Financial markets thrive on news headlines, but like a blow upon a bruise, the repetition of the same topic becomes deadening.
As the shockwaves of December’s market turmoil slowly recede, asset prices are maintaining their recovery mode. Major equity benchmarks sport solid year-to-date gains, led by the Nasdaq Composite and China’s CSI 300, which have both rallied north of 10 per cent. The FTSE All-World index has risen 8 per cent for the year, although the benchmark is 3 per cent lower over the past 52 weeks.
One notable observation is how equity volatility as measured by the Cboe’s Vix index for the S&P 500 and that of Europe’s Stoxx 50 have both retreated to levels seen back in early October when the previous wave of market turmoil began swelling.
A waiting game is under way allowing equities and credit to slowly push forward until the next big shock erupts. What is apparent is how the narratives of US political dysfunction, China-US trade negotiations, Brexit, a slowing global economy and a downgraded earnings outlook for the first half of the year are well established. While asset prices continue to fluctuate on headline risk, the reaction function has become duller. One way to understand the mood across markets is perhaps that familiarity breeds contempt.
Guy Stephens at Rowan Dartington makes the following point:
“It is the unexpected which affects the markets, causing a temporary spike in risk aversion as traders learn how to price in the new risk. Once they have done that, asset values adjust and then the repeating original story becomes old news and fails to register anything like the previous influence.”
As noted on Monday in Market Forces, for all the gloom about a US corporate earnings recession in the first half of the year, investors have decided that salvation beckons through a second-half rebound. That’s the power of central banks for you, led by the US Federal Reserve calling a time out from tightening. The cooing of the doves keeps the animal spirits bubbling and helps explain why risk assets will probably continue a cautious ascent for a while yet.
Here’s George Lagarias at Mazars:
“For all the talk about politics, policies or even the economy, it is wise for investors to remember that their exposure lies in stocks and bonds.”
This raises the big question as to what might break the current spell for markets.
George identifies two conditions:
“One, that an event so great emerges that über-accommodative policies might not solve.”
Prime candidates include a dissolution of the euro, a disorderly Brexit or a complete breakdown of the Chinese economy.
The second condition is far more worrying:
“Or, that the economic damage from failed policies becomes so pronounced that central banks creating wealth out of thin air does not solve it.”
Quick Hits — What’s on the markets radar
Bargain hunting in emerging markets — That’s the call from many investors. The latest monthly survey of portfolio managers by Bank of America Merrill Lynch on Monday has “long” EM as the most crowded trade for the first time. Just as last year’s beaten-up stocks and sectors have led the rebound, the BAML research highlights how opinion towards EMs has swung pretty hard — being “short” EM was number three among the survey’s crowded trades just last month.
BlackRock notes that the difference in yield between EM debt and US investment-grade credit “remain wide in the context of the last few years, even with [EM debt’s] recent outperformance over investment grade and high yield”.
The rally in EM debt is seen extending into the second quarter of this year, bolstered by the Fed’s pause in tightening policy that in turn is seen as containing the US dollar, a key risk factor for EMs.
“A softer or stable USD supports EM currencies and underpins local currency debt returns. A relatively stable USD outlook means no clear advantage in hard over local-currency EMD.”
The hedging barrier — US bond yields remain high relative to Europe and Japan, offering higher fixed-rate returns. But the cost of hedging the currency risk remains a barrier for foreign investors as noted by the Institute of International Finance:
“USD hedging costs have been increasing since late 2015 (in line with the Fed funds rate) and in the past few years have risen so much that they now entirely offset the positive rate differentials.”
As this chart from the IIF shows “on a hedged basis the spread of FX-hedged UST yields over euro area, UK and Japanese 10-year bond yields is now negative”.
Market Forces recently highlighted how big Treasury market dealers and investors have begun to look at how to attract more buyers of US government debt. Gillian Tett's recent column also looked at this topic. Clearly there is concern that as US deficits continue to rise into the next decade, who will step up and buy Treasury paper?
As the Treasury Borrowing Advisory Committee noted recently:
“A significant financing gap over the next 10 years in the context of the potential need for domestic investors to participate more if foreign reserves were to grow at a slower pace.”
The IIF makes a couple of interesting points about foreign demand for US debt:
“The widespread scarcity of government bonds in Japan and the euro area (given large-scale central bank asset purchase programmes) has also helped [to] sustain foreign demand for Treasuries.”
The IIF also observes that with the European Central Bank’s large-scale bond buying having concluded, investors across the region “could repatriate a portion of their overseas assets, prompting Japanese investors to reallocate some assets from the US to the euro area”.
An astute reader questioned the chart that ran on Monday comparing the performance of Boeing to the S&P Industrials sector so far this year. Having gone back to the data provider, there was an input error which is very frustrating. Here’s the correct chart that shows Boeing still leading the sector but not by the margin shown on Monday:
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