
“99.6%” — probability (via ESPN) of an Atlanta Falcons victory in Super Bowl LI with nine minutes remaining in the game and the Falcons ahead 28-16.
The Lead Story: What, me worry?
Has complacency seeped in to equity markets? On the surface, that seems to be the case. Since jumping 5% during the month after the presidential election, notching record highs along the way, the S&P 500 Index has risen at a markedly slower pace. Moreover, the index hasn’t closed up or down by more than 1% in a single session since December 7.
The market’s relative inertia suggests that not enough risk has been priced in despite a number of potential hotspots, including political uncertainty at home and the upcoming elections in Europe, especially in France.
Moreover, trading indicators seem to confirm a lack of investor unease:
- Short interest as a percentage of shares outstanding is at its lowest level since late 2013. ("Short" refers to short selling, a trading strategy in which investors seek to profit on an anticipated decline in a security’s price.)
- Investors are buying relatively fewer puts. (A put option is a contract that gains value when the underlying asset declines.)
- The VIX, or “fear factor” gauge of stock market volatility, is near a multi-year low.
But looking under the market’s hood, we see a different story: rising anxiety. According to the SKEW Index, which estimates the probability of an abnormally large decline in the S&P 500, hedge funds and other institutional investors are paying more to protect against such a downdraft.
To illustrate, on January 20, the SKEW Index reached 146, up from 120 in mid-December. (By contrast, the index nearly hit 155 the day after the Brexit vote.) What does this mean? At 100, investors are ascribing little chance of a recession or “black-swan” event fueling a 25%-30% S&P 500 selloff. At 115, there’s a 6% chance. At 145, the risk rises to 12%. As of February 10, the SKEW index sits close to 130, implying that risks are not severe but remain elevated compared to normal levels.
So as a football referee might say, “Upon further review, investors do not appear to be irresponsibly complacent.”
Which brings us back to the Falcons. While their chances of winning were excellent that late in the game, assigning a 99.6% likelihood to any outcome in which human elements are involved is probably excessive. And, of course, the Super Bowl wasn’t the first time in recent memory that statistical models incorrectly ascribed near-certainty to the outcome of a binary event. (Hello, 2016 election polls!)
In other news: Late-week tax talk powers global equities
President Trump’s February 9 promise to enact “phenomenal” corporate tax reform propelled equity markets. After meandering through mid-week, the S&P 500 Index rallied to fresh record highs, finishing with a gain of about 0.9% for the week. Financial stocks were the main beneficiary of the news, advancing 1.4% on February 9 alone. Europe’s STOXX 600 Index followed the U.S. higher, returning 0.9% (in local terms) for the week.
While equity investors were upbeat, fixed-income markets expressed caution amid political risks in Europe and reduced expectations for new fiscal stimulus from the Trump administration this year. March’s general election in the Netherlands may test the strength of European populism. Also looming: the possibility that a far-right party could win the French presidency, potentially leading to the country’s withdrawal from the Eurozone. In our view, such an anti-euro government outcome is not likely. Against this uncertain backdrop, demand rose for U.S. Treasuries, sending the yield on the bellwether 10-year note down to 2.34% on February 8 before closing the week at 2.41%. (Yield and price move in opposite directions.)
Current updates to the week’s market results are available here.
Below the fold: Emerging-market equities off to a quick start
After years of heavy outflows and poor performance, emerging-market (EM) equities attracted investor interest in 2016, a trend that has continued this year. According to MSCI indexes for the year to date through February 9, EM stocks have advanced 7.39% and 5.14% in U.S. dollar and local currency terms, respectively, outpacing their international developed-market counterparts (+3.0% and +0.99%). In our view, EM equities have further scope to outperform, as both their earnings and valuations have only recently bottomed.
Highlights from the key “BRIC” (Brazil, Russia, India, and China) markets include:
- On February 7, Brazil’s leader Michel Temer and Argentine president Mauricio Macri signed a series of bills designed to improve trade, diplomacy, and border security. Although the two countries remain fierce soccer rivals, they are seeking to rekindle relations after years of bilateral trade tensions.
- Russian equities and bonds have benefited from stabilizing oil prices and a potential thaw in relations with the U.S. The MSCI Russia Index has surged 20% (in U.S. dollars) since the November election, and the yield on Russian 10-year sovereign debt has fallen from 10.8% in January 2016 to 8.2%. Meanwhile, the ruble has outperformed all other currencies over the past 12 months, rising over 34% against the dollar, easily beating the next best performer, the Brazilian real (+26%).
- India’s central bank surprised markets by electing to leave its main benchmark rate unchanged at 6.25%, rather than opting for a widely anticipated 25 basis point (0.25%) cut. While this policy stance may indicate that no additional stimulus is forthcoming this year, the Indian equity market remains one of the world’s best performers in 2017.
- To prevent further weakening of the Chinese yuan and curb capital outflows, China has spent just over $1 trillion of its formerly $4 trillion in foreign reserves since mid-2014. The government is also engaged in generous fiscal stimulus to support its decelerating economy.