Worry, Repeat. There was lots and lots of hand wringing this past weekend over the state of global risk markets. Needless to say this is a bit of a strange exercise in self-flagellation as most of the economic and geopolitical data received last week and over the weekend amounted to either an improvement or status quo. It’s hard to wade through the concerns and risks as they seem to be mounting quickly although not dissimilar to the risks three or six months ago. They include:
- Federal Reserve mistake of policy mismatch (with market expectations);
- Further geopolitical devolution or new crises (e.g., Japan vs China);
- European disinflation that turns into deflation;
- Japanese growth dies on the vine;
- US credit or equity becomes or is considered a true bubble in valuation terms or risk/reward terms; and,
- US economic growth significantly slows.
There are a panoply of other minor risks to go with the biggies that the market is currently focused on. Those amount to Ebola, crisis or crippling inaction in the US government, the German Constitutional Court ruling unfavorably on ECB actions, Banco Espirito Santo, Argentina and general mismanagement of emerging market economies. And then there are the cataclysmic and large type risks that are known but not currently the focus of markets. Those primarily amount to the ECB’s upcoming “Asset Quality Review,” and the next round of Japanese economic data. Beyond, the known risks there are the “black swans” that by definition are not just unexpected, but also unknown.
With all of these risks swimming about, it is no wonder that we saw markets look tired in July with equities and high yield bonds losing steam in the US. As a reminder the S&P 500 lost about 1.6% in July and high yield bonds lost about 2.5%. What to do? Two options seem to face the trading crowd right now: a) keep calm, trade on; or, b) take risk off the table, as it’s August and going to the beach seems like the right thing to do. Notice, that neither of those options are panicked selling. That does not mean, however, that a slow burn lower is not very possible if not likely.
The overarching point that the markets brought to bear over the last three trading sessions is that the Federal Reserve is still the most important element to markets. The most popular interpretation of last week’s jobs and GDP reports is that they amount to a goldilocks scenario where the jobs report was robust but did not produce any wage pressures and the GDP report was very good but real final sales after inventory stocking means that inflationary pressures are well under control. That being said, the bears have some
“’splainin’ to do” when you consider the fact that a higher labor participation rate is the logical outcome of a better economy and with a higher participation rate, wage pressures may develop very slowly. The counter to that argument is that after the Great Financial Crisis, the US isn’t headed back to the same labor participation rate (i.e., the labor participation rate is structurally lower now), therefore wage pressures might be quicker to develop than a first blush reading when job seekers do initially increase. Ultimately, there were 329,000 new job seekers last month and if that data point becomes a trend, it could prove helpful to the Fed in keeping rates low for another “considerable amount of time.”
THINGS I AM THINKING ABOUT
The Data and the Truth. Honestly, the news of the day only carries so far. Trade at your will and method, but don’t forget that there are two central tenants to US risk markets. They are i) that US stocks are driven by earnings; and, ii) that US credit is driven by interest rates. For stocks, the Q2 earnings season has been a good one so far (graphic below, note that 75% of S&P 500 companies have reported so far).
The Healthcare, IT and Materials sectors appear to have the best earnings so far with Telecom the laggard. Notwithstanding all of the macro noise, if earnings season continues apace and the US economy continues to be warm but not too hot, stocks can continue to rise. BUT, this is not a willy-nilly, buy-the-dip type of environment. Trading this market should be a high conviction only ordeal. Find stocks or sector trades with asymmetric payouts that can be cut very quickly should positions prove faulty. Take small losses, and do so quickly.
Relative Value of US Equities. Is the idea that US equities are more attractive relative to other US assets or international assets over? Perhaps this is the question that traders should be asking above all else. The idea that US assets were “better” than other assets has been a market theme for some time and that theme has been solidly framed by the support of the Fed. Take away that support, and voila, you have to question this thesis. Still, in credit-land, US yields look attractive compared to the risk/reward of European sovereign risk as much of the ECBs policy moves have been priced into these markets and the upcoming AQR of the European banking sector has yet to be worried about in earnest.
Focus on the US 10yr Treasury Bond. Strangely, the 10yr has been immune to much of the Fed policy worry (e.g., tapering of QE and inflation at slightly higher levels). Nick Colas of ConvergEx Group has termed the 10yr “Teflon” and he is on to something. At the beginning of the year, US stocks had the uncomfortable feeling that the bond market knew something that stocks didn’t – that the US economy was not performing well. Largely, that concern has been taken out with recent data. Yet, the 10yr has barely budged from yield levels that can be categorized as unexpectedly low. Perhaps the geopolitical risk trade (i.e., buy Treasuries) is holding down yields, but those positions have already been layered in and the recent good US economic data should have weakened some hands. Again, the relative value of US yields in a yield starved world speaks for some of the strength of the 10yr. Bull flattening trades may have had their run for the time being though. Trying to see through the Fed to a scenario whereby Fed policy pushes US risk assets into losses and therefore US Treasuries catch a bid is certainly a plausible scenario, but one that does not lack imagination.
DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS NOT A RESEARCH REPORT. THIS IS FOR ENTERTAINMENT PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS OR OMISSIONS.
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