In this week’s market update: there’s a spike in volatility as big derivatives bets on tech stocks are uncovered; Brexit is in the spotlight as the UK plays hardball and the pound takes a beating; and Goldman Sachs spells out why the bull market could have further to run.
The summer lull came to an end this week as traders returned to their desks and market volatility spiked higher.
The action was mainly in the tech stocks which have driven the market higher since March. Last week the music stopped, and investors scrambled for a safe seat as the Nasdaq index fell sharply on Thursday and Friday.
The finger is being pointed at Japanese investment company Softbank, which the FT says has been betting big on a continued rise in the big US tech stocks like Apple, Amazon and Alphabet.
The company has been trading like a hedge fund as it has apparently piled into so-called call options, derivatives that rise in value if a share price rises above a pre-determined level. These can be used to protect a portfolio but also as speculative plays by more aggressive investors.
There has been talk over the summer of what’s been called a Nasdaq Whale, an investor that has placed such big bets on rising technology share prices that the rally in these stocks has become self-fulfilling.
Retail investors, taking advantage of cheap or free share dealing in America, have further fuelled the technology boom.
The unusual nature of the options buying recently has been illustrated by a widening gap between call options, which bet on rising prices, and put options, which pay out if prices fall. The ratio of calls to puts in Apple shares, for example, is at its highest for 10 years.
The danger of this kind of derivatives trading is that it can lead to a fragile feedback loop in which stocks can be pushed to dangerous valuation extremes.
When trades become this crowded, they can suddenly switch direction, which is what investors experienced at the end of last week. On Wednesday evening the Nasdaq index was 78% higher than its low point in March. By Friday that had fallen to 62%.
The scale of the rally in tech stocks has been shown by some eye-watering statistics recently. Apple is now estimated to be more valuable than all the shares in the FTSE 100, for example, and all the stocks in the Russell 2000 index of smaller US shares. Just the five biggest US shares, all tech stocks, now account for nearly a quarter of the value of the S&P 500 index.
Despite the fall in share prices last week, some market watchers remain positive on the outlook. Goldman Sachs, one of the bull market’s principal cheer-leaders, recently set out 10 reasons why the rally still has room to run.
These include the fact that we are in the first phase of a new investment cycle, following a deep recession. This ‘hope’ phase that starts a new cycle for the market is often the strongest, which explains why shares have rallied so fast since the spring.
Goldman is also bullish on the prospect of a vaccine for Covid-19 being found sooner than expected. Its economists have also recently revised their growth forecasts higher. It thinks that central bank and government policy will remain supportive.
Other reasons to be positive include the likely continuation of very low interest rates, which makes investors more inclined to invest in risky assets like shares. Equities are also seen as a good hedge against inflation, which many experts think may be set for a return. Low interest rates also mean that shares are relatively cheap compared with bonds as in many cases they offer a higher yield than the fixed income alternative.
Finally, Goldman remains a believer in the digital revolution which continues to transform the economy, and which has helped technology stocks become the biggest beneficiaries of the pandemic.
For this positive view to be proved correct, investors will need to overcome a long list of worries as the summer rolls over into autumn. The list is longer than ever this year. Top of it is the upcoming US Presidential election, which is in the headlines again this week as talk of Russian interference returns to muddy the waters of the world’s highest profile democratic vote.
Opinion polls still point to a likely victory for Joe Biden, but no-one is ruling out a win for the incumbent President after Donald Trump defied the sceptics four years ago.
Also high up the list of concerns on this side of the Atlantic is the prospect of a no-deal Brexit at the end of the year. The likelihood of this has risen this week after the UK Government apparently threw down the gauntlet to the EU with the threat that Britain could re-write the withdrawal agreement it agreed last year.
The prospect of the UK backsliding on its promises has shocked many in diplomatic circles and threatens to destabilise talks which are due to resume this week. In particular, the Government appears to be playing to the hard Brexiteers who continue to dislike the sections of the agreement which govern trade between Northern Ireland and the rest of the UK in a post-Brexit world.
The Prime Minister, Boris Johnson, has attempted to draw another line in the sand by warning Brussels that Britain will walk away from talks if nothing is decided by the middle of October.
Although no-one is quite sure whether this is anything more than a simple negotiating ploy, currency investors have taken no chances this week, pushing the pound 1% lower against the dollar and reversing some of the recent strength of sterling against what has been a weak US currency. The pound had gained 4% against the dollar since June.
As is often the case, a weak pound has helped push the FTSE 100 higher. It rose more than 2% yesterday as the overseas earnings of its international constituents were boosted by sterling’s retreat.
Investors are also betting that markets will become more volatile as the end-December deadline approaches. The price of derivatives contracts which pay out if exchange rates become more volatile surged this week, with the three-month contract at its highest level since May.
In other markets, commodities have also retreated after a strong run. Copper, in particular, which is seen as a bellwether of economic activity has fallen back after rising by 45% since March. Having reached a two-year high last week of $6,830 a tonne, the price slipped to $6,775 by the end of the week.
As with shares, the bulls remain convinced there is further to go. They point to rising demand in China, the world’s biggest buyer of the metal, as manufacturing activity rises at its fastest rate since 2011. Stockpiles are dwindling, hitting a 15-year low on the London Metal Exchange.
The oil price has also given back some of its recent gains. The price of crude dropped to its lowest level in more than a month after Saudi Aramco, the kingdom’s giant state-owned producer, said at the weekend that it would cut prices on its shipments to Asia. Brent fell 1.7% on the news to just under $42 a barrel.
There is once again little to watch out for on the corporate front this week. Just a handful of company results here in the UK, including Morrisons the supermarket chain on Thursday. On the economic front, the key focus will be inflation data later this week in the US.
Attention has shifted to the outlook for inflation in the wake of the recent Jackson Hole summit of central bankers, at which the Federal Reserve set out a new framework for monetary policy that will explicitly allow an overshoot of inflation above its 2% target in order to make up for long periods of undershooting in the past.
The new approach puts much greater emphasis on the Fed’s obligation to promote maximum employment, one of its three objectives alongside stable prices and moderate long-term interest rates. In the past, most famously under 1980s Fed chair Paul Volcker, the focus was on price stability even if that meant sacrificing jobs. Now it looks as if the Fed is looking to boost the jobs market even if that means higher prices.
In the short-term this is probably a sensible response to the Covid-19 pandemic. In the longer run it remains to be seen how relaxed investors will be if inflation, the scourge of the 1970s, returns and hits returns.