Balance-sheet reduction: implications for equities, volatility and bonds

Much attention has been brought to the low levels of volatility, either realised or implied, within financial markets currently. Within this report, we address whether this stability is likely to persist and assess the impact that central bank balance sheet reduction may have on markets.

Volatility remains abnormally low. Is this a cause for concern? In our view, low volatility has some fundamental underpinnings: low GDP growth and inflation volatility; low default rates; and the low real Fed Funds rate. The latter, though, is now consistent with a modest pick-up in volatility. Previous instances of very low volatility have not necessarily preceded a significant sell-off. There have only been two occasions since 1964 when the S&P 500 has not corrected by more than 5% over 14 months (as is the case now), and six months later the market was up 1.0% and 7.6%, respectively. We believe that low volatility, by boosting the relative risk-adjusted return of equities, could encourage an asset allocation shift towards equities (with nearly $1trn of risk parity and CTA assets).

Many indicators we look at are not consistent with complacency. Global risk appetite, equity sector risk appetite, the price relative of non-financial cyclicals against its six-month moving average and our aggregate tactical indicator of markets are all at neutral, or justified, levels. This normally does not last. The risk-on trade would be supported by: i) the equity risk premium remaining too high (by around two percentage points in the US and Europe, on our models); and ii) bond yields being too low (the market underestimates the chance of a December rate hike, global PMI new orders are still at 3½ year highs, lead indicators of US employment/capex imply a recovery, while the 10-year term premium remains negative and speculative positioning near 3-year highs).

Will the Fed’s balance-sheet normalisation disrupt markets? Janet Yellen has expressed hope that the reduction in the size of the Fed’s balance sheet would be “like watching paint dry”, and we would be inclined to agree. The Fed’s ownership share of the Treasury market has already declined by 3p.p. since 2014, and this was accompanied by a decline in US yields, not a rise. Given ongoing purchases by the BoJ and the ECB, global central bank balance sheets are unlikely to contract in aggregate until Q4 2018. Over the next 12 months, the Fed’s balance sheet appears set to decline by c.$300bn, compared to an $11trn increase in G4 central bank balance sheets since 2009. Financial conditions remain very loose, and any rise in yields accompanying balance-sheet normalisation is unlikely to be large enough to significantly alter this. Global excess liquidity growth (M1 less nominal GDP) is yet to signal multiple contraction. Beyond this, many of the fundamentals supporting equities remain in place. The key threat, to our mind, is not balance-sheet reduction, but rather if the FOMC changes its emphasis to ignore low inflation and instead focus on ‘elevated’ asset prices. Other risks are US wage growth, a widening of credit spreads or a sharper-than-expected slowdown in Chinese growth.