The recent stock market tantrum reveals the uncertainty surrounding the likely policy path of the Powell Fed, writes Cam Hui from the Pennock Idea Hub. 1) How will the Powell Fed’s reaction function to inflation differ from the Yellen Fed? The risks of a policy mistake are high during the current late cycle expansion phase of the economy, says Hui. Should the Fed adhere to overly strict rules-based models of monetary policy, They risk tightening too much or too quickly and send the economy into a tailspin. Allow the economy to run a little hot based on the belief of a symmetrical 2% inflation target, and inflation could get out of hand. The Fed would consequently have to step in with a series of staccato rate hikes that guarantee a recession. 2) What about the third unspoken mandate of financial stability? Will there be a “Powell put” that rescues the stock market should it run into trouble? From this report Hui concludes that notwithstanding any fears over a possible trade war, the combination of short-term positive fundamental momentum, washed out intermediate-term sentiment and probable rising hawkishness from the Fed paint a scenario of a short-term equity market rally, followed by heightened downside risk later this year.
Despite a traumatic couple of weeks for financial markets, Gavekal Research’s Nick Andrews and Cedric Gemehl reiterate their longstanding recommendation that the best way to play the cyclical upturn in the eurozone is to be overweight mid-caps exposed to domestic demand. The eurozone is graduating from recovery to expansion pointing to continued strong growth, likely euro appreciation, expansion in corporate earnings and a boost for European equities. Inflation will be a more prominent theme this year but within ECB target. They give greater weight to mid-caps, which are more in tune with Europe’s domestic cycle than large caps, recommend being selectively overweight financials (well placed to benefit from the next phase of the cycle), overweight the capital goods sectors excluding defence and aerospace, and would add positions in the luxury good sector. Sectors to avoid are telecommunications and consumer staples. Click below to request trial access to view the piece entitled: ‘’Five Ways to Play European Equities.’’
Callum Thomas, from Top Down Charts, produces a comprehensive weekly macro report, which consists of charts and data driven primary research with a global macro and multi-asset scope. In last week’s edition, published on Friday, he looked across the asset classes in the wake of last week’s volatility to see whether some of recent drivers of markets have been shaken out, and what investors need to be looking out for. Firstly looking at global equity relativities, Top Down’s analysis shows that the global equity market correction failed to shake some of the extremes observed in the major styles/factors, these extremes remain on the risk radar. As for high-yield (which was surprisingly little changed amid all the volatility) Top Down see a couple of early warning indicators stirring in the HY credit space, and so as a minimum it warrants closer scrutiny of an already risky looking asset class. Thomas also look at the Equity Risk Premium, which has been shrinking and highlights the changing relative risk/reward outlook as we move later in the cycle. Turning to USTs, Top Down’s indicators suggest bond market sentiment, technicals, and valuations have shifted but could easily move further, particularly given the trends in monetary policy, this current levels are not yet the time to fade. Finally on gold, rising real yields and the move from QE to QT have put gold at significant downside risk as it comes up against key resistance levels. Click below to request trial access to read the full report or view other samples from Top Down Charts.
TS Lombard’s EM team have released a useful report that breaks down growth drivers of each of the major EMs, into a grid that can be used for objective and comparative analysis. The factors they look at for each market comprise: short term factors such as consumption and investment; long term growth drivers from supply side reform and long-term growth drivers from stability and economic outlook. Using this matrix, they conclude that the most attractive equity markets are China, Russia, Thailand and South Africa. India is the least attractive market, followed by Turkey, Philippines and Indonesia, while Brazil and Mexico are essentially flat. EM equities as a whole are equally attractive as EM credit, while local rates and currencies are less attractive.
JPMorgan released an EM outlook and strategy report for 2018 recently where they argued that the 9% fall in the MSCI EM index last week presents a buying opportunity for investors. EM fundamentals still present a compelling picture. In particular, they cite upward revisions to global growth, a weaker US dollar and rising commodity prices. On the technical side, they make some interesting arguments. They found that on average EM equities have returned 19% in the year following a 15% correction. The post-correction upside during the EM bull market of 2002-2006 was 48% (when macro conditions were similar to today). They also note a strong correlation between flows into EM fixed income and EM equities. With EM FI flows projected to be $80 billion in 2018, they expect a $70 billion of flows into EM equities, providing strong support to the asset class. They do acknowledge risks however. These include: geopolitics, a dollar rebound, investor complacency and over tightening in Chinese regulatory and macro policy. JPM Clients can view the full piece entitled: ‘’Emerging Markets Outlook and Strategy; Maintan EM Exposure, but Hedge DM Rates Risk.’’
Cross Border Capital are experts in analysing global liquidity across the public and private sectors. In this note They say that the latest madness in markets centres less on the price of ‘risk’ assets and more on the valuation of ‘safe’ assets. For a couple of months now, CBC have argued that US safe assets – the US dollar and US Treasuries – have been 10-20% expensive. As they adjust, more traditional risk assets will similarly adjust downwards in price, much like previously occurred in 1987 and 1994, CBC say in this report. The obvious question is: Whether this will be an orderly exit or a Crash?
The answer largely depends on capital flows, says CBC. Whereas the market is focussed more on the negative effects of perhaps US$450 billion of prospective ‘reverse QE’ by Central Banks in 2018, CBC’s worry centres on the odds that US$3 trillion of cross- border ‘flight’ capital would exit even quicker. With the US dollar already down sharply in 2018 and US 10-year bonds testing 3% yields, much damage has already been taken, the report says. However, two continuing factors remain of concern: (1) Treasury term premia – the key valuation metric for bonds – still look too low, and (2) major Forex reserve managers are pondering their long-term commitment to the US dollar amidst a growing interest in the Chinese Yuan. This shift is unpredictable, but it does seem inevitable, conclude CBC. They add that investors should watch the success of the planned Shanghai oil futures contract in March as a bellwether. This note can be
The newsletter, Epsilon Theory, authored by Ben Hunt, chief risk officer of Houston-based asset manager, Salient Partners, examines the markets through the lenseshttps of game theory, history, and behavioural analysis. Salient also happen to own the index that tracks the risk parity. So they know a thing or too about it, and in this note Hunt seeks to address a lot of market misinformation about risk parity. For him, it’s a classic example of the ‘’Gell-Mann paradox. This relates to how an expert reacts to information they read where they know exactly what the facts are, and where – in their view – it is not just that the facts are wrong but it is also wrong in interpretation, impact, motivation … everything. Yet as soon as the said expert reads an article on something he or she knows nothing about, that person might go go, ‘hmm, that’s interesting.’ It’s as if they’ve been struck by amnesia. This occurred to Hunt last week when he read an array of pieces that suggested risk parity was at the heart of the sell off in risk assets. These stories were completely wrong, and he provides references to a piece from AQR, that he cites an example of something closer to the truth. Also check out WRGuinn on twitter, which is also quite useful. Last weeks Epsilon Theory captures what Hunt does think is responsible for what’s going on in February (and the months ahead), Click here to read the full note.
Ewen Stewart at Walbrook Economics is an expert on BREXIT analysis and has a much more sanguine than the consensus so his work is worth taking notice of. In this report, published this week, he makes a strong case that even if there is no Single Market access nor passporting for the UK financial services sector, there will be little overall impact on the overall sector, apart from a few pockets of activity. He presents four possible choices the UK faces, but concludes that in the end a deal will be reached, that will effectively enshrine the status quo. It will be made politically acceptable by time dating it post the transition period. The report goes on to say that the UK’s share of the European financial services market is huge and cannot be replicated in any other financial centre. So even if there is no deal and the UK has to trade with Europe under the WTO, it will still dominate. He concurs with the figure of up to 10,000 job losses being likely and points out that this is only 3% of the total employment in high-end UK financial services. Click below to request trial access to read this full report.
Alot was written and said last week about the breakdown in the inverse correlation between bonds and equities, which struck fear into the markets that there was no safe place to park money in the event of an equity market rout, aside from cash that is. Of course it’s all the fault of Risk Parity (Isn’t it?). we thought we’d flag up the work that’s BAML have done in this area the easily pre dates last week. In a piece published on Dec 14 last year ”Moving on from the safe house” BAML analysts predicted that the conventional wisdom about the ‘safe haven’ and diversification attractiveness of USTs will likely be challenged in 2018. While no mention was made of ”short vol unwinds,” BAML argued that the possible increase in deposit betas (given hikes and Fed balance sheet run-off) will make cash a competitor to US Treasuries. Indeed, history also suggested equity corrections that happen in a high growth and high inflation environments are not hedged by Treasuries. This is what seems to be playing out now, BAML writes in last Friday’s Global Rates Weekly. BAML clients can read the full piece on BAML Mercury.
If you thought the sell off in Chinese equities last week was simply a reaction to the global rout in equities after the volatility spike, then think again, writes Gavekal Dragonomics. In fact Chinese equities did worse. But why? To be sure the global sell-off was an aggravating factor in the mainland’s market meltdown, it was not the trigger, Gavekal say in the report. Instead the slide in Chinese stocks owed more to heightened local investor anxiety over Beijing’s new financial regulations, exacerbated by a crackdown on leveraged buying. When the regulatory dust settles, which is likely after the coming week’s Lunar New Year holiday, benign fundamentals and attractive valuations should come to the fore again, with Chinese stocks resuming their upward march, the report concludes. Click below to request trial access to read this report or to request samples.