Which Asset Classes Are Most Vulnerable To 'Policy' Disappointment?

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The lull in market activity over the past weeks is poised to give way to a multitude of events that could potentially determine the market direction for the remainder of the year. Policy responses from both sides of the Atlantic are awaited, though nuances rather than headlines may be more important. In the short run however, Deutsche Bank notes some indicators suggest that risky assets may be vulnerable. Specifically, relative to fundamentals they also find that the US equity rally over the past quarter has now been excessive relative to the US economic leading indicators. Looking at cross asset valuations by comparing the level of asset prices today vs. their peaks and troughs since Sep-2008 we also find that the S&P500 appears to be the richest relative to fundamentals.

 

 

Deutsche Bank: The cross asset view: Equities could be vulnerable in the short term

In the table below, we calculate a ‘pointer’ for each asset, corresponding to the position of today’s price relative to its historical peak and trough. A pointer equal to 0% means that the current price is equal to the historical trough, a pointer equal to 100% means the current price is equal to the historical peak. We use the pointer of the global PMI Composite as a benchmark (pointer of 68.5%). In this simple framework, assets with a pointer above/below this level have under-reacted or over-reacted to the deterioration of global fundamentals.

 

For the market to move further into a risk-on mode from current levels, positive developments regarding one or more of the following issues would be required:

  • Spain will need to make a formal application for the aid program, which, as Draghi mentioned, is a necessary though not sufficient condition for bond purchases by the ECB
  • Political developments in Italy signaling an intention to follow Spain in seeking aid via the ECB/EFSF/ESM bond buying program
  • Further clarity on the mechanism of ECB bond purchases: whether the ECB would target yields levels or pre-commit a potential size of asset purchases. Setting an explicit cap on yields could be politically contentious as it commits the ECB, at least theoretically, to unlimited bond purchases. In addition, a justification of the level of cap would be onerous
  • Draghi mentioned that the ECB is working to address the seniority issue of ECB bond purchases, though exact details are yet to be specified. Ultimately, there will always be a risk that, in extreme situations, ECB does not fulfill its pledge of not being explicitly senior. The ECB could nevertheless make its commitment more credible by either (1) an explicit specification of the parri-passu nature of the purchases via a guarantee from the EFSF/ESM for any ECB on these purchases or (2) by retroactively being more supportive of the Greek PSI by allowing T-bill issuance refinanced at the Greek central bank to pay for redemption of bonds held by the ECB
  • Resolution over the Greek negotiations: We maintain the view that a compromise agreement between Greece and the EU leaders is likely to be reached, with more time to Greece for fiscal adjustments. Recent political commentary does appear to suggest that a compromise may be feasible. Implementation, however, will continue to remain a concern, and Greece’s adherence to fiscal plans may be revisited again in the future.

Eventually, we do expect a resolution on the above issues and a support framework for Italy/Spain to be set in place; however headline risks may dominate over the coming weeks. Some of the key events which could impact market valuation in the near term include:

  • 30th August: Italian BTP auction
  • 31st August: Bernanke’s Jackson Hole speech
  • 6th September: Spanish bond auction
  • 6th September: ECB meeting
  • 6th September: Meeting between Rajoy and Merkel
  • 12th September: German constitutional court ruling on the ESM
  • 12th September: Dutch elections
  • 12th/13th September: Fed meeting
  • 14/15th September: EcoFin meeting

Given the deluge of potential new information in the near term, the risk reward perspective would argue to exit trades with high sensitivity to headline risks.