At Business Of Finance, we try to be pragmatic on our views and approaches to the financial markets. The whacky ideas of yesteryear calling for a "doom and gloom" type of environment have never seen the light of reality; what they have however done is fostered sentiments of fear and the urgency to be overly prepared for an apocalypse.
Over the last couple of weeks, there has been a renaissance somewhat reminiscent of those times with mainstream news outlets proposing that global markets were overly egged and might be doomed for a major setback. We aren't at all surprised.
We are in fact looking at this and asking ourselves if there are semblances of justice in these annotations, or whether they are an imaginary bluster buffeting on the receptors of the schizophrenic community at large.
Sentiment Lags Reality
Understandably, recent circumstances have analysts sitting at the edges of their chairs - seemingly inane volatility, broad derisking across asset classes, a smorgasbord of rather dim economic data, and commentary that fluttered like a flag flown at half-mast behind a setting sun. The incontinence can therefore be pardoned.
That being said, we wanted to put some meat on these bones and see if it all coalesced into logically plausible. Readers will recall that we were the first to explain how the end of the Fed's QE program roiled the volatility markets, and which hallmarked a cycle of greater idiosyncrasies (see our 1 April note).
However, as bad as the U.S. economy was disappointing expectations, we felt that the treasury market was signaling a generally normalizing economy, albeit admitting that one should continue to expect disappointing economic figures (see our 10 April note). The turn of the first quarter did give us some much needed perspective, that the U.S. economy was indeed slowing and the Fed had many reasons to remain patient.
More recently, we deconstructed the collapse in the German bund market, where the safest government bonds in Europe (arguably) sold of harder than any sovereign fixed income asset including defunct Greek Government Bonds (see our 30 April note). We, alongside other professional traders and dealers, believed that the selloff was technical and temporary in nature. Hindsight proved that we were correct in material but wrong on timing; bunds continued to collapse until the 10-year reached a blistering 0.84% yield from 0.04% 3 weeks prior.
In our experience, we can confidently reckon that bunds were the primary cause of volatility flares across the global markets. Traders were surprised when U.S. treasuries too began to selloff, along with the greenback and most other major currencies (for more of our post-April analysis and outlook, see our May 7 note).
While we wish to leave this discussion for a separate piece, the tangents of this episode prove that markets have gotten more fragile than ever before - with moves that are supposed to occur once in a few years happening at regular intervals now.
Bank Of America On The Next CRASH:
Without opining further, here is Bank of America Merrill Lynch on what it sees as highly plausible causes of the next CRASH .
In short, they are: Consumer, Rates, A-shares, Speculation, High Yield.
Via BofAML's Barnaby Martin:
Investors are unambiguously positioned for the US consumer to once again lead the global recovery. Should US consumption, profits & payrolls (Chart 13) continue to disappoint, equity valuations will be forced to cheapen. Few are positioned for a contagious sell-off in US dollar, bonds & stocks if US GDP growth were to stumble once again in Q2 & Q3.
Investors are positioned for low and stable rates, anchored by central banks. Yet rate volatility (see MOVE index) is on the rise, expectations for a Fed hike in Sept have dropped sharply (3m Eurodollar rates have dropped from 0.865% to 0.540% in the last 3 months), and should growth or inflation surprise to the upside in the summer, rates (e.g. front-end in US, long-end in Europe) are mispriced.
Investors are not positioned for full-blown policy failure in China. Chinese growth expectations may be weak, but the A-share market hardly portends a collapse in Chinese activity. Should Chinese PMI or FAI data indicate a lurch lower in activity at a time of policy easing, the ripple effect via Chinese stocks, rates & FX into global markets is likely to be significant. David Woo argues investors are underestimating the cross-market implications of US-China policy divergence.
Investors are not positioned for cash to offer competitive returns. Yet cash has outperformed global fixed income in 2015. There is a risk that investors, in particular systematic macro funds, have crowded and levered positions that do not assume a rise in cash rates. In addition, the correlation coefficient of CTA returns and the DXY dollar index is currently 0.51, its highest level in the past 13 years, and CTA performance has also recently become correlated with German bunds (Chart 14), the Euro, and oil.
Investors are positioned heavily in high yield, high dividend yield and high PE strategies (Chart 15). The quest for high yield (relentless multi-year inflows to dividend funds, MLPs, REITS & HY bonds - $415bn inflows since Mar’09) remains the biggest Achilles’ Heel for positioning, in our view.
These treacherous times continue to make us feel that reducing risk rather than maximizing return is the smarter mid-2015 strategy. We are cognizant of high cash levels and sentiment measures (e.g. BofAML’s Bull & Bear Index currently at 4.4) which do not signal “sell risk”.
Nonetheless the summer months offer a lose-lose proposition for risk assets: either the macro improves and the Fed gets to hike, which will at least temporarily cause volatility; or more ominously for consensus positioning, the macro does not recover, in which case EPS downgrades drag risk-assets lower. We advise selling risk into strength, buying volatility into weakness, advocate higher than normal levels of cash and would add some gold.
We continue to expect risk-off moves in the direction of 0.2% for 5-year German bunds, 2% for the Italian 10-year yield, 20 on VIX and 2000 for the S&P500 in Q2.