Waiting for a receding tide to turn

A watershed week for financial markets is ending as it began: with the tide still heading out. A 10-year Treasury yield plumbing the depths of 1.12 per cent along with further selling in equities and credit illustrates how “fear” has shunted “greed”; aside.

The tone and extent of the selling pressure seen over the past week across equities and credit is not hard to understand given the high valuations and how crowded some parts of the markets were. Exhibit A in this regard is how the winners of the past year in US equities — growth and quality companies — have been among the hardest hit of late. Here’s an update on how various markets have performed during the current quarter from their recent peaks in price. 

Greed, known as Fear Of Missing Out, worked well for some time but “fomo”; masked how many companies were lagging against a backdrop of slowing trade growth, intense competition from new technology, and low pricing power that was showing up via margin compression. These macro trends explain the slumbering government bond yields during the past decade, which in turn encouraged the search for higher returns through credit and stocks with growth and quality characteristics.

Aggressive central bank policies have also encouraged investors to venture further along the risk spectrum. Little wonder investors are looking for signs of greater central bank liquidity support, a policy response that would do the job of mitigating economic weakness while also boosting asset prices. But whether this playbook works, given the unique challenge posed by demand-and-supply constraints across economic activity, is hard to gauge at this juncture.

However, given the importance of asset prices for the broader economy, the playbook will no doubt be dusted off. A 50 basis point rate cut from the Federal Reserve is very much in play if the current Wall Street correction gathers pace and approaches the 20 per cent drop seen in late-2018. Rising credit risk premiums (with leveraged loans looking vulnerable too) are another aspect of tightening financial conditions. Sustained large credit fund outflows will eventually prompt an easing response from central banks.

In that regard James Bullard, president of the St Louis Fed, downplayed immediate action on Friday:

“Further policy rate cuts are a possibility if a global pandemic actually develops with health effects approaching the scale of ordinary influenza, but this is not the baseline case at this time.”

But that was followed by a Fed statement late on Friday that stated that policymakers stood ready “to act as appropriate to support the economy”. That did help Wall Street trim some of its losses before the week ended (it remains the worst week for the S&P 500 since the financial crisis), and what certainly sticks out at the moment is the lack of a definitive rebound.

Based on past market routs, the pace of this week’s slide in equities (circa 14 per cent for Europe and near-15 per cent for Wall Street on Friday) and a 10-year Treasury yield motoring sharply lower from about 1.50 per cent a week ago, suggests a near-term bottom is not that far away — or at least it’s getting closer.

There were some signs of that on Wall Street today, with semiconductor shares turning positive and closing up 2.2 per cent. Other big tech names, such as Microsoft and Apple, bounced off the canvas during trading with mixed results. Microsoft ultimately rose 2.4 per cent, whereas Apple was unable to sustain its earlier rebound and closed a touch lower. Apple’s opening drop of 6.3 per cent on Friday briefly pushed its losses beyond 20 per cent from this month’s record peak before the share price recovered ground. 

An air of caution naturally remains given the likelihood of greater economic disruption as infections rise and more restrictions are imposed on people and businesses. The Geneva Motor Show, which had been due to start on Monday, has been cancelled following a ban from Swiss authorities on events attended by more than 1,000 people. Expect similar moves elsewhere if the coronavirus expands its global footprint. 

Seema Shah, chief strategist at Principal Global Investors, questions buying the dip in risk assets for now: 

“In the coming weeks news-flow is likely to remain decidedly panicky and, as a result, markets may not have yet found their floor despite having hit correction territory. Further drops are possible so investors should resist the urge to buy the dip.”

Over at Absolute Strategy Research, Ian Harnett and David Bowers believe risk assets have reached a “critical point” whereby “a failure to rally here could signal major risks”.

This comes down to “whether lower bond yields tempt equity investors back into the markets” or do investors cut back equity exposure as they suspect a bigger hit for the global economy beckons. The sharp downgrades in corporate earnings growth for 2020 by bank analysts this week will only encourage the exit from equities and credit. 

ASR conclude:

“If a meaningful rally and rotation back into risk assets fails to materialise in the coming days this will, potentially, signal a much darker narrative. In such a scenario, investors may begin to be concerned that further supply chain dislocation, at a time when our global Nowcast models are already close to recession levels, will result in larger scale layoffs and labour income weakness with subsequent knock-on effects for credit markets and equities vs bonds.”

Also playing a critical role during the next few weeks is how investors and funds adjust their holdings in risk-management terms. That will probably see plenty of investors selling into any recovery rallies in equities and credit in order to rebalance their portfolios. Given the speed of the market shifts, there are likely to be an array of “trapped” positions that still require unwinding. 

Mark Dowding at BlueBay Asset Management notes:

“For the time being, fear has replaced greed and should virus fear continue to grow in the next few weeks, it may be difficult to project how this will turn much better in the short term — even if a normalisation of activity in China should add some reassurance.”

The US equity strategy team at Morgan Stanley warns that a bigger positioning shake-out remains on the table:

“Despite selling from systematic strategies this week, we believe discretionary investors and a retail base that recently entered the market in some size pose risk of selling and that risk is concentrated in certain parts of the market like technology, growth stocks, and pockets of consumer discretionary. If risk appetite turns more broadly along with economic data, de-grossing, particularly in these crowded areas, poses index and portfolio-level risk for a large swath of investors.”

In that context, a true buying opportunity does not appear close at hand. Indeed, risk management-based selling will probably push valuations too far south in the next few weeks, a process that will eventually provide attractive buying opportunities. Or, as Mark, says:

“The current environment can be characterised as one which, we believe, will ultimately lead to alpha opportunities as the dust settles.”

And at some point when the tide does turn, Chris Iggo at Axa Investment Managers reminds us of a very important long-term point:

“Bonds are now super expensive and equities much cheaper. Another 10% or so on equities would create one of those once-in-a-every-few years types of buying opportunities.”

Quick Hits — What’s on the markets radar

Losing that haven feeling on Friday was gold, with the price sliding more than 4 per cent in earlier trading. Some believe the pullback reflects investors selling the metal in order to meet margin calls in equities and other “underwater” positions. It still leaves gold with gains of 4 per cent for the year, so ahead of plenty of other asset classes. 

Brent crude oil neared a floor at $50 a barrel, last seen in late-2018 and not since the summer of 2017 has the price been under that level. Along with other big falls for key commodity prices, this helps reinforce expectations of weaker growth and disinflationary pressure. Long-term US inflation expectations have slid below 1.5 per cent, towards the lows seen in mid-2016. 

One sign that a rebound in equities looms is how measures of implied volatility for the S&P 500 are much higher for one month versus that in six months’ time. This inversion, says Longview Economics, “highlights markets that are fearfully priced” and its analysts add “this indicator is now at its most extreme since the January 2018 sell-off”

Steepness of Vix curve (6 months less 1 month) vs S&P 500

Source: Economy - ft.com