A Turbulent Start to the Holidays

21 December 2018

We wrote about our outlook for 2019 last week. After that slightly lengthy read, we thought a shorter note discussing what has caused market behaviour would be helpful.

So, this week all eyes were on the US Federal Reserve's Open Markets Committee (FOMC) meeting. As widely expected, the FOMC raised interest rates for the fourth time this year. However, given the current state of capital markets - the sell-offs in equities and the increase in credit spreads - investors hoped that they would acknowledge the likelihood of an economic slowdown is ahead and would adjust accordingly. They obliged; in his press conference afterwards, Fed chairman Jerome Powell lowered the central bank's expectations for rate rises next year from three to two.

And yet, despite guiding rate expectations lower for next year, markets sold off heavily. So, what's going on?

Perhaps it might be that the FOMC's expectation of two rate rises next year is still one-and-a-half more than markets are currently pricing in. Markets are pricing an impending economic slowdown, one which would force the Fed to hold off completely next year. 

More likely, some investors seem to have been hoping that for an adjustment in the pace of the Fed's balance sheet reduction. No such luck - Powell indicated quantitative tightening (QT) would go ahead just as planned.

A liquidity 'shortage' caused in part by QT is, we think, behind 2018's market falls. Many investors hoped that a change of heart from the Fed would be the catalyst for a stabilisation of both the economy and financial markets. Some commentators are calling their 'inaction' a policy error.

We've written (quite a lot) about liquidity this year. Although they're linked, there are two different kinds of liquidity: First, there's the cash created by a central bank which provides fuel for financial markets, keeps yields down and valuations high. This is the kind of liquidity that QT directly affects. Given that the removal of QE now seems set in stone - not just in the US but globally - this is the kind that will keep falling throughout next year. Secondly, there's liquidity provided by the market, enabling transactions to happen. In the past, large investment banks 'made the market', enabling liquidity by providing risk capital. Changes since the financial crisis (both regulatory and technological) have meant that, today, investment banks have significantly reduced their role in providing transaction liquidity. Institutional investors have had a larger role, but see transaction as a cost, so would rather reduce the involvement than increase it. 

Indeed, institutional 'active' investors have been under pressure as retail investors have switched towards 'passives', especially Exchange-Traded Funds (ETFs) which track mechanically-priced indices. Historically, institutional investors have tended to increase cash when valuations get expensive, and reducing cash to buy when valuations cheapen, effectively acting as a dampener on market fluctuations to a degree. 

The rise of ETFs has reduced this available cash, while increasing the market's sensitivity to direct end-investor risk-appetite. 

When markets are trending up, things don't feel risky. But when prices start falling, the risks seem a lot clearer. A run for the hills causes liquidity to fall further and volatility to spike even more. 

That's exactly what happened this year.