Sharp swings in stock prices over the past few days have torn away the mask of complacency that has characterized much of trading in equity markets over the past two years.
That has led to renewed calls that investors avoid investing in “risk assets” like stocks. Against a backdrop of roiling markets, analysts at Société Générale took this chance to list a few reasons why skittish money managers should stay cautious in 2018.
“The search for yield and fear of missing out (FOMO) remain king in the current environment. ... But beware! We don’t want to end up as the frog that gets boiled in a cauldron of complacency,” they said.
Going all-in?
More than before, hedge funds are ill-prepared for a sudden reversal in market sentiment. The analysts described 54% of hedge-fund bets in a group of 24 assets as in “extreme” positions, according to the Commodity and Futures Trading Commission.
Speculators have placed a record number of bullish bets on crude futures, while similar optimism has been seen in the euro EURUSD, -0.2343% , which is climbing on the back of growing expectations for an early end to the European Central Bank’s asset purchases in September.
The spectacular demise of exchange-traded notes allowing investors to “short” volatility in the S&P 500 SPX, +1.74% has underscored the danger of feeling confident in overcrowded trades.
“The bubbling short volatility positioning has been caught off guard by the first move down of U.S. equities. Strong negative performances triggered an unwind and more equity selling to cover the losses,” Société Générale said.
Central banks’ impact
Investors are concerned the frothiness in stocks, corporate bonds and government paper could come to an end, as a potential curtain-closer on easy-money policy rumbles through the corridors of central banks. Improving economic data in the eurozone and Japan has caused investors and pension funds to clamor for the European Central Bank and the Bank of Japan as they look to cut back on ultra-accommodative monetary policies.
That could have an impact on illiquid corners of financial markets, like high-yield bonds and small-cap stocks, that have benefited from the continued flows as investors search for yield in a world of low interest rates. Equity valuations can appear stretched when bond yields make a rapid rise, as they can reduce the total value of cash flows, and therefore a company’s stock price.
“Reduce the equity allocation – it will become increasingly harder for the equity space to stomach a rising yield environment,” Société Générale said. But the analysts added they preferred the large-cap S&P 500 over the minnows-dominated Russell 2000 RUT, +1.08% .
Inflation expectations
Stronger wage gains, rising oil prices and expansionary fiscal policy point toward inflation finally making a comeback this year, after its absence in 2017 was described by former Fed Chairwoman Janet Yellen as puzzling.
By Société Générale’s own proprietary “newsflow” indicator, inflation expectations in the U.S., Europe and Japan were at a 10-year high (see chart below). Its in-house gauge measures the number of articles that highlight price pressures.
The five-year forward inflation expectation, a more widely adopted measure derived from Treasury-inflation protection securities, was up to 2.35%, the highest since October 2014.
Inflationary pressures could push the Federal Reserve and other central banks to either ratchet up the pace of rate hikes or make a turn away from easy monetary policy. Tighter financial conditions could have a ripple effect on valuations, and restrict the flow of credit into an economy that’s used to depressed borrowing costs.