Morgan Stanley IM: Fed’s hawkish surprise, yet markets unruffled
This month the Fed surprised by moving its dot plot for 2023 to include two rate hikes - a hawkish divergence from the one rate hike that markets were expecting would be signalled.14.07.2021 | 07:10 Uhr
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This moves forward the timeframe for interest rates to rise, as inflation expectations increase for this year. However, the real surprise was that investors did not react more strongly; whilst markets did sell-off slightly during the week of the release, equities bounced back.
Despite the projection, the US 10-year Treasury yield in fact moved down over the month, settling at 1.5%2. The S&P 500 continued its upward momentum, gaining 2.3%2 (USD) over the month and reached an all-time high. Europe continued its move up with the Euro Stoxx 50 returning 0.7%2 (EUR). US Services PMIs peaked in May, moving down in June, whereas Eurozone Services PMIs surprised to the upside3. The Nikkei 225 continued to lag at -0.1%2 (JPY). The VIX started moving up before the Fed’s signal, reaching 214 in the subsequent days. By month-end it had moved back to 162, reaching its lowest level since before the pandemic.
Low volatility may not be a good sign
That said, we do not view the low volatility as a good sign and though markets appear unruffled by the Fed’s surprise forecast, volatility may come back were a catalyst to emerge. Far from indicating benign forward-looking conditions, the lack of volatility may suggest that market participants are not acknowledging problems ahead. Fundamental investors, who would normally sell in reaction to the negative developments, appear to be holding back or hesitating to act. They may have finally capitulated, having tried to sell into bad news many times, but then finding momentum traders buying the dip and pushing markets back up. If correct, then the market’s ability to anticipate future macroeconomic developments may be reduced and pricing in important information could be slower than normal. This is likely an important reason for the low volatility and we expect this to persist, absent a catalyst.
Potential catalysts for volatility
Another example of a substantial negative development, which so far has seen no obvious market reaction, is the antitrust legislation being introduced to the US Congress, where there is meaningful bipartisan support. Six antitrust bills, which could substantially impact some of the larger growth names in technology, have passed the House Judiciary Committee. The Ending Platforms Monopolies Act5, or “Break Up Bill”, is a particularly strong potential threat to some of the biggest growth stocks. In addition, Lina Khan, a highly regarded critic of tech firms’ “monopolistic” practices, has been appointed to the Federal Trade Commission (FTC). We are monitoring catalysts that could trigger a volatility spike beyond these antitrust bills, including inflation, employment and Federal Reserve meetings.
Investment Implications
We remain constructive on the global growth outlook. However, we reduced risk in early June, as we expect rising volatility in risk assets as we head into 2H 2021, driven significantly by a likely increase in global interest rates. The recent sharp drop in overall market volatility, which we believe is due to the above mentioned hesitation to act by fundamental investors, has dropped our portfolio volatility further than expected. Therefore, we may need to raise risk exposure tactically, until we see a catalyst that can offset this effect. Longer term, the three factors on which we focus, fundamentals, valuations and sentiment, all point to the potential for higher volatility.
Fundamentals are indicating a negative outlook for equities, given the highly likely headwinds such as tapering, combined with upside pressure on real rates. Additional headwinds gathering strength are higher US corporate taxes, the G7 breakthrough on a global minimum tax and regulatory pressures impacting growth stocks in particular. Valuations are also stretched, especially in growth sectors such as technology. Finally, investor sentiment (a contrarian indicator) is positive, with equity flows having risen dramatically and the AAII Sentiment Survey6 flagging strongly bullish sentiment. As a result, we have not changed our view and are still tilted towards value versus growth.
In June, we made one tactical change of view, moving from neutral to underweight in European Investment Grade Credit. We describe below the rationale for this change:
European Investment Grade Credit
Whilst we do not expect spreads to move much higher, given benign economic fundamentals, we believe the upside potential is rather limited. Fundamentals such as inflation, oil and EU banking lending standards suggest that spreads are likely to widen. The less than 100 basis points carry could be easily offset by a small upward movement in spreads. Moreover, the close-to-zero expected return in the current mid-economic-cycle warrants a move to underweight.
Tactical positioning
We have provided our latest tactical views below:
Source: MSIM GBaR team, as of 30 June 2021. For informational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The tactical views expressed above are a broad reflection of our team’s views and implementations, expressed for client communication purposes. The information herein does not contend to address the financial objectives, situation or specific needs of any individual investor.
RISK CONSIDERATIONS
There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio.