Eerie calm in global markets fuels hunt for 'catalysts of carnage'

With markets touching record highs and volatility touching record lows, many investors are starting to worry they are being collectively complacent, but they are struggling to find a justification for being bearish.

The Federal Reserve pushed further into its tightening cycle with another 25-basis-point rate hike on June 14, despite some recent weak data leading to claims that the U.S. recovery is running out of steam. U.S. stocks continue to hover around record highs, while the VIX volatility 'fear index' remains stubbornly low and buying put options that insure against a large fall in the S&P 500 remain extremely cheap.

In Europe investors are agreed that valuations - at least in fixed income - are very rich, but eurozone government bond yields fell to multi-week lows on June 14, dragging credit yields with them, and while the European Central Bank is aiming to exit quantitative easing at some point in 2018, bond buyers are reluctant to sit out.

"Valuations are generally awful," said Alex Eventon, a portfolio manager at Dolfin, "but it is hard to see anything in the short term that would be a catalyst for carnage."

"You look at yields and you know you are not being rewarded for the duration risk you’re taking, but it doesn’t pay to sit in cash at the moment."

Morgan Stanley's chief cross-asset strategist Andrew Sheets neatly captured the problem facing the markets in his mid-year outlook, published June 4, saying that his team's biggest concern, by far, was how little they were worried.

"There was a distinct unease regarding the low level of volatility and the fact that both growth and policy seemed fine," he said.

Mounting risks

Bank of America Merrill Lynch's latest global fund manager survey, published June 13, suggests there is plenty of concern on the buy side, however.

Some 44% of investors surveyed by the U.S. investment bank in June thought equities were overvalued, up from 37% in May and the highest number on record. Nearly 40% thought the Nasdaq index was the most crowded global trade, suggesting many feel tech stocks are the main source of that overvaluation. What's more, nearly 60% of respondents expect global corporate profits to improve from here.

Chinese credit tightening and a slide in global bond markets are by far the two biggest risks in the eyes of investors, according to BAML.

"We are buying volatility and protection when it is cheap," said Jorgen Kjaersgaard, head of European credit at AllianceBernstein.

And there is good reason for their concern, according to UBS global chief economist Arend Kapteyn, who in a June 12 note said that from peak to trough, the current deceleration in global credit growth is now approaching that during the global financial crisis.

"Over the last six months, the culprits are the U.S. and China but the size of the declines in Germany, Italy and Mexico are notable," he said. "And the message ... is basically that global [industrial production] and import volume growth have peaked."

Sluggish economic data from the U.S., Europe and now the U.K. has reinforced views that the optimism unleashed by Donald Trump's presidency late in 2016, along with the subsequent market rally, may have been misplaced.

But Morgan Stanley's Sheets concluded that neither investors nor companies were "showing exuberance," and that the bull market probably had even further to run.

"Current 'guarded' optimism could become more unguarded before the cycle ends," he said.

BAML's strategists agreed, pointing out that asset managers' cash allocations had not fallen as they did during the dot com bubble, meaning there was no "irrational exuberance."

Carnage catalysts

The potential for what BAML said could be a "crash in global bond markets" is a different story, with a number of market participants concerned that the sheer scale of central bank intervention since the 2008 crisis means sentiment could reverse quickly and catch investors out.

The ECB has so far taken an extremely cautious approach to discussing its withdrawal of stimulus measures, having cut its inflation forecasts through to 2019 this month and with President Mario Draghi suggesting it could keep buying bonds through 2018.

"Whenever Draghi changes his rhetoric, the whole market will shift in sentiment," said Kjaersgaard. "We've had five years of a core rate rally and if you're a prudent portfolio manager you start to take profit on that. In my view, 2.5 years should be your max duration in Europe right now.

"The danger [for Europe] could be that markets around us go wider, especially U.S. high yield, dragging European spreads wider."

European assets are also benefiting from a euro-dollar basis swap, which allow investors to bet on interest rates in different currencies, approaching 200 basis points in five years, he added. This could cause a flight to U.S. assets if it began to contract.

Eventon agrees that timing an exit from the ECB-inspired carry trade in fixed income will be crucial, and investors' withdrawal will not be as orderly as the central bank's.

"The ECB is going to withdraw QE as gradually as possible, but that doesn’t mean investors will pare their exposure just as gradually," he said. "If someone with $10 billion AUM decides enough is enough and they are pulling out of a certain sector, say sub financials, then that could have a big impact."

"If a fund that size decides they suddenly want to generate even 5% additional cash then that could trigger a decent shake-out."