The Tolling Bells of Complacency

Global CIO Commentary by Scott Minerd

Last week, after writing my most recent commentary about market complacency, I was surprised that the latest Federal Reserve minutes revealed that the Federal Open Market Committee is also concerned investors are growing too complacent, raising the prospect of excessive risk taking. That followed remarks from Federal Reserve Bank of New York President William Dudley that low market volatility has made him nervous. Fed Chair Janet Yellen reinforced that view in her latest testimony to Congress, saying investors reaching for yield could increase the risk of market problems, and that some valuations, particularly lower-rated corporate debt, are stretched.

It is commendable that the Fed is acknowledging complacency and trying to remind investors of the uncertain path ahead; but perhaps the largest contributor to the rise in risk taking has been the Federal Reserve itself. The Fed is far from alone in fueling complacency, as central bankers around the world have continued to provide easy money to prop up overleveraged economies with large structural imbalances. The Bank for International Settlements has summed the situation up saying that global central bank policies have reduced price swings and market volatility, encouraging greater risk taking.

The Fed and other central banks are to be commended for having avoided a global financial meltdown by pumping up economic activity through cheap money and inflated asset prices, but this approach is not without risks. Now, with unemployment falling to 6.1 percent, the U.S. economy is building a strong head of steam. Despite that, Dr. Yellen has dismissed as “noise” the possible signs of building U.S. inflation, notably evident in Consumer Price Index data showing inflation running at 2.1 percent. That “noise” may well be an alarm bell that the complacency created, and even promoted, by central bankers could eventually result in unintended adverse consequences in the coming years. As policymakers globally contemplate the source of today’s market complacency, I am reminded of the words of 17th century English poet and cleric John Donne: “Never send to know for whom the bell tolls; It tolls for thee.”

Low Realized Volatility Reflects Widespread Market Complacency

The past few years of central bank-induced liquidity have calmed markets to a degree that is nearly unprecedented in the last 25 years. From equities to fixed income to currency markets, volatility is near historically low levels. The last time such complacency was seen was the summer of 2007, suggesting investors should not be lulled by the current market calm, and instead prepare for choppier days ahead.

ANNUALIZED REALIZED VOLATILITY BY ASSET CLASS

Source: Bloomberg, Guggenheim Investments. Data as of 7/16/2014. Volatility refers to annualized 30-day standard deviation. Volatility of the 10-Year U.S. Treasury is yield volatility. The MSCI Emerging Markets Index captures large and mid-cap representation across 23 Emerging Markets countries. The S&P 500 is a market-weighted stock market index comprised of the stocks of 500 U.S. corporations; the index is owned and maintained by Standard & Poor’s. The S&P GSCI® is recognized as a leading measure of general price movements and inflation in the world economy. The DXY is measured against major foreign currencies. The Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated and covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

Economic Data Releases

U.S. Retail Sales and Industrial Production Confirm 2Q Rebound

• U.S. retail sales were below expectations in June, rising 0.2 percent as May’s gain was revised up to 0.5 percent. However, sales were stronger, excluding the volatile categories of autos, gas, and building materials, up 0.6 percent.
• Industrial production increased 0.2 percent in June, putting the quarterly growth rate at the fastest pace since 2010.
• Initial jobless claims declined to 304,000 for the week ended July 5.

• The Empire Manufacturing survey reached 25.6 in July, the highest in over four years.
• The NAHB Housing Market Index increased more than expected in July, rising to 53 from 49, the best since January.
• Producer prices ticked down again in June to 1.9 percent year over year. Energy costs rose 2.0 percent month over month.

Euro Zone Production Weak, Chinese GDP above Estimates

• Euro zone industrial production fell 1.1 percent in May, the largest drop since September 2012.
• The ZEW investor survey of the current situation in Germany fell for the first time in eight months in July, while the expectations index fell for the seventh consecutive month.
• Industrial production in France dropped 1.7 percent in May, the largest decline in a year and a half.
• French consumer prices fell to 0.6 percent year over year in June, the lowest since 2009.
• U.K. consumer prices rose more than expected in June, rising to 1.9 percent from 1.5 percent.

• China’s second-quarter GDP growth increased to 7.5 percent from a year ago, the first uptick in growth in three quarters.
• Chinese exports expanded less than expected in June, showing a slightly faster pace of growth at 7.2 percent year over year.
• Chinese retail sales growth ticked down to 12.4 percent year over year in June from 12.5 percent.
• Industrial production in China accelerated to 9.2 percent year over year in June, the best growth since November.

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