Irrational Equanimity Has Taken over the Markets

Let us take a sentimental journey through the Bloomberg terminal. Many of us have spent much time analyzing what steps the US and Chinese governments might take next in their trade spat. It’s all speculation, as we do not know how it will end. But it is possible to analyze how markets have reacted and gauge the sentiment at work among investors. And they appear remarkably relaxed.
This week has seen the actual imposition of 25 percent tariffs on a range of Chinese goods, China’s retaliation, and a series of practical preparations for possible war with Iran. None of this would have been predicted even two weeks, and all of this is bad for the markets and the economy. And yet the reaction has been calm, at least in the US and in the stock market.
The foreign-exchange market, however, does show concern. The exchange rate between the Australian dollar and the Japanese yen, the old “Yen Carry Trade” in which people borrowed in yen and parked the proceeds in Australian assets to take advantage of the higher interest rates there, has always been a gauge of risk sentiment. When people are nervous, they buy the yen, and when they are confident they buy the Aussie. On this measure, the currency market looks very nervous, although still not quite as alarmed in the days after the UK’s Brexit referendum in June 2016.
But another popular measure of risk appetite, the Chicago Board Options Exchange Volatility Index, or VIX, has stayed relatively calm throughout the drama of the last two weeks.
In the last five years, the event that scared the US market the most, by a wide margin, was the surprise Chinese yuan devaluation in 2015. This round of Chinese trade tension, already abating, is seen as far less alarming. Note that both the Brexit referendum and the US election of 2016, widely denounced as shocking, were also greeted relatively calmly.
Looking within the US stock market, there is no great sign that trade fears are prompting investors to move. The following chart shows an index of S&P 500 stocks most dependent on foreign revenues relative to those most dependent on domestic revenues since the 2016 election. There was an immediate grab after the election for the safety domestic-focused companies, but since then exporters have ruled the roost. Yes, exporters sold off more last week, but this is only a slight correction to what continues to be strong relative performance.
Looking for strategies that are working also gives little sense that there is great fear among investors. The following chart shows the S&P 500 Minimum Volatility Index. Minimum volatility strategies buy relatively calm low-volatility stocks, which tend to outperform during times of stress. This has been a very popular strategy among exchange-traded fund salesmen in recent years, but it has not performed well of late.
The Lehman bankruptcy and the Brexit referendum saw big spikes for Minimum Volatility stocks. The gains for those stocks over the last few days have been tiny by comparison.
Or, of course, we can look at the classic gauge of risk: the price of gold. Dividing the S&P 500 by the price of gold, to get an effective price of the S&P 500 in gold terms, often belies apparently strong stock market performance. But again, this latest sell-off looks tame when valued in gold. Valued this way, stocks are still well under President Donald Trump, even if they remain below the high they made last fall before worries about a hawkish Federal Reserve set in.
The trade war is primarily a bilateral affair, which stands to push up prices for consumers and damage the prospects for exporters in the US and China. But the trade spat has barely dented the continuing outperformance by the US compared to the rest of the world since 2016. Much of this is to do with Silicon Valley and American dominance of the tech sector. As the chart confirms, the S&P 500 tech sector has massively outperformed MSCI’s index of all the world’s stock markets outside the US since the election, and this has only sustained a slight dent in the last few days. Meanwhile, the rest of the S&P 500, compared to the rest of the world, has been far less impressive, but has had no correction at all during the trade conflagration.
There is another market that can be taken as a gauge of confidence of the economy: bonds. Falling bond yields often indicate declining confidence in the economy. Bond yields in the US are close to their lowest since 2016. In Germany, the yield on 10-year bunds has again gone negative. This does appear to suggest major concerns and a flight to safety. But if we look at other indicators of mood and of investor preoccupations, this drop in bond yields looks different from the one that came before.

source: Bloomberg