We view recent activity as indicative of a new reality in equity markets: that the market structure is radically different today than it was a decade ago and the old rules no longer apply.
Recent volatility in equity, fixed income and commodity markets was driven mostly by macro factors.
Recession fears in Europe, concerns regarding weakness in Asia, ISIS, Ebola and the potential end of Fed taper in October fueled extreme negative market reactions and most importantly, a notable short-term decline in liquidity. Some major equity indices reached correction territory, credit markets experienced significant weakness (especially the below-investment-grade sectors), energy markets saw large declines (mostly from geo-political maneuvering), and treasury yields approached decades-long lows. We view the volatility as technically–rather than a fundamentally–driven.
Most importantly, we view recent activity as indicative of a new reality in equity markets: that the market structure is radically different today than it was a decade ago and the old rules no longer apply. Absent an exogenous shock like Lehman Brothers, downside volatility is likely to be steep and short.
While it appears that liquidity has decreased, we believe the opposite is true – liquidity is much deeper than it used to be, and the liquidity suppliers are more disciplined, which means liquidity suppliers disappear and reappear quickly. In other words, we think the days of the “capitulation trade” so frequently referenced on CNBC, are over. There are simply too many pools of capital today, levered and un-levered, oriented toward short-term trading or not, that capital ultimately fills the vacuum. V-shaped recoveries in stock prices are here to stay.
In credit markets, we saw significant weakness in bank loans and high yield most likely driven by retail outflows. Fundamentally, corporate balance sheets remain healthy and the corporate default environment remains benign while yields have increased significantly. Considering the low default environment, high recovery value, and its floating rate nature, we believe this new, improved entry price point for bank loans is a compelling value. Likewise, we see the same in high yield, despite its fixed rate coupons. However, but not surprisingly, during this period of increased volatility the investment grade corporate market and liquid asset-backed securities market remained relatively stable, highlighting the benefits of allocating to this asset class.
The big declines in energy prices will ultimately have a net positive impact on the US economy. Citigroup research projected the impact of lower energy prices to represent approximately a $1.1 trillion stimulus to global economies. Lower energy prices may also have the potential to dampen further escalation of hostilities in Ukraine as the Russian economy is highly dependent on energy exports (indeed, we believe the move down in oil prices was orchestrated by Saudi Arabia in part to put pressure on Russia).
Overall, we believe that the macro variables support our thesis of continued US economic expansion. For this reason, we believe that the current fixed income market volatility represents opportunistic entry points for selective investment positions. This, however, should be done with caution as macro catalysts could continue to shift the markets and inject volatility.