Caught Between Uncertainty And Easy Money

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Russ Koesterich, CFA
Summary

Stock prices have spent August caught in a tug-of-war. On one side: increasingly accommodative central banks and easier financial conditions. On the other side of the rope: rising economic uncertainty driven by a quickly deteriorating trade situation.

So far, the pullback in equity markets is similar in size and magnitude to May.

In assessing why this summer's correction has been far milder than last fall's, it is useful to look to two factors: policy uncertainty and financial conditions.

Easier financial conditions have lessened the blow of greater political uncertainty. Can that continue?

Stock prices have spent August caught in a tug-of-war. On one side: increasingly accommodative central banks and easier financial conditions. On the other side of the rope: rising economic uncertainty driven by a quickly deteriorating trade situation. As I write this in late August, uncertainty is winning this month. That said, this is not 2018. Accommodative policy is helping to cushion both the economy and stock market.

In late July I highlighted the role financial conditions play in equity market volatility. As discussed, the market is vulnerable when investors have no reasonable way to assess future policy. However, while stocks are no longer "tweet proof," easier money is helping dampen the reaction.

So far, the pullback in equity markets is similar in size and magnitude to May. In both instances, equity market volatility, as measured by the VIX Index, peaked at around 25. The magnitude of the draw-down has also echoed May's: Global stocks are down roughly 6% from their peak, just about the size of the May correction.

In assessing why this summer's correction has been far milder than last fall's, it is useful to look to two factors: policy uncertainty and financial conditions. Starting with the former, there is no doubt that policy uncertainty is rising. In fact, BlackRock's proprietary Geopolitical Risk Dashboard suggests that policy and political risks are the highest in years (see chart below).

But while policy and politics are increasingly volatile, investors typically pay less attention to these factors than the cost of money. Historically, there has only been a loose relationship between volatility and policy uncertainty. Higher levels of volatility are associated with higher levels of uncertainty, but the relationship is weak, with policy explaining only 16% of the variation in volatility. And while it may seem that markets are now responding lock-step to every tweet, the relationship has become weaker in the post-crisis era.

In contrast, since 2010, monetary and broader financial conditions have dominated other considerations. A simple two-factor model, based on high yield spreads and the St. Louis Fed's Financial Stress Index, has explained approximately 80% of the variation in the VIX. Based on current financial conditions, the model is suggesting volatility appears about 50% too high.

Bottom Line

None of the above suggests that uncertainty is not a threat. Eventually, erratic policy and heightened uncertainty undermine confidence in a way that affects the real economy. This could happen in a number of ways: a safe-haven bid that drives up the dollar and credit spreads and/or a sharp decline in business confidence that begins to impact spending and hiring plans.

Should either start to occur, the risk is no longer just investor mood swings but a more pernicious slowdown and market correction. In the absence of those developments, while easy money cannot eliminate uncertainty it can mitigate the effects.

This post originally appeared on the BlackRock Blog.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editor