Bob's back with his latest take on current market conditions.
Bob's World - Is a flash crash imminent?
This is a follow-up to my last note from early May, and will not focus on Greece. Rather, I want to review my early May views against actual outcomes, and to look ahead into Q3/early Q4.
A review
1 – In terms of fundamentals, my May note focused on some familiar themes which remain the central concerns for markets. These were that global growth would continue to disappoint, with “FX wars” taking centre stage again; that sustainable core inflation (very different from much more transient asset price inflation – in some cases at dangerous levels (e.g. Chinese equities) – pumped up by extremely loose global policy settings) is nowhere in sight, with the latest disappointing payroll report from the US showing hourly earnings growth remaining very low and the participation rate now back at multi-decade lows, matching levels last seen in the 1970s, which was one of the worst periods for growth and markets in US post-war history; and lastly, the sustainability or otherwise of the eurozone/Greece, which of course is currently centre stage.
2 – In terms of markets themselves, my expectations for Q2 as set out in my last note were for increased levels of volatility, some risk-off in credit and equities, a cessation of the sell-off in global core rates/bond yields, and a weaker dollar. My stop losses to protect against being wrong were set at a “2175 weekly close” for the S&P500 and consecutive weekly closes on the 10yr UST above 2.4%. The actual outcomes over the past two months have been very much in line with these expectations. Volatility levels are higher across the board, as seen easily for example in the VIX and MOVE indices. Credit spreads are well off their tights – as a proxy measure, the iTraxx Crossover index is 60bp off its early May levels of sub-280bp. Global equities are lower over the past two months as per the MSCI World index (4.5% from its Q2 peak to its Q2 trough), with the Eurostoxx index well over 10% off its Q2 peak and with Chinese equity markets off by 30%! In fact, the only major equity market that has not fallen as much as I had expected (I was looking for a 10% to 15% fall from Q2 highs to Q2/early Q3 lows) is the US, where the peak to trough fall has been around 4%. While my stop loss has not even been close to being threatened I’d still class this as a miss amongst hits. However, this “miss” also leaves me much more concerned about the health of risk markets deep into Q3/early Q4 (see below). In terms of core bond yields, the sell-off in yields has indeed stopped and partially reversed over Q2. In this context my stop loss, focused on the 10yr UST and which was set at consecutive weekly closes above 2.4%, has so far proved to be extremely helpful. And lastly, over Q2 the USD has fallen from a Q2 high of 100 on the DXY index down to 93, pretty close to my 90 target, before a partial recovery.
Looking ahead
1 – I do not expect the global fundamental themes to change. With the current very worrying situation in Greece and China, it would be foolish to focus too much on what may or may not happen in the very short term, but I am confident in my view that by the end of Q3/early Q4 we will still be worried about weakness in global growth and about the lack of sustainable core global inflation – if anything, the deflationary wave that is currently engulfing China, and which has been given a major boost by both the collapse in equity markets and by China’s unwillingness (for now) to weaken its currency, will soon wash up all over the world, particularly in the US. In this regard, note that the price of crude has fallen by over 15% from its Q2 high to current levels. In terms of the sustainability of the eurozone/Greece, it looks like the next three months will be crucial, but NEVER underestimate the willingness of eurozone leaders, the EU and the Eurogroup to “fudge” a way through – we are well over five years into this “fudge” era, despite being told many times that things were “fixed”, and I think the sustainability of the eurozone/Greece may well be a core global theme for at least another five years. Overall, all things globally point to looser monetary policy for longer as the only lever that is perceived to work is the FX devaluation route. And, of course, for now, the USD and the RMB are on everyone’s “other side”.
2 – A quick word on the Fed: my view is unchanged. The Fed does not need to hike for some time yet. I think a hike in Q3 would be a major policy error and would occur because the Fed has made some pre-determined decision to reload its monetary policy ammo before it’s too late. In other words, I think the Fed is caught between a rock and a hard place. Let’s see but based on what is in front of us right now, any hikes by the Fed would add significant risk to markets, risk assets in particular. For USTs, if the Fed does hike, I think its hiking cycle would likely be 2 x 25bp and done, which to me would make 2s20 and/or 5s30s curve flatteners very attractive.
3 – Lastly, in terms of my outlook for markets into end Q3/early Q4, I think a considerable risk is building of some form of mini crash. Of course, anything can happen in the very short term. But over the course of Q3 and into Q4, I think we may see a significant short, sharp but large (15% to 20%) correction. I note with extreme interest that when I talk to clients they are very keen to ignore the risks of Greece contagion both in terms of global markets and particularly about what recent events (and what is to follow) will mean for private sector confidence across Europe. I also note that a significant majority of people I talk to in markets are impressed that US equities have held up so well (so far), and so are long and looking to add; and pretty much the same majority are unimpressed with the weak (so far) rally in core govvie, and therefore are short/looking to get short. My concern is not just that markets are mis-pricing Greece contagion, mis-pricing deflation, mis-pricing street liquidity and mis-pricing the (now negative) trend in corporate (US) revenues and earnings (Q2 earnings season is upon us and may well show year-over-year earnings down 5%/5%+). My concerns are also that markets are way too optimistic about global growth (especially the US), about China, about the ability of policymakers to do anything new and/or effective to alter things meaningfully to the upside, and in particular I think market participants are increasingly positioned for risk-on perfection. I do not think it will take much in the form of data disappointments (macro-economic and/or earnings) and “suddenly elevated” concerns with policymakers to trigger a significant weakening in risk assets.
4 – In terms of targets, I would first like to reiterate my stop losses – they are unchanged from my last note. I was tempted to lower my equity stop loss to a “2135 weekly close” for the S&P 500, and to lower my 10yr UST yield stop loss to 2.4% on a weekly close (as opposed to consecutive weekly closes), but I suspect that July may be a very jumpy market, so I will persist with my May stop loss levels for the rest of Q3/early Q4. In terms of actual targets, for now I keep my “low 1900s/1800s” target for the S&P500 with more weakness over the quarter globally. And I still target sub-2% for 10yr UST yields.
To finish, I would repeat that I am not making a call on the next week or next month but rather on the next three months. In this context, my stop loss levels will afford critical protection to my call if I am badly wrong in my expectations around the fundamentals and around policy responses in particular. I will revert if the facts change materially and either of my stop losses are triggered; otherwise, I will be patient deep into September.
