Share market volatility rising after hawkish Fed statement

The US Federal Reserve has sparked a new round of market volatility. Picture: AFP

Volatility has picked up markedly since the surprisingly hawkish June Fed statement last week.

So far there has been a sharp fall and an equally sharp rise in global equities.

Swings in global bond yields have been equally sharp, while the US dollar has seen more of a sustained rise against the major currencies and commodities since the Fed meeting.

Of course, some Fed officials argue against the significantly higher inflation and faster than previously forecast pace of interest rates rises projected by a ­majority of Fed members, particularly after sharp falls in share prices like those seen on Friday in the US and on Monday in Australia.

New York Fed president John Williams did that on Monday – predictably, since he’s a known dove.

Wednesday’s testimony from Fed chairman Jerome Powell at the House Select Subcommittee on the Coronavirus Crisis will be watched for his thoughts on the outlook for inflation, and the emergency interest rate settings and gigantic asset purchases behind the “rally in everything” in the past year.

His written remarks beforehand focused on his view that a sharp rise in inflation this year would be transitory, but he has already said the Fed plans to talk about tapering in upcoming meetings.

Indeed, it’s likely to be a case of two steps backwards and one step forward in terms of Fed ­rhetoric.

Having delivered the message that it’s time to devise a plan to taper its asset purchases so that it can lessen that stimulus and be ready to start normalising interest rates if inflation stays above its target this year and next, as most of its members now expect, Fed officials will be aiming to avoid a sudden tightening of financial conditions caused by negative sentiment in the financial ­markets.

But monetary policy stimulus globally seems to have reached a turning point which should tend to weigh on valuations. Higher volatility is often associated with turning points.

While the VIX index of volatility on S&P 500 futures peaked at 21.82 per cent on Monday, above the long-term average of 19.5 per cent, it’s not hard to see a period of above-average volatility amid sustained “temporary” impacts from inflation, Fed tapering and more worrisome strains of Covid-19.

Higher volatility would lessen the exposure to shares that multi-asset investors are prepared to have. The high bond-equity correlation (until last week) could also restrain balanced funds.

In the very short term, a consistent dovish message from Powell could easily push the US and Australian markets up to new record highs. Such levels were less than 1 per cent away after strong rebounds at the start of the week. Moreover, the S&P 500 has consistently made new records after regaining its 50-day moving average after brief dips below it since the US election, as it did on Monday.

But such a “relief rally” would be a gift for those looking to lighten their exposures, particularly to the cyclical sectors some say are now the most vulnerable after an exceptionally strong performance relative to defensive and growth stocks this year.

For those looking to take profits on exceptionally strong performers like the banks and miners and carry forward losses on “dogs” like AGL and Origin before the financial year ends next Wednesday, an additional relief rally in shares could be a good chance to do so.

While the outlook for the overall market is harder to predict, cyclicals should be more vulnerable to the combination of slowing economic growth and lessening monetary policy stimulus globally.

According to State Street Global Advisors, investors’ exposure to cyclical shares may be similar to the extreme in their defensive exposure experienced a year ago.

Based on SSGA’s proprietary “sentiment” indicator – which includes measures of companies’ expected financial trends as well as indirect measures taken from the operating environment and a range of investors perspectives designed to capture the expected outlook for companies – the “top 10” are BlueScope Steel, Boral, Reliance Worldwide, OZ Minerals, CBA, ANZ, Mineral Resources, Westpac, ALS Limited and Charter Hall.

“Defensive companies are nowhere to be found in this list of hot stocks – a marked contrast to 12 months ago when defensive businesses had some of the highest sentiment scores,” said Bruce Apted, SSGA’s head of portfolio management.

“Today cyclical and financial companies dominate the highest sentiment scores.”

He found that the top “sentiment” stocks lined up with the list of those companies getting the most investor attention or what is “hot right now”.

But he warned that relying solely on positive sentiment as a guide to what stocks to own could be “hazardous, especially when it is at an extreme like it is now”.

Moreover, the recent sentiment extreme had “many similarities to the post-GFC sentiment extreme and should provide some caution to investors in cyclical stocks”.

In his view, the “sentiment tilt” to cyclicals seems to have peaked in March.

“Since the end of March 2021, we have started to see sentiment move out of cyclicals and towards more defensive businesses,” Apted said. “If this move continues to normalise it should bode well for defensive businesses compared to cyclical businesses.”