The third quarter saw increased volatility, with fears of rising rates in the US coupled with concerns over an escalation in the trade war between the US and China and broad concerns over emerging markets exacerbating volatility levels. The US economy continues to outperform the rest of the world which led to outperformance of US assets (equities and FX). The MSCI World returned a healthy 4.8% in Q3 but it is telling that within that, emerging markets were down in aggregate and Europe was flat. Rates continued to rise (US 10 yield increased by 20bps) causing further issues for fixed income performance.
As we write this, markets are in the midst of a bout of volatility with MSCI World –9.5%, S&P500 –9.4% and MSCI Emerging Markets –10.2% with just a couple of days left in the month. There has not (as yet anyway) been more fullscale risk aversion as credit spreads have remained contained with only marginal widening and merger arbitrage spreads are largely unchanged.
The structure of the market is changing and in some ways reverting to normal, which entails much higher levels of volatility. We should look at 2017 as an outlier in its lack of volatility; since 1980 the years when the S&P500 has delivered positive returns the average maximum drawdown has been 11%. 2018 has seen a return of volatility, albeit sporadic. In late January and early February there was a spike in market volatility and a drop in asset prices surrounding the unwind of short volatility trades. We then saw further volatility when the coalition Italian government was formed in April. The cause of the most recent sell-off can, in part, be pointed to an increase in interest rates and a resetting of the prices of risk assets in that context. However, we do see these market moves as a change in the structure of the market rather than due to purely idiosyncratic factors. Quantitative Easing (“QE”) has been massive and its decline and unwind will have profound effects. There is a deceleration of global liquidity growth (liquidity is still growing, though is forecast to shrink in 2019) and there is a transition from central bank derived liquidity to more organic, less predictable forms. It is worth remembering that the ECB and BoJ are still buying assets. Since the US Fed stopped additional purchases in 2016, the ECB and BoJ combined have injected nearly USD4trn of liquidity. This will turn negative with the ECB exiting its purchase program at end-2018.