The shape of things to come?
Investment professionals like to "tell the narrative," but good ideas also require market recognition. Sometimes, though, the story that appears least compelling can offer the best longer-term investment opportunities. Lately, I've been comparing the spread between 2- and 10-year US Treasury yields (2s10s) with a backward-looking version of the CBOE Volatility Index (VIX) and considering some of the implications of generally rising volatility (see chart below), along with areas within financials that may benefit.
The VIX data is lagged 3 years, whereas the 2s10s is a "real time" indicator. The trends are not coincident; together, they potentially hint at the shape of things to come. If the correlation holds, it would suggest to me that recent volatility isn't transient, that the VIX may keep rising, possibly for years. This could present an opportunity to get ahead of what I think could be a big theme in 2019 and beyond. As long-term investors, we want to be where the market isn't (yet).
Looking back to see ahead
Such low levels of volatility last occurred in 2007. The spike provoked by the 2007–2008 financial crisis was followed by an extended trend of generally declining volatility. A cyclical bottom in the VIX at the beginning of 2018—at the top of the market—more or less matched 2007's, and I think we may be at a secular turning point. Why?
We've seen tremendous change around global monetary and fiscal policies, plus a distinct increase in political uncertainty. Also, interest rates may be at a tipping point. Add to that a US business cycle that seems to be shifting to the late phase, where the yield curve tends to compress. These factors could form a foundation for generally rising volatility, especially if the 2s10s spread indeed reflects the contours of the economic cycle.
As we move into and through late cycle, I’m on the lookout for companies with less vulnerability to market shifts but greater exposure to activity levels. Amid volatility, institutional and retail investors alike tend to trade more or look to hedge their positions, so, exchanges and online brokers come to mind. Trust and custody banks tend to benefit from foreign-exchange volatility. To a lesser extent, investment banks are of interest, but their market involvement can be a double-edged sword: Trading may improve, but intermediary activity, such as mergers and acquisitions, could fall off.
From synchronicity to divergence
After years of globally synchronous growth, central bank policies are diverging. The US Federal Reserve, for example, is tightening interest rate targets on the short end, and it's affecting market sentiment.
Many seem to feel as if Fed hikes just started; I think it goes unrecognized that, in reality, the Fed has been tightening for nearly three years. Even if the increments have been small, I think we are in a new interest rate regime. Early on, rising rates were viewed as a response to solid economic growth, but now interpretations are less uniform, with more "debate" about whether the next hike might tip us into recession. This debate translates into increased market action, or volatility.
Moreover, growth in central bank balance sheets has been enormous—and likely helped suppress stock market volatility these past several years. Now that's starting to reverse and, intuitively, investors must ask: If this type of intervention (easing) caused market distortion, what might its opposite do? Additionally, different central banks are going about things differently, which can introduce new relationships, ambiguities, and unintended consequences.
Not just policy but politics
The political backdrop also has changed globally, amid rising populism, partisanship, and protectionism, not to mention issues related to Brexit, the Middle East, and US–China trade relations. What might second-order effects imply for the strength of the eurozone? For US inflation? For stocks?
Given the overall environment, investors might reasonably pursue more defensive and stable earnings streams, preferring property & casualty insurers, for example. Historically, though, markets often have stayed strong in late cycle, even after a yield-curve inversion. While the mosaic suggests a tone of caution, I believe opportunities remain.
Next steps to consider
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