It feels like the panic selling of last week has finally stopped and we may about to resume normal service, David Stevenson argues.
I can’t quite understand the cause of the recent sell-off. I agree that some equities are overvalued but I equally can’t see any compelling reason to panic.
Obviously one of the reasons equities sold off last week was that US government bond yields have risen – an obvious occurrence given that US interest rates are rising. In fact, US Treasuries have now reached their highest level in seven years.
But the headline yield rate is driven by a number of factors, not least the interplay between real interest rates and inflation expectations as measured by the breakeven inflation rate derived from inflation-protected securities (TIPS). According to a note out last week from analysts at Deutsche “the bulk of recent yield rises was due to rising real interest rates, now also at a 7-year high. This suggests solid economic momentum ahead, which might eventually calm some nerves in equity markets as the earnings season gets underway. It also implies that for now anyway, the Fed is tightening roughly at the right place, meaning quickly enough not to let inflation expectations out of hand.”
So, nothing to panic about there?
Not so fast. Deutsche reckons that U.S. Treasuries may be oversold at current levels. “Several technical factors, from a temporary rise in currency hedging costs to the expiry of a tax break in mid-September probably contributed to weak Treasury demand and the resulting steady rise in yields. These factors may already be fading; according to recent survey evidence, short positioning has returned to extreme levels last seen in the middle of September. ”
Investors also need to be aware that “rising real rates look like an odd trigger for equity markets to sell off. Perhaps US Treasuries are less of a trigger than a scapegoat for equity investors fretting over other risks, starting with the simmering global trade tensions”. In sum, stop obsessing over bond yields and look at earnings momentum.
But equity investors can’t of course entirely ignore macro factors. Yield rates are a useful signal but the real factors impinging on earnings growth are likely to be powered by global liquidity flows. I closely follow Cross-Border Capital’s analysis of global capital flows – both private sector and central bank based. Their latest note last week was certainly deeply troubling. They observed that liquidity was tightening in virtually every major country they follow.
“The scale is unprecedented.”
More and more of the firm’s signals are now flashing amber or red.
“Overall, we remain nervous and feel convinced that volatility is set to rise; that the US dollar will strengthen moderately and that risk appetite has definitively turned lower. This should be a precursor to slower economies over the coming months. Signs that yield curves are steepening will underscore our conviction because they tend to inflect upwards roughly at the same time that risk appetite falls and economies weaken. Looking into 2019, investors should begin to expect an upturn in the Global Liquidity Cycle and, in our view, this will be likely led by Asia. Already, the People’s Bank of China is easing liquidity conditions and seems prepared to allow a slow slide in the value of the Yuan. If we are correct, the Japanese Yen should follow”.
Is this the end game? Probably not. But expect a bumpy ride over the next 12 months. Maybe we’ll get a melt up or maybe China will ride to the rescue. Maybe Trump will pick a fight with the Treasury. Everything’s to play for.
Image source: Bloomberg; DWS