Please see the below update from Legal and General Investment Management’s (LGIM) Asset Allocation Team:
Investors often think that whatever happens in financial markets is the most important thing in everyone’s lives. Last week, with COP26, it was easy to wake up from that distortion. World leaders and captains of industry, including our own CEO, Michelle Scrimgeour, gathered for the United Nations climate change conference. It looks like they made good progress, though much still needs to be made concrete.
Back in the world of macro minutiae, central bankers mostly indicated that monetary tightening will take longer than investors expect. Both equities and bonds liked that message.
As with all Key Beliefs emails, this represents solely the investment views of LGIM’s Asset Allocation team.
It might be a COP out, but…
We use a cyclical framework (a sort of investment clock) to drive our medium-term risk taking. Our confidence in our assessment of the current position of the cycle is lower than normal — due to the pandemic, the extraordinary policy response and the unique nature of the supply disruptions.
We see the risk that the US and some other economies are later in the cycle than realised, and that the currently high rate of inflation will act as a catalyst for more persistent inflation.
Even though uncertainty is increasing, our research shows that even a late-cycle view isn’t necessarily bad for risk assets as long as the recession risk remains low. We think the 12-month recession risk is increasing, but from a low base. We are wary of taking risk off too soon, especially as we see the majority of possible outcomes for now as equity-positive with above-trend growth. So, despite the challenges to our framework, we are sticking to our bullish medium-term view and remaining long equities.
VIX and MOVE: Good COP bad COP
There’s a growing gap between bond and equity volatility. While the VIX index – a summary measure of US equity implied volatility – has revisited post-Covid lows, the MOVE index – a roughly equivalent measure for US Treasury bond implied volatility – was busy making new post-Covid highs.
Bond volatility has broadly risen in line with yields over the past year. The positive correlation between the two makes sense: assuming the existence of some implied lower bound to interest rates, large yield movements are less likely to occur at low levels. As yields rise, so too then should market-implied volatility.
The relatively gradual increase in the MOVE index masks a pretty dramatic increase in volatility at the shorter end of that spectrum over the past month. One-month two-year swaption volatility rose threefold from mid-October to the start of last week, as short-term rates reflected a more hawkish Fed.
While the low level of equity implied volatility may be an attractive entry point for a long position – in strategies that allow it, we currently hold VIX calendar spread positions to take advantage of the sort of short-term spikes in volatility that become more likely as we move from mid- to late-cycle – we don’t see the rise in bond implied volatility as an opportunity to go short. To the contrary: with rising yields and uncertainty around inflation expectations, two-way risk is ever more present, so we are holding on to our long interest rate volatility positions for now.
Calling the COPs on the currency manipulators
In the easing cycle, we saw some central banks resorting to currency intervention as the zero-bound in interest rates kept them from cutting rates further. We believe that with the tide turning, the first thing those central banks will do is step away from currency intervention and allow their currencies to strengthen. It could be argued that currency strength is more effective than rate hikes in managing inflationary pressures resulting from supply-side constraints.
Switzerland and Israel are clear examples where central banks had intervened to stop their currencies from appreciating, but now the franc and shekel have resumed strengthening. Some central banks are more explicit about their goals than others, but our emerging market economists have done some interesting work to unmask the “currency manipulators” by scrutinising foreign exchange reserves.
This is important, as we believe we may see more strength from such currencies. Based on this work, we have increased our exposure to the Indian rupee. In the latest US Treasury Department’s semi-annual report, India is on the list of countries that merit close attention to their currency practices and macroeconomic policies.
If it’s not inflationary pressure that convinces India’s central bank to stop currency intervention and let the rupee appreciate, political pressure may do the trick.
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Andrew Lloyd DipPFS
09/11/2021