Tyranny of the Benchmark


Tyranny of the Benchmark

Tyranny of the Benchmark
11 Oct 2018 - Oliver Brennan

  • Market surveys on trade wars indicates escalation is expected
  • But asset markets remain largely undisturbed
  • This is the nature of a continuous market attempting to discount a bimodal event; asset prices could still undergo a sudden shift

The inefficient market

Back in school distributions were normal, markets were efficient and Trump wasn’t even a TV host. In theory, efficient markets fully reflect all available information. In practice the hypothesis just about holds around short-term events, where financial markets discount a distribution of possible outcomes into a probability-weighted average ‘price’, but rarely elsewhere and rarely for a long time (thankfully, then, there is still a role for your humble independent strategist). 

For example, the FOMC publishes forecasts to represent individual committee member’s midpoint of the appropriate fed funds target range. The market interprets the median of these dots as a point forecast for fed funds and then discount a range of outcomes around this median. Usually this process works well: there are sufficient FOMC contributors to afford statistical significance to the dot distribution, the market is sufficiently liquid to afford pricing of a distribution around the median, and pricing coalesces around clearly defined event dates.

The market is very good at pricing a range of expected outcomes, assuming the distribution of such outcomes is normal and on a clear timetable. That is to say, assuming markets behave. The further the expectations distribution is from normal, the harder it gets to approach a fair ‘price’  and the market cannot be efficient. St Louis Fed President Bullard’s model for the fed funds rate, for example, is regime-based. He does not submit longer-run forecasts as ‘predicting exactly how and when a regime will change is difficult’. 

We agree, and we reckon this applies to the trade war. The sell-off and relief rally in Chinese stocks after the most recent round of tariffs were imposed at 10% rather than 25% suggests markets were efficient close to the escalation event, but markets are not discounting an overall change in regime to a ‘trade war world’. 

And this helps us to understand the market’s current dichotomy: in the survey we conducted at our seminar most investors expect at least some trade war escalation, and it is the biggest ‘tail risk’ according to the BAML Global Fund Manager Survey. But the S&P500 is approaching 3,000 and USD has hardly moved against G10 currencies. In such a scenario we expect global markets to roll over and USD to rally on risk-aversion: the market is not efficiently discounting the risk of a trade war because it is a regime change rather than a point on a continuous normal distribution. 

The tyranny of the benchmark

An investor benchmarked against her peers, being cautious and insuring against a quite responsible view that (for example) volatility is too low, would have seen underperformance against competitors over the long-term. It is instead more rational to stay close to the pack and be nimble enough to move fast if the pack looks to be changing direction. (This idea was espoused by Gavyn Davies in a 2013 FT Opinion column “Why have markets ignored Washington risk?” about the US fiscal cliff). A rational investor may end up chasing the market during a large move, no matter her view of the prevailing risks.  

In this context “volmageddon” in February and the sharp rise in Italian yields in May make sense. Equity vol has been considered too low for a long time and Italy is regarded as the big euro area risk. But investors did not put a trade on until the event risk was imminent. Although volmageddon didn’t last – the tyranny of the benchmark in action – the persistence of high BTP yields can be explained by the change in behaviour of global fixed income markets as QE fades. 

Trade war regime to come into focus towards year-end

For now, we see two possible market regimes – no-trade-war and trade-war. We think the latter is the most likely outcome (we have discussed what will happen in the former in an earlier Daily Note: “What if we’re wrong”), and we reckon the market is currently discounting a greater chance of the no-trade-war regime than the trade-war regime. The timescale for escalation is longer than we originally thought thanks to Trump’s new year timescale for the next 25%, but the destination is unchanged. 

The trigger point for a sudden shift in asset prices is likely to come towards the end of this year as the 25% escalation becomes fully-discounted and the market’s modal case moves closer to ours. Before then, the G20 meeting at the end of November is an opportunity for Trump and Xi to meet on the sidelines: we expect no compromise made by either party anyway but if they do there may be another pop in risk as the tyranny of the benchmark drags cautious investors back to long positions. 

We remain negative on EMs due to other emerging headwinds-tightening global liquidity, specific domestic idiosyncrasies, Chinese credit tightening, etc .Thus the balance of risk remains  another move to the downside when eventually the rest of the market catches up with our longer term  more pessimistic trade war expectations-ie the US & China are increasingly locked  in an existential geopolitical battle. However medium term the ensuing recalibration of global supply chains is likely to benefit high technology sectors in Japan, Korea & Taiwan & ASEAN manufacturers/component suppliers.

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