Co-founder and CIO
18 June 2020
Since the onset of March’s market crash, we’ve mentioned that policy stimuli is helping to cushion the markets despite the gloomy picture in the economy. Particularly, we’ve discussed how the Fed’s $2.3 trillion USD monetary stimuli could eventually compound to $12.65 trillion USD through the banking system in the US. In addition to the $3 trillion USD of aid approved by the US Congress, the total stimulus could amount to approximately 8.5 months of lost GDP.
In essence, the economic value of policy stimuli carried out by central banks and governments around the world is so massive that the stimuli has caused the financial markets to disconnect from the economy. In the financial markets’ eyes, even if the economy has stopped producing output, the central banks’ policy stimuli are nearly enough to make up for that loss in production.
As of 15 June, the MSCI World Equity Index and the S&P 500 have recovered 35.5% and 37%, respectively, from their bottoms on 23 March, and are roughly 10.8% and 9.4% shy of their previous highs.
Figure 1 shows the markets’ expectations of economic growth against the incoming data from the Conference Board Leading Economic Indicator (LEI) as of 15 June. While the LEI reports a -11% YoY growth, the S&P 500 is pricing in about -4.6% YoY growth as inferred by ERAA®. This divergence implies that markets aren’t pricing in as much negative news as the LEI. Whenever the markets diverge from the economic data, there’s a greater chance of higher market volatility going forward.
Source: StashAway, Bloomberg. Note: LEI YoY stands for the year-on-year percent change in the Conference Board Leading Economic Index for the US economy
Although the sharp V-shaped rebound in the S&P 500 paints an optimistic picture of the economy for the coming months, the more forward-looking options market is cautious of the stock market’s overall optimism.
Specifically, we’re referring to the VIX index, which is the index derived from the options market on the S&P 500. Essentially, the VIX measures the amount of volatility expected in the S&P 500 by the options market over the next 30 days. The VIX is often referred to as the “fear gauge” because more fear and uncertainty in the stock market often translates to more frequent ups and downs in the market. When the VIX goes up, the options market expects that there would be more volatility in the S&P 500. During the worst of the COVID-19 market crash, the VIX was trading as high as 53.5%.
As shown in Figure 2, the VIX still remains at a level that is above the range seen before the pandemic despite the sharp rebound in the S&P 500: The VIX traded between 10% to 20% before the COVID-19 crash, and the VIX is currently trading around 27.5%. The VIX futures market, which trades contracts up to 9 months in the future, is also anticipating that volatility will not return to pre-COVID levels for at least the next 9 months (see black line in Figure 2).
Source: StashAway, Bloomberg
So, what does the VIX tell us about the markets? The elevated levels of the VIX and its futures contracts tell us not to take the current market rally at face value, and that options investors expect higher than usual volatility to continue in the coming months.
In line with the VIX, our investment framework, ERAA®, also detected elevated volatility in growth-oriented assets for the foreseeable future, and all of our portfolios are already prepared to navigate the likely market volatility, as we re-optimised them for an uncertain economy on 14 May.
While the Fed’s policy stimuli helped cushion the US economy, the stimuli also created a significant downside risk in the US Dollar. As quantitative easing will create an abundant supply of the US Dollar, the natural law of supply and demand dictates that this oversupply could cause the Dollar to depreciate in value.
History offers a lesson here: Similar to today’s crisis, the Fed introduced quantitative easing in mid-March 2009 to support the US economy after the 2008 Financial Crisis. In the period after the quantitative easing, the trade-weighted US Dollar depreciated by around 20% between March 2009 and September 2011. In that same period, the US Dollar also dropped by 22% and 19.4% against the Singapore Dollar and Malaysian Ringgit (see Figure 3).
Figure 3 - US Dollar Depreciation Post March-2009 Monetary Stimuli between March 2009 and September 2011
Source: StashAway, Bloomberg
Additionally, ERAA®’s currency valuation model1 estimates that the trade-weighted US Dollar is overvalued by 5.9%, indicating that the US Dollar is relatively overvalued against its trading partners. This overvaluation adds to the prevailing downside risk presented by the Fed’s stimuli.
The depreciation risk of the US Dollar is a crucial consideration for international investors because this risk can impact an investor’s long-term returns. To grasp the impact this could have on an international investor, consider this example: If an individual invested $100 USD in US technology stocks, and her investment gained 40% in a one-year period. After 1 year, her total investment would be $140 USD. Say, however, the US Dollar depreciated by 20% during that same period. Because of this depreciation, the total value of her investment wouldn’t be $140 USD. Rather her investments would only be $112 USD in her home currency terms (investment x USD return x (1- USD depreciation) = $100x 1.4 x 0.8). In other words, the US Dollar depreciation significantly diluted her returns in her home currency!
Here’s another way to look at it: An investor only needs to make a 12% return on a local or regional asset to equate the spectacular return on US technology! To mitigate the potential impact of this depreciation risk on your returns, ERAA® has already preemptively reduced your portfolios’ exposure to the US Dollar in the mid-May re-optimisation.
Since the beginning of the pandemic, we’ve seen an avalanche of opinions about what will happen in the markets written by optimists and pessimists alike. But successful long-term investing isn’t about navigating the conflicting media narratives at any given time. Rather, successful long-term investing involves preparing yourself and managing your risk long before any potential risks factors could impact your investments.
At StashAway, this risk management happens in two ways. Firstly, our system uses economic and market data to look out for potential risk factors that can impact your portfolio and make adjustments so that your portfolio stays resilient in the face of those risks. Secondly, and more importantly, you need to make sure that you’re mentally and emotionally prepared to navigate the inevitable ups and downs of the market. And, mentally and emotionally preparing yourself starts with choosing a risk level that aligns with your risk tolerance and sticking to the investment plan that you’ve set out for yourself, regardless of whether markets go up or down in the short-term.
1ERAA®’s currency valuation model evaluates the value of an FX pair based on interest rate differential, relative inflation and relative growth between the two nations.