After more than a year with impressive market performance and low volatility, the last few days have been a real shock to the system. Volatility is back with a vengeance. For medium-term investors like us there are many difficult questions. What caused this change and does it mean something is fundamentally different? Were markets ahead of themselves and this is part of a broad repricing to a significantly lower level? Is this just an overreaction to the realization that interest rates are headed higher? And if so why?

To try to answer these questions we need to discuss three different but very relevant topics: a) the historical shift in the policy stance of G3 central banks (monetary policy normalization); b) the changes in the structure of financial markets since the 2008 crisis; and, c) economic fundamentals. None of the above were secrets before last week, but this is how markets tend to work, with sudden realizations and behavioral patterns that sometimes seem extreme and hard to explain. We believe our portfolios were structured with the expectation of rising interest rates, especially through the very tight and strict restriction on duration in our fixed income allocations.

G3 Monetary policy normalization

We have written many times before about the normalization of monetary policy. Since 2008, developed markets have embarked in unprecedented monetary policy stimulus, through historically low interest rates and asset purchases by central banks. Those G3 Central Banks balance sheets grew 3 to 4 times their historically size. Now that the global business cycle shows synchronized and still improving growth, with signs of the timid return of inflation, and historically tight labor markets it is natural to expect central banks to be looking to normalize their stances, which means higher interest rates and smaller balance sheets. The first natural implication of this historically unprecedented process is higher interest rates. The problem seems to be that markets had grown accustomed to 10 years of low interest rates. Thus, the volatility since last Friday can be interpreted as the over-reaction to the shock from interest rates.

Financial markets structure

The technical term ‘market microstructure’ refers to the inner workings of markets, regulations, players, etc. Since 2008 there have been significant changes in the market microstructure, in a way that volatility appears to be exacerbated in times like these.

Regulation since the crisis of 2008 has changed how banks operate, how much risk they take, in a way that reduces their participation in markets as intermediaries, as brokers. This has the most drastic effect when there are imbalances, more sellers than buyers, because there is less capital at risk to intermediate or to take advantage of extreme situations, which in effect would smooth the swings. Thus, liquidity in markets is generally lower, and even more so when volatility increases.

Regulation is not the only factor, there are two other changes that push in the same direction: the growth of passive strategies (mostly Exchange Traded Funds or ETFs), and more importantly, the growth of computer trading strategies or computer trading accounts (CTA) and algorithms.

Of the two factors identified above, the size and trading frequency of computerized strategies is the most relevant in days like the last few trading sessions. Gamma traders and volatility targeting strategies (which in technical terms, have negative convexity) tend to exacerbate market moves when liquidity is low and they are a non-trivial part of the market trades. Increases in volatility are exacerbated as many of such strategies have to buy when markets go up, and sell when they go down, and because some of them are leveraged strategies, price moves have magnified implications inside those funds.

Fundamentals, etc.

Opposite to all the issues explained above, fundamentals and other factors are reasons to be optimistic and remain calmed. The global business cycle continues to produce data that validates the view of synchronized and improving growth, which had first manifested itself last year. At the level of companies in equity markets, the ongoing earnings season is showing better results and fairly optimistic guidance for the future. Most importantly, capital expenditure is rising broadly, which lets us think that the slump in productivity growth has a chance of being broken.

At the same time that growth seems healthy and still bound to improve, the recent policy changes in the US are an additional push to better growth and most importantly these days, higher equity valuations. The tax reform just passed reduces the tax burden on US companies significantly, transferring part of that reduction to individuals. Additionally, the change to a territorial system is about to produce a large capital repatriation flow back into the US, which is bound to be used to a large extent in stock buybacks over the next few months.

Thus, despite the fact that valuations before this recent sell off seemed to be at the higher end of the spectrum, we believe they were justified by fundamentals. The speed at which interest rates moved over the last few weeks seems to have triggered some rebalancing, which got exacerbated by some of the sellers of volatility and the other factors explained above. Though it is impossible to eliminate the scenario in which this is part of a broader secular repricing because of rates, we believe patience is warranted, as fundamentals are bound to dominate in the medium-term, over the transitory factors that exacerbate volatility. We remain vigilant and open minded, but have decided not to change course for the time being. The structure of our portfolios allow us the luxury of patience, especially in the debt allocations (very low duration or interest rate risk).