Macro uncertainty lingers... Main certainty is that uncertainty rules again!

Author: Valentijn van Nieuwenhuijzen, Head of Multi-Asset at NN Investment Partners (NN IP)

Risky assets continue to make impressive intra-day moves, but essentially started to trend sideways since late August. Basically the same holds for government bonds as daily moves in yields remain much larger than in recent years, but the level of yields isn't too much different from earlier in the summer. A sense of calmness has returned to markets, but nobody seems to feel comfortable about it.

Valentijn van Nieuwenhuijzen

The lack of comfort that many investors have with the market at this point probably stems from the awareness that pockets of turbulence rarely travel alone, implying that periods of higher volatility on their own already increase the probability of further near-term turmoil. Obviously the perceived fragility in the current market environment is also influenced by the lingering macro questions on the table.

How will the gap between EM and DM growth momentum that has opened up this year be closed -- by weakness in EM dragging DM down, or by resilience in DM pulling EM up? When will the US Federal Reserve finally pull the trigger on its old-fashioned interest rate weapon? What other policy magic will be unveiled in Europe, Japan or China to support market sentiment and ease financial conditions further? When and how will the supply-demand imbalance in the oil market be tackled? Mainly by price action, or also by supply curtailment?

Probably most of you have been discussing these matters at length. The main conclusion at this stage is that all these questions are much easier raised than answered. The main certainty is that uncertainty rules again. This is reflected in the combination of sideways movements in bonds and risky assets with the persistence of high volatility (see Figure 1), but also underscored in the behaviour and confidence of active players in the market. Available survey and positioning information of global fund managers clearly shows they have scaled back risk substantially in recent weeks and have brought cash levels to heights not seen since the Summer of 2012.

Moreover, investor sentiment metrics have dropped sharply as well as growth expectation of investors have declined and their overall confidence has also plunged.

Furthermore, the price evolution of mutual funds, global macro hedge funds, risk parity funds, long-short equity funds and momentum (CTA) strategies have all shown a falling correlation (beta) to global equities over the last three to four weeks. This implies that the responsible managers not only sound more cautious in the surveys they fill in, but also actually have taken risk off the table in their funds to be less exposed to further falls in risky assets like equities, credit and commodities. All in all, this paints a picture of serious macroeconomic challenges and downside risks stemming from weakness in emerging markets and lingering policy uncertainty.

It seems however that many investors have adapted to this more fragile reality, probably helped by the fear factor of market volatility in August. At some point this raised the question of who will be left as the marginal seller against a backdrop of the deteriorating emerging market news flow. Not only are emerging markets and commodities already well established and large underweights amongst allocation players, it now also seems that overall risk amongst investors has been scaled back substantially over the last one to two months. A global recession would probably easily do the trick of creating an additional wave of selling in risky assets.

Stay on guard!

Without it, however, one should also be aware that a lot of problems are priced by now. Therefore, stay on guard for some sort of "short squeeze" where the lack of additional bad news is enough to create a technical bounce in the markets where many will find themselves wrong-footed and potentially forced to buy into the rally, which would give the risk-on phase another leg up. It is too early to actively play this move and increase our risk taking at this stage, but it is an important thought that prevents us from joining the crowd in scaling down risk further.