The calm before the storm?

Missile threats from North Korea. Donald Trump’s irascibility (see below). China’s debt bubble. The ever-present threat of European populism. These are unusually turbulent times, so you’d expect investors to be nervous and tread carefully in global markets. Yet they think the “outlook… is more stable and benign than anything seen for 24 years”, says Gillian Tett in the Financial Times. 

America’s Vix index, known as Wall Street’s fear gauge, has fallen to its lowest level since it was first published on a real-time basis in 1993. Seen as an international barometer of investor sentiment, the Chicago Board Options Exchange Volatility Index measures the expected volatility of the stockmarket over the next 30 days, using the prices of a basket of put and call options on the S&P500. A put option is essentially insurance against a price slide, while a call option is a bet the market will move higher.

At present, the index has slipped below ten for only the third time. Its previous forays below this level were in 1993/94, before an interest-rate hike caused jitters, and in 2007 before the crash. A figure above 30 is considered high. In 2008 during the slump it reached 89, while it shot to a record high during the crash of 1987. Interestingly, the low volatility isn’t just an equity-market phenomenon, says Implied volatility across the G10 major currencies is close to a three-year low. US Treasury market volatility is near record lows.

So what gives? One interpretation is that investors are getting “over-complacent” after a long bull run, says Ian King in The Times, tuning out potential political shocks at a time when valuations are on the high side, especially in the US. Then again, valuations have been high for some time, and the fundamentals have actually improved strongly of late. Europe and Wall Street have just produced their best first-quarter earnings season for 16 and 13 years respectively. Note, too, that the Vix is hardly a short-term timing tool. Two periods below ten are too few to make any predictions about what happens next. According to Morgan Stanley, both times markets kept rising for two to three months before turning. Central-bank policy is also still broadly loose, helping to prop up stocks.

But that doesn’t mean we can relax. Financial history shows “stability breeds instability down the road”, as Mohamed El-Erian notes on Bloomberg. “The smoother the road, the faster people are likely to drive”. Calm engenders complacency and excessive risk-taking. In short, concludes Tett, “the longer the Vix stays low… the greater the risk of a future snapback”.

Stocks shrug off talk of “Trumpgate”

Washington is abuzz with speculation over Donald Trump’s sudden firing of FBI director James Comey. The event is being compared to Richard Nixon’s “Saturday Night Massacre” in 1973, when he sacked the special prosecutor who confronted him over the Watergate scandal. Some think Trump was desperate to prevent his administration’s links to Russia emerging, and reckon the imbroglio could culminate in Trump’s impeachment.

“Yet one constituency has remained notably quiet about the affair,” says Rob Cox on the equity market. Wall Street barely budged when the news emerged last Wednesday. The post-election rally of around 10% has held firm. Investors may be calculating that the affair will be a “containable political tempest”, as Cox puts it, perhaps because it is hard to see Republican lawmakers trying to impeach a leader who remains popular with his voters just before the mid-term elections. But the markets may be overlooking the downside. “A president bogged down in Watergate-like constitutional malarkey… will struggle to deliver a bill offering even modest tax cuts.”

Which is awkward, adds Ambrose Evans Pritchard in The Daily Telegraph, because stocks have fully factored in a $2trn tax “shake-up” and a spending spree on infrastructure. It seems less likely now that “this reckless, ill-timed, late-cycle… fiscal debauchery” will occur.

That may be good news for America’s long-term economic health, but it means it is currently “hard to justify” a cyclically adjusted price/earnings ratio of 29 on the S&P 500. That’s the highest figure in the past 130 years, except for the bubbles of 1929 and 2000. An eye-wateringly expensive market is looking dangerously exposed.

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