Mid-year outlook: Beware that peaceful, easy feeling

Has a sense of unfounded complacency settled in among investors as we move through the second half of 2014?

In our Strategists’ 2014 Global Outlook – Third Quarter Update we discuss the possibilities.

The most widely used volatility indicator, the VIX index1 (often called the fear index), has fallen to near record lows. These levels reflect the reality that many of the issues investors were anxious about earlier in the year have become less worrisome to them:

  • China’s economy appears to be stabilizing.
  • The U.S. Federal Reserve’s (the Fed’s) tapering has not caused a financial collapse.
  • Europe is on the mend.
  • First quarter U.S. GDP contraction looks an aberration.

Such developments could easily lull investors into a more settled state of mind, especially amid the low volatility, slightly up market conditions of 2014. For example, the U.S. broad-market Russell 3000® Index  reflected a relatively calm 6.9% gain for the first half of 2014, though it maintains a more celebratory annualized return of 19.3% for the past five years as of June 30, 2014.

Amid quieter markets at mid-year 2014, perhaps the primary risk that investors face isn’t geopolitical per se, but instead how they react to some future shock that rattles markets, shattering their sense of complacency.

The combination of complacency and stretched equity market valuations means that markets are especially vulnerable to shocks. Geopolitics is one obvious risk, with events escalating in Iraq and the ongoing China-Japan dispute rumbling in the East China Sea.

The equity market upswing is getting old compared to previous cycles, but shows no sign yet of ending. Bull markets typically end for one of three reasons: restrictive Fed policy, extreme overvaluation, or excess leverage. We’re a long way from tight Fed policy, valuation is stretched but not extreme, and although firms are levering up, overall leverage in the developed economies is still declining.

High equity market valuations tell us that the longer-term return outlook is subdued, but for now our value, cycle, sentiment process, and models tell us to favor equities over fixed income and maintain some credit exposure. Still, the risk of a market correction is rising, and in our view an inflation scare or adverse geopolitical events will be the most likely culprits.

That said, our sentiment indicators are not signaling an imminent risk of a pull-back.

Regarding bond markets across the world, we believe in recent months they are increasingly priced for complacency. In Australia, for example, the spread of 10-year Treasuries over the U.S. are trading at 7-year lows as of June 30, 2014. That’s in line with the relative pricing of early 2007. In other words, they’re expensive in historical terms. As an investment, we would view both long bonds, and credit, as being vulnerable to any increase in market volatility or risk aversion, from whatever cause.

While unsustainably low volatility and high equity valuations make us wary of a pullback, our overall views on the direction of markets are broadly unchanged. We still have a modest pro-equity bias and think that global growth and earnings are on track to validate last year’s large gains in global developed equity markets.

Yes, volatility is at worryingly low levels, but at the same time we still think mid-2014 offers buy-the-dips market conditions. So, perhaps complacency is OK for now; just watch yourself if (and perhaps I should say when) markets rattle your peaceful, easy feeling.

 

1 The VIX index is the commonly used name for the CBOE SPX VOLATILITY INDEX.