Say hello to the bear. It ain't over folks, and there is reasonable suspicion that this rout could spiral into what we think might just be the perfect storm. What a week it has been in the markets! It was the worst first 5 trading days of any year in recorded history for almost all stock indices across the world. The S&P 500 crashed nearly 6%, while Chinese equities were crucified when the fuse was lit during the first few hours of Monday's trading following another disappointment in China manufacturing PMI.
Could this get worse? We reckon so. In today's Snippet, we discus why.
Adele's record smashing hit "Hello" colloquially floated into our minds when we looked back at the week that was. A very ugly week indeed because everywhere you looked, under every cleanest of the dirty rugs, risk assets were continually offered while both safety and liquidity were bid, much more the latter. Such a dynamic hints to us that this is less of a technically inspired sell off, but a more of profound structural change.
But we must mention that we absolutely do not predict the future. We merely take the cues the market has freely provided everyone with, and pass our own humble judgements. We have been both right and wrong in the past. However, views are what drives asset prices up or down, or in this case, in circles. For the last year or so, we are down on most major equity indices, while cross asset volatility have become elevated.
Risk assets, such as carry and commodity linked currencies, high yield corporate credit, low rates sovereign debt, stocks and the like, have systemically seen what we believe was institutional selling in the past week. This doesn't happen frequently, but when they do, we take heed.
China. The juggernaut that has so far proven to be untamable. Much has been said about the second biggest economy on Earth. The problems are real, and Chinese officials might have little choice but to let the unwinding run its course. Earlier Monday, Chinese equities were halted for about half a day when the so called "circuit breakers" were tripped at their preset thresholds of 5% and 7% respectively. Trading was suspended across all of China's stock market when the benchmark index declined more than 5% (a few hours) and 7% (the rest of the day).
In the past, these mechanisms worked their charm of stemming large players from liquidating, but they seem to have had the reverse effect this week. We observed that as markets in the mainland were halted, selling intensified in markets elsewhere. This speaks of a broader tapering down in gross exposures and fresh hedges being opened. Exposure is the context here. We don't believe we saw a substantial reduction leverage in the few weeks before the new year.
Another interesting anecdote was a clear breakout in gold prices above $1080, a key technical level which demarcates how we perceive the yellow metal in terms of its medium term trend, price wise. The rally in gold took place in an environment where the U.S. dollar was generally bid. For that to happen, gold must have seen strong inflows, and there has to be a good reason behind that.
We wish to wait for a few more weeks before we compile our piece laying down 2016's themes, but for now, the case of the Year Of The Bear seems more plausible than not. Why?
Central banks of many developed economies (Fed, BoE, BoJ, RBA...) have stopped easing and are on the fence. The Fed has raised interest rates for the first time in almost a decade, so no backstop there. Markets were very used to what we call the "Fed put" where accommodative monetary policy would typically be the sponge that absorbs an overdose of limitations and negative sentiment. This is now practically gone. We have written about how the end of QE spooked volatility markets in almost all financial markets.
We then have China which has shown its hand of using 'controlled' devaluation of its yuan in a bid to soften its hard landing. When the yuan collapses as much as it did this week (nearly 6,000 pips or 9% in 2 months), it sparks massive outflows from the world's hottest and largest emerging market. This isn't good for risk, short term and long term. The PBoC has yet to intervene directly by adjusting interest rates and its reverse repo operations. We believe they will do so in due time; they have little choice but to. There's nothing much the Chinese government can do to circumvent capital fight from a huge bubble that has already burst.
The dollar, which should gradually strengthen, is likely going to be the harbinger for a broad scale deleveraging in highly geared sectors and EMs in general. We've already seen that last week. The size of these outflows shouldn't be undermined, and will likely persist until asset prices and interest rates reach a point of moderation.
Falling commodity prices have continued to reign in on inflation expectations, which is totally counter intuitive to the Fed's policy; unless of course it is the Fed that has made a major policy error, which be believe is the case. Widely watched oil prices (WTI & Brent crude) have already breached their 2008/2009 lows, and we don't see an exhaustion of that trend. The broader market has become ever more sensitive to oil prices; oil itself is heaving more like a risk asset rather than a commodity. The same is for industrial commodities and metals.
On the micro side things have also likely reached their peaks. Margins have little wriggle room upwards and should see a sizable correction this upcoming earnings season.
In short, there is little reason to be bullish the market and many reasons to be a little fearful. Fearful that this week's decline could morph into full-fledged bear market reminiscent of 2008's global financial crisis. Watch the markets closely, because the next few days of trading will be critical in shaping secular sentiment that drives global capital flows. Don't be at sea when the tide turns. More updates to follow.