It’s All Relative
Volatility returned to equity markets last week, but it was a quick visit. The S&P 500 slid 1.8% on Wednesday, the VIX jumped and babies were thrown out of with the bathwater in Brazil. For a short while, it looked like a significant chink in the armour, but this market is not easy to bring down. Equities snapped back at the end of the week and volatility receded. On the week, the S&P 500 ended down 0.4%—after a 0.3% decline the week before—just about the same as the MSCI World. One of the main debates on the Tee Vee Thursday morning was whether this “pull-back” marked the beginning of the big kahuna sell-off and a global recession. When the market goes up, we cry foul due to high valuations and tentative evidence of “bubble behaviour,” and when it finally stumbles it stands to reason that it must the beginning of the big unravelling. I can’t refute the internal consistency of this argument, but I am pretty convinced that the resilience or this meme is one of the key reasons why equities have been able to withstand just about anything bears have thrown at them.
The good news for the bulls is that it makes absolutely no sense to talk about a recession inducing sell-off given the price action last week. The bad news is that it can get a whole lot worse in the short run without altering the underlying story. But investors and markets need narratives to get up in the morning. The dumpster fire of Mr. Trump’s presidency has been identified as the main reason for the combination of struggling equities—with underperformance in the U.S.—and a weaker dollar. The first chart below, which shows that specs are now net long the euro, has been going the rounds. The second chart shows that trailing equity inflows—proxied by Vanguard’s country/region ETFs—have pivoted recently in favour of Europe and emerging markets over the U.S.
I am a big believer in the idea that narratives drive markets, and the charts above hint at a significant change. They suggest that the “Trump reflation trade” has been replaced by an “overweight Europe/EM trade” implying that buying non-US equities, and selling the dollar, is now the sweet spot. This story has been boosted by the victory of Mr. Macron in the French presidential elections, and the increasingly desperate situation for Mr. Trump in the White House. We started this year with the notion that the U.S. growth miracle was on track due to a swashbuckling no-bullshit presidency, while the EU/Eurozone was on the brink of collapse. Nearly six months in, however, continental Europe is a beacon of political stability while the U.S. sinking into a quagmire of a dud presidency.
