Yesterday, markets continued to move more in favour of risk-off assets in response to rising geopolitical worries and perhaps declining market optimism. At time of writing, yields are at 2017 lows for US Treasuries beyond 7-year maturities. Likewise gold returned to $1,275 nearing November pre-Trump election levels, the Japanese yen dipped back below 110 to the US dollar, and Brent crude furthered its rally to the $56 level having hovered at for most of the first quarter of 2017. Equity indices shrugged off a temporary decline with today’s European markets looking stronger than Asia’s earlier. But the Vix broke above 15, marking a high for the year and a 25% rise in the volatility index in under a week.
The Vix is also popularly known as the ‘fear index’ and had been uncharacteristically low and steady for most of the year, which may have helped sustain what we see as excessive optimism in equity market valuations. Though even at current higher level the Vix is still below the past decade average of 20. Over that period it almost touched 90 (intra-day) during the Global Financial Crisis and has surpassed 40 on only 3 other recent occasions: in response to the European Debt Crisis in April 2010 and August 2011, and very briefly following Trump’s election in November 2016.
The Vix will clearly be one to watch in the coming weeks if even these moderate levels unsettle investors. Any fragile market confidence could be tested if there is a culmination of further disappointment from the Trump Administration, deterioration of the situation regarding Syria, and any further uncertainty from European elections or debt negotiations. We think market confidence is most spurious and least warranted in richly valued stocks and overbought high yield debt - especially from those who have levered-up or overreached for yield throughout this period of low volatility. In contrast, holders of unsexy high-grade debt from creditor regions should be able to be more confident in the valuations and resilience of their holdings. Our macro view and value-driven investment process attain yields of around 4% for weighted average single A rated portfolios. According to our Relative Value Model calculations this equates to over 3 rating notches cheap or correspondingly an 85bps cushion in the spread. This offers additional portfolio protection alongside our focus on creditor nations; but should risk-off conditions continue or our macro view change we can reposition into value credits with a higher average credit rating. Or if market moves create attractive enough value further down the credit curve our models will help identify potential opportunities there also.