Why is Wall Street’s Fear Scale so Low?

After inflation fears shocked investors in the first few months of 2021, markets turned into a different situation: lethargy.

The Vix Index, a measure of expected volatility in the S&P 500 stock index on Wall Street, dwindled to a pandemic-era low of 15.7 on Friday, after rising above 80 during the early stages of the pandemic. A measure of volatility in foreign exchange markets produced by Deutsche Bank also fell to its lowest level since February 2020 last week.

Analysts say the lull period partly reflects the wait-and-see tactics of the Federal Reserve, which is poised to counter a wave of unusually high inflation without removing monetary support, whose withdrawal is likely to destabilize markets. But some investors are becoming concerned that complacency is starting.

“We are feeling increasingly cautious” about calm conditions in stock markets, said Gergeli Majoros, investment committee member at European fund manager Carmeniak. “That means you need to open your eyes wide about what’s coming next.”

In a research note, the investment committee of Swiss bank Credit Suisse also warned of a “high level of investor satisfaction” across the asset markets, suggesting “more downside risks to news flow than usual”.

Global stocks rose to record levels as developed countries’ economies recovered from the coronavirus emergency, boosting corporate earnings expectations. But gains have been subdued in recent weeks, with some investors saying the good news has long been prepared. The FTSE All World measure of developed and emerging market shares is up just over 1.4 percent so far this month.

Core US consumer price inflation hit 5 percent in the 12 months to May, after a 4.2% Increase in April with prices linked to the reopening of the economy and supply chain bottlenecks – such as cars and second-hand goods – rose.

Central banks have traditionally tightened fiscal conditions to combat rising prices. But the Federal Reserve, which meets this week, has stressed that the wave of inflation is temporary. It has succeeded in convincing many investors of that as well.

“Markets are in agreement, at least for now, with [Fed chair Jay] Margaret Vetrano, portfolio manager at ClearBridge Investments, said Powell says the inflation we’re seeing is ephemeral.

A Bank of America survey of 207 global fund managers responsible for $645 billion in client assets this week found that more than seven in ten believe post-pandemic inflation will be temporary. Many have also already scaled back their bond holdings in anticipation of the Federal Reserve easing support for this market in the future, bringing the share of bonds in portfolios to a three-year low. Investors said the negative attitude toward bonds was another factor that convinced asset managers to stick with stocks.

“Stocks should continue to rise this year but not at the same rate as when activity was accelerating more rapidly earlier in the year,” said Caroline Simmons, chief UK investment officer at UBS’s wealth management arm.

Historical data indicates that low volatility is not always a signal to sell stocks. Figures compiled by Schroders analyst Duncan Lamont showed that since 1991, buying the S&P 500 on a day when the Vix was between 15 and 16 years would yield a total return of 14.6 percent in the following 12 months.

But the sense of calm in the markets suggests complacency could be shattered, analysts say, if inflation explodes before the Fed’s expectations.

“If persistent inflation means higher costs of inputs that companies cannot pass on… because food and energy costs for households are also higher which really affects profitability,” said Vitrano of ClearBridge, “the stock markets have been going in the water,” she said. Because it’s too early to make a call about this.”

Currency markets have also been paralyzed by the prospect of the Federal Reserve keeping financial conditions loose for longer than traders initially anticipated.

FTSE All-World's % change bar chart shows stock market gains are pulling back as investors believe recovery has peaked

The dollar index, which measures the strength of the US dollar against the currencies of trading partners, is up less than 1 percent this year, after strengthening in the first quarter and giving up most of its gains since then.

‘The main narrative of the deadlock in [currencies] “It’s very straightforward, and underscores the confrontation between the irresistible force of deflation in the US and the unwavering objective of the impatient Federal Reserve,” said Paul Meghese, head of global FX strategy at JPMorgan.

The Conference Board expects that US economic output will rise at an annual rate of 9 percent in the second quarter of this year, and decline thereafter. Corporate earnings are expected to follow a similar path.

Analysts expect earnings for S&P 500 companies to rise overall by 35 percent this year, declining to 12 percent in 2022, according to FactSet. At the Stoxx Europe 600, earnings are expected to increase 51 percent this year and 14 percent in 2022.

“The only direction the Fed and other central banks can take now is to reduce easing, and that could cause correlation shocks,” said Olivier Marciot, director of cross-asset investment at Unigestion, buoyed by higher bond yields. “The markets are in a wait-and-see mode, it’s not about what happens next but about when… If you move too early in the game, you’re going to take a beating.”

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