Macro Wrap-Up

Some Quant Holiday Market Cheer

Topics - Macroeconomics

${ numberSection } ${ text }
Some Quant Holiday Market Cheer

As 2018 comes to a close, market participants are pondering the themes and lessons of the past year. While one rotation around the sun doesn’t necessarily have any particular significance for markets or economic cycles, 2018 is an interesting year to contemplate. If we had to pick the most important market event of the year, it would probably be the dramatic equity sell-off and accompanying volatility spike in February. 1 1 Close The VIX Index jumped from 13.5 on February 1, 2018 to 37.3 on February 5, 2018. This followed higher than expected wage data that was released on February 2, 2018 and the extreme move in volatility led to the liquidation of several volatility exchange traded products. Source: Bloomberg. It was a reminder that even though life is short, it is also rich and varied. 2 2 Close A rich and varied life is not as desirable for investors as it is for self-actualized people. The lesson from February was not that volatility was suddenly going to rise to previously unseen levels. In fact, 2018 turned out to be only a moderately volatile year by historical standards, even though the average VIX level was higher than in the prior two years. 3 3 Close The average VIX Index level for 2018 through the market close on December 12, 2018 has been 16.1, while the average over 2016 and 2017 was 15.8 and 11.1, respectively. Source: Bloomberg. Rather, February taught us that seemingly interminable economic and market conditions can change. The sudden move put a little seed of doubt in even the most confident of investors. And it reminded folks about the importance of risk management and portfolio construction in investing. In some ways it was a return to longer-term normalcy from the recent period of complacency.

There was something else unusual about the year: very few markets are up. 4 4 Close From the beginning of 2018 through the market close on December 12, 2018, the MSCI World Total Return Index was down -4.3%, the Barclays Global-Aggregate Bond Unhedged Total Return Index was down -2.5%, the Barclays Corporate Unhedged Total Return Index was down -3.1% and the Bloomberg Commodity Total Return Index was down -5.0%. For the same time period the hedged USD index returns for the Barclays Global-Aggregate and the Barclays Corporate indices were +1.0% and -1.6% respectively. Source: Bloomberg. It has been a bad year for market beta and one in which diversification has done little to help. The asset price deflation has been fairly mild—it isn’t like markets are down by huge amounts, but the broadness of the losses did not fit the usual patterns of the past 35 years. While fairly rare, we had seen periods of asset price deflation during the previous century with the early 1980s being the most recent. In that case, the Fed was raising rates aggressively to combat inflation and bring down prices at all costs, even if it meant causing two recessions. Conditions are very different now. The Fed is raising rates, but it is being neither aggressive nor combative. 5 5 Close Except maybe with the President. This isn’t a policy of forced disinflation. If anything, the cautious hiking cycle shows the Fed’s concern about excessive disinflation.

The asset price deflation has coincided with an apparent decline in market sentiment. 6 6 Close As we pointed out a few weeks ago, consumer and business sentiment have been strong. Market sentiment is more difficult to measure, but recent weakness in markets makes it seem gloomy. Market logic is often circular. Global growth had been broadly solid in 2017, and at the beginning of the year many economists were predicting good growth in the U.S. and around the world. U.S. growth accelerated but the rest of the world was more mixed. Both Europe and China slowed, and some emerging market (EM) countries had sharp economic declines. Forecasters have become more cautious and so have markets. Many pundits are talking about the possibility of recession in 2020, and it probably won’t be long before such forecasts bleed into 2019 outlooks. Short term interest rate futures are now pricing a chance of a rate cut in 2020. 7 7 Close As of the close on December 12, 2018, the spread between December 2020 and December 2019 Federal Funds futures contracts was -9.5bps, showing market expectations of a potential rate cut over this time frame. Source: Bloomberg.

As with any year, some folks will attribute the market performance to political events. There was a fair amount of turmoil in politics around the world. Populist governments were elected in Italy, Mexico and Brazil, while Brexit continued to make headlines. As Italy has demonstrated, a shift toward populism will often lead to the desire to increase fiscal spending and lower taxes, potentially resulting in higher deficits. 8 8 Close Italy has altered its budget to be more acceptable to the EU, but deficits may still rise. There seems to be a global move away from so-called fiscal responsibility. For example, the protests in France were triggered by an increase in taxes. This aversion to austerity has appeared in budget statements. Deficits are up in many developed countries including the U.S., which is rare in times of economic expansion. 9 9 Close Deficits usually expand during recessions as tax revenue falls, then shrink during expansions. For many years, pessimists have been saying elevated levels of debt will bring the world down, warnings that markets have largely ignored. 10 10 Close As evidence, markets have been up as deficits have risen. Maybe 2018 was the year in which deficits started to matter to markets. Maybe sentiment has changed because folks are more worried about future debt burdens and their effects on markets. If debt is too high and it destabilizes the finances of wealthy countries, then it can be a generally bad environment for both risky and safe financial assets. The resulting economic contraction could bring down the prices of some commodities as well.

It’s certainly possible that debt fears are spooking markets and forecasters, but if folks are really afraid of debt, we think they would probably bid up non-financial safe assets such as gold, which has not happened. 11 11 Close Haven’t checked but maybe crypto-currencies have done better than gold? Since there are plenty of negative year-end summaries out there, we thought it would be good not to dwell on debt levels, but instead to point out that much of what the market is pricing can actually be viewed as a positive for asset prices. If inflation stays low, as Treasury Inflation-Protected Securities (TIPS) imply, and the Fed is able to stop hiking rates in 2019 and maybe cut rates in 2020 as Fed Funds futures imply, then maybe the economy can avoid a recession. Such an outcome would leave us with moderate growth, low interest rates, and falling long-term yields. This sounds like something we’ve had in the past.

We don’t make economic forecasts, and perhaps if there is one lesson of 2018 (and other years), it’s that forecasting is very difficult, and investors shouldn’t have too much confidence in their tactical views. 12 12 Close Unlike the U.K. Parliament, markets don’t have no-confidence votes in investors. But shell -shocked market participants may have learned that lesson too well. They may be overreacting to the uncertainty, which is always present. Uncertainty doesn’t mean a necessarily bad outcome or that you should doubt everything. It just means you don’t know.

So there you go—this week’s piece is as close to quant holiday market cheer as you can get. This will be the last Macro Wrap-Up of 2018. Have a Happy New Year, and we’ll be back in January!

What We Are Watching

Mexico 2019 Budget (Saturday or Sunday) Over the weekend, the new administration of Andrés Manuel López Obrador (AMLO) is scheduled to release its 2019 budget proposal. During the campaign, AMLO promised increases in spending on social programs and public investment to be paid for via reductions in government corruption and waste. Some of AMLO’s recent policy steps, such as the ad hoc cancellation of a major airport construction project, have damaged market sentiment. Investors will be looking for reassurance that the new president will stick to his promises of fiscal discipline. A disappointment could weigh on Mexican assets and potentially impact the outcome of a central bank meeting later in the week.

FOMC Meeting (Wednesday) The Fed has raised its target range for overnight rates at each of the last four quarterly meetings 13 13 Close The FOMC meets eight times a year, but the committee has adopted the habit of announcing changes in interest rates at the quarterly meetings that feature a press conference and updated economic forecasts. and both forecasters and market participants appear confident that policymakers will deliver another hike next week, bringing the Fed Funds target range to 2.25%-2.5%. The outlook for next year, on the other hand, is looking less clear. As of September, the Fed’s Summary of Economic Projections (SEP) showed a median forecast for three hikes in 2019, which would bring rates a touch above the 3% median estimate for the “neutral” interest rate. 14 14 Close Defined as the level of rates that would neither boost nor depress growth. However, policymakers have lately been emphasizing that they will be more cautious and data-dependent as rates approach neutral. For example, Chair Powell recently noted that rates are now “just below the broad range of estimates” for the neutral rate, then stated that “there is no preset policy path” and the committee “will be paying very close attention to what incoming economic and financial data are telling us.” 15 15 Close Chair Powell: “The Federal Reserve's Framework for Monitoring Financial Stability,” 11/28/18. Markets have moved to price a much more dovish policy trajectory, with Fed Funds futures implying only one hike in 2019 and a shift towards cutting rates in 2020. This outlook appears at odds with continued strength in U.S. economic data, and suggests that investors may see recent weakness in equity and credit markets as a harbinger of slower growth next year. The Fed’s updated forecasts will be watched closely to see whether policymakers are putting more weight on positive trends in the data or on more worrisome signals from financial markets. If forecasts for next year are little changed, it could trigger weakness in stocks and bonds and strength in the dollar.

Sweden Central Bank Meeting (Thursday) Recent communication from Riksbank policymakers has reiterated that Sweden’s first rate hike in seven years could come in either December of this year or February of next year. Until recently, markets were pricing a reasonable chance of a hike in December. However, after two months of downside surprises to the Riksbank’s key inflation measure, CPIF, market expectations have now shifted to February. The Riksbank has communicated that it views inflation risks as skewed to the downside following a long period of low inflation and low inflation expectations and has thus tended to lean in a dovish direction. Market participants will be closely watching the central bank’s economic and policy rate forecasts for an updated view on the expected timing and magnitude of policy tightening.

This material has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision.


Past performance is not a guarantee of future performance.


This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.


The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the author or AQR will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only.


The information in this document may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.