Deleveraging or Heralding a Recession?

What You Need to Know 

We gathered a group of AB’s senior investors across asset classes last week to reflect on the recent bout of market volatility and what it means for future positioning.

From a macro perspective, many indicators (labor data, liquidity, credit dynamics) suggest that this was primarily a deleveraging event after a period of abnormally low volatility—not an indication of a change in the economic paradigm that implies recession. Set against this, evidence at the company level hints at areas of weakness for the consumer from a bottom-up perspective. The evolution of these two narratives is key for market direction.

In the month prior to the selloff, we made the call that the equity market would end the year higher but that investors should expect significantly higher volatility. We think that is still the right call. If anything, it was the low level of volatility that looked amiss rather than the market level.

On balance, we think it would be wrong to be too bearish, but we outline what diversifiers for equity risk might be appropriate given this backdrop and the expectation that volatility levels remain higher than they were in the first half of the year.

We recently gathered a group of AB’s senior investors across asset classes, including portfolio managers, traders, economists and strategists. We reflected on the recent bout of market volatility, the ensuing rotation and what this means for portfolio positioning. With such a broad group, there is inevitably a diverse set of opinions reflecting a range of viewpoints, be it from the perspective of liquidity, corporate fundamentals, credit dynamics or economic data.

Going into this recent downturn and volatility spike, the juxtaposition of high valuations and low volatility was an uneasy one. High valuations do not necessarily lead to sustained selloffs, but they do tend to beget volatility, because there is less ability to absorb bad news or a change in the narrative. We heard comments from clients in recent months reflecting a fear of complacency in low implied volatility. But implied volatility was actually not that low when compared to realized volatility, which was relatively lower still. For example, S&P realized volatility had declined to levels last seen in January 2020 a long period of low levels that was unlikely to persist. Our published view prior to the selloff expected the market to be slightly higher at year-end, but with volatility significantly up. That view remains the same.

The parallel news flow from Japan has also clearly been key for market dynamics over the last two weeks. Rates in Japan were not always going to be at zero with no volatility. The unwinding of yen carry trades has been painful and spurred significant repositioning. One can debate how much of that positioning has been unwound, but much of the tactical need to unwind appears behind us. We note in passing that there is a broader strategic point for markets to digest at some point in future. The Bank of Japan’s response to the rapid market repricing fits a pattern that central banks may be somewhat less independent in the post quantitative easing (QE) world, a lesson we think investors should take on board as a strategic point. But that is a narrative for another day.

Moving from macro fundamentals to more technical aspects of the selloff, there was “froth” in investor sentiment prior to the sell off, such as in the strong flows into equities and out of money market funds. Events of recent weeks have caused significant deleveraging that calms some of that “froth.” We think that the deleveraging represents the unwinding of positions that have built up in a near-monotonic market with remarkably low equity volatility.