What's different in the global markets cycle?

This is the thesis of Hatem Mustapha, Co-Head of Global Markets Activities at Societe Generale and  Kokou Agbo-Bloua, Global Head of Economics, Cross-Asset and Quant Research at the French bank.

Making money over the past two years has been relatively straightforward for a standard 60/40 portfolio of stocks and bonds despite the instability of the correlation between equities and bonds. Developed market equities have rallied as the major central banks have successfully wrangled inflation (at least according to the latest inflation data) -- opening the way to interest rate cuts -- without tanking their economies.

The S&P 500, further spurred by enthusiasm for technology generally and AI in particular, has led developed markets higher and is up by a fifth over the past year and a third over the past two. Meanwhile, bonds have rallied too as monetary policy has started to loosen, with 10-year US Treasury yields down from close to 5% to around 3.7% over the past year. Meanwhile, the VIX index that measures market volatility has been, with one exception, flat as a pancake.

Many investors, therefore, have done just fine by simply parking their money in equities, government bonds or short-term money market funds. But this era of cash and carry looks to be coming to an end.

The return of risk

August’s sharp sell-off, when Japan’s Nikkei index fell 12% in one day, the Nasdaq corrected by 10% and the VIX went from 15% to 64%, has been dismissed by many as a classic case of crowded positioning in a thin summer market. But it can also be interpreted as a genuine warning sign as investors look through apparently random economic data to focus on potential risks.

Perhaps, investors have had enough of “being fooled by randomness”, as Mr Agbo-Bloua puts it: the ups and downs of US inflation and labor market prints that have led them, in rapid rotation, to price in a hard landing, a soft landing and even no landing since the start of 2024.

Instead, they may be starting to focus on two different risk scenarios. The first, borne out by two successively weak non-farm payroll numbers in July and August, is that the US economy is about to experience a bumpy landing after all. The US Federal Reserve would, of course, try to offset that with more aggressive rate cuts which should be positive for stocks and especially bonds. However, if American growth suddenly slows sharply, fixed income outperformance will not compensate for the equity losses in most standard portfolios.

The second risk is, more or less, the opposite. While inflation appears beaten, some data suggests it may spike again (in services, for example), just as the labor market and the overall economy weaken. Under those circumstances, the Fed would be judged to have made a “policy mistake”, the specter of stagflation would raise its ugly head and all asset classes would suffer, argues Mr Agbo-Bloua.

Volatility squared

In addition, the August correction showed that volatility is once again becoming a factor. “The speed with which the VIX spiked and then calmed down again is something completely new”, says Mr Mustapha, pointing to the preponderance of algorithmic trading and the influence of index funds as potential causes. “Volatility itself is becoming more volatile”, adds Mr Mustapha.

How should clients react to this intriguing mix of risks? By recalibrating both asset allocation and portfolio structures.

If the easy stock market gains of the past two years are fading to single-digit returns, at least the market rally is broadening out: since August, the S&P is no longer being led by technology but by more defensive sectors such as healthcare and consumer staples supported by declining long term government bond yields.

By the same token, emerging markets should become more interesting again and investment-grade credit should outperform government bonds as investors look for yield in the face of 150 basis points of rate cuts between now and the end of next year – on both sides of the Atlantic.

In fact, they should consider private markets too, since looser monetary policy will support private credit and private real estate, both of which have grown hugely in the past few years but come under some scrutiny lately. “As falling rates force investors to reallocate parked cash, all of these asset classes should benefit”, suggests Mr Mustapha.  

However, and this is where the change in volatility comes into play, investors must rethink the size of bets they place and the leverage they take on. In an environment where the price of an asset can swing by plus/minus 20% in a single trading session, lower leverage and smaller positions are essential to avoid being forced to sell into a falling market by a margin call.

It is a challenging needle to thread. But with a clear strategy and disciplined execution, investors should be able not only to navigate these risks but to turn them into opportunities for generating outperformance.

Interested in learning more about the subject? Join us at the Global Markets conference in London on September 26th! Please contact your Societe Generale representative for registration or questions.