As they typically do, the capital markets have gotten into a waiting game. Look around—all large markets seem to be trading in quite a narrow range. It may be a blip up or a blip down, but there have been no groundbreaking moves either way. In my view, the primary driver of this lackluster performance is low level of positioning in the market. That is, over the volatility of the 2nd quarter—and very unlike last year, and to some extent the 1st quarter—most investors have gotten very close to home. In sum, investors are waiting for a sign on either the economic or policy front to take a position. But they may have to wait some time—maybe even until the fall—before things change meaningfully. Just look at what is going on in the world:
United States : As the non-farm payroll data released July 6th showed, the economy is certainly not growing fast enough for investors to rejoice, yet not growing slow enough to induce further action by the Fed. The possibility of a third round of quantitative easing (QE3) is acting both as a floor and a cap for the markets. If economic data soften (as they have recently), the downside will be buffered by the prospects of QE3. If economic data strengthen, however, the upside will be capped as prospects of QE3 fade.
The bottom line: The possibility of QE3 keeps the markets range-bound, with no incentive for anyone to change positions.
Europe: In typical fashion, European policymakers are doing just enough (at this stage maybe just “talking”) to ensure that the markets don’t trip, but certainly not enough to take the pressure off the peripheral countries. While governments continue to discuss long-term plans for further integration, there is still no near-term agreement to deal with the immediate issue of sovereign funding. The European economy is not immediately falling off a cliff. There is enough liquidity in the banking system as a result of the European Central Bank’s Long Term Refinancing Operations (which means fewer bank funding pressures), so politicians are less pressured to move aggressively. Additionally, anyone who is inclined to short-sell European investments probably already has. So in this case, the prospects of any policy action, which could resultin violent rallies and cheaper valuations, diminish the rationale for increasing that short position further.
The bottom line: Euro fatigue. No one likes what is going on, but there is no inclination to change current positioning.
China: China and the emerging markets (EM) are clearly slowing down, as the trend in commodities prices suggest. But here also, they are not slowing down fast enough to break the secular allure of EM investing, and the possibility of policy action dims the allure of selling short. Unfortunately, the policy actions that have been implemented so far have failed to help the growth outlook. The bright spot here is that inflation is slowing down across the board which, in turn, increases the options for policymakers.
The bottom line: Although investors are concerned, they are not cutting exposure to the emerging markets. That said, I believe that if the EM economies break down from their secular trend—which I don’t think is likely this year— the reaction could be quite violent.
In sum, if investors hold no high-thematic convictions, which appears to be the case at the moment, they have plenty of reasons to do nothing. The net result of this malaise is low volatility.
In my opinion, the U.S. economy will come out of the current soft spot, but won’t reach the level that everyone wants. Two percent is the new growth trend, a perfect environment for U.S. credit. If I did not already hold long positions, increasing my exposure at this point of time would make perfect sense due to decent prospects for income and appreciation.
European policymakers continue to stumble along. The big opportunity to short the euro and European securities may resurface later this year or next, but for now, it is over. A slowing trend in the emerging markets will continue, but not fast enough to prove catastrophic. As a result, EM flows will remain modestly negative, resulting in greater vulnerability for already vulnerable countries, such as India and Russia, but won’t take down countries such as China and Brazil.