Thin world markets rally may run longer, draw new cash

Reuters: After a full throttle rally since January, risky assets may be primed for a further, although less stellar, run higher in the coming months, pulling in new money under pressure to perform.

Average daily trading volumes in equities, bonds and commodities are down 16 per cent this year, reflecting some investors’ hesitation at joining the risk party fuelled by a wave of money printing by major central banks.

Furthermore, investment statistics show that thin volume rallies tend to outlive high volume stampedes.

World stocks, measured by MSCI, are up 10 per cent this year, although the market is merely back at levels seen at the end of last July, before concerns about European sovereign debt and banks combined with fears of another US recession to trigger a major sell-off.

“All the evidence we look at suggests a lot of long-term investors adopting more defensive positions have been hurt by the timing and extent of this rally. Volumes haven’t been huge,” said Philip Saunders, head of investment strategy at Investec.

“Nothing is going to go up in a straight line, but it’s not that investors have suddenly bulled-up and positioning is at extreme. That means it’s a reasonably encouraging environment. There is a lot of pressure for people to deliver returns.”

One possible explanation for the thin volume is that investors may want to avoid a repeat of 2011.

At the start of last year, investors encouraged by the improving global economy went en mass into risky assets, only to see them reverse into the mid-year due to high oil prices, the euro debt crisis and concerns about a US economic slowdown.

Many say the wall of cash – Credit Suisse estimates excess liquidity in the developed world to be $8 trillion – will create asset inflation in the immediate future, before it translates into general inflation problems in the long run.

Missing the party

According to most recent data from the US Securities Industry and Financial Markets Association, average daily trading volumes in broad US bond markets fell 7 per cent on the year to $879 billion to end-January.

Order book turnover on Xetra, Deutsche Borse’s electronic trading platform for equities and bonds, fell 9 per cent on the year in February to 96.4 billion euros.

At Eurex derivatives exchange, an average daily volume in international derivatives fell to 8.7 million contracts in February, down from 10.3 million a year ago, with equity and interest rate derivatives volumes both posting a decline.

Based on US stocks, Treasuries, Bund futures, oil, gold and copper futures, JP Morgan says average daily trading volumes in these asset classes are down almost 16 per cent this year, while US high grade and high yield credit volume is down around 4 per cent, compared with the same period last year.

Nomura, which analysed volumes and performance in European stocks in the past six years, found that low volume rallies such as the current one tend to last longer than the high volume rallies which are prone to reverse.

All the high volume rallies in 2007 and 2008 reversed in the following six months, by falling as much as 35 per cent. Out of the five low-volume rallies since 2006, only one was followed by a reversal.

Coupled with stock correlation which fell sharply from an all-time high in the fourth quarter of 2011, Nomura said stock picking is likely to become a more profitable exercise and flows into active funds relative to passive would pick up. Equity allocation at Deutsche Bank Private Wealth Management, which manages assets for often conservative wealthy clients, now stands at 39 per cent of their portfolios, up from 33 per cent seen during a risk sell-off in August and September.

But it still has 11 per cent in cash, compared with last year’s low of just 3 per cent seen in the March-April period.

“The secular story in the West is still problematic but cyclically it’s in the upturn,” said Kevin Lecocq, chief investment officer at the Deutsche PWM.

“In the short term - that means a couple of years - we’re constructive on the world, although we may not see a turbo charge we’ve just experienced.”

Hedge funds

Hedge funds, whose buying and selling activity often adds to the trading volume, have also been slow to start. The average gearing ratio for hedge funds hit the lowest level since August 2010 of 1.22 in January before ticking up to 1.49 last month, according to Bank of America Merrill Lynch.





Their net exposure to equities stands at 34 per cent, compared with a post-crisis high of 40 and a pre-crisis peak of 56.

Deutsche’s research shows the percentage of hedge funds in the 0-0.25 net equity leverage band remained high, reflecting their cautious outlook.

“There is a lot of pressure, especially on hedge funds, to deliver returns. Investors have had pretty dismal returns. If markets are rising, they expect you to participate in that. You’ve got to make hay while the sun shines,” Saunders said.

“If general market beta is supportive, what’s the point of paying high fees? If you deliver low returns if you have high fees, you have a lot of headwinds.”