On Saturday, in “One Bank Reminds You That ‘Grumpy Isn’t Just One Of Snow White’s Dwarfs,'” I highlighted a note from Citi in which the bank endeavored to make a list of all the things analysts, clients, and strategists are concerned about. That list was hilariously long. To wit:
Yet, such feelings seem elusive as the Street has been worried about politics (Trump, Merkel, Le Pen, Wilders, Grillo, Hard Brexit), geopolitics (North Korea, Syria, Iran, Libya, Venezuela, Brazil) and central bank policy (Fed, ECB, BoE and BOJ) as well as economic growth (US, China and Europe) plus valuation, profit margins, money flows, inflation expectations, fiscal initiatives, automation replacing workers and retailers closing shops leading to layoffs, not to mention auto sales sustainability given signs of subprime pressures. Investors also bemoan sluggish business loan growth, an alleged lack of capex, weak M&A trends and low volatility.
So yeah, “besides all of that“…
As Trump’s political capital rapidly disappears and as the market faces reality check after reality check (think: Brazil’s latest corruption scandal), more and more people are asking whether the disconnect between geopolitical uncertainty and market volatility is sustainable.
In a way, this is a battle between modern markets (e.g. VIX ETPs, programmatic strats) and central banks on one side, and harsh reality on the other. Technical factors and central bank liquidity have allowed markets to suspend disbelief.
How long that can persist is the only question that matters. It could be 10 years, or it could be 10 days. No one really knows.
Below, find the latest from Barclays on the quick “mean reversion” we saw after this month’s fleeting risk-off episode.
Developed market risk assets have shown remarkable stability in the face of continued political headlines from both the US and Brazil. The sell-off last Wednesday was short lived, with the S&P 500 index now trading above levels prior to the move lower…
The same is true for credit spreads, which are now tighter than they were last Tuesday…
We expect this trend to continue; while political uncertainty may remain elevated in the medium term, we believe it will drive sustained weakness in credit only if investors see evidence that the uncertainty is negatively affecting economic growth or corporate fundamentals.
That has not happened in the US. Despite some weakness in housing data this week, the overall economic backdrop remains supportive, as evidenced by the labor market. Initial jobless claims again came in lower than expected, and continuing claims came in below two million for the sixth consecutive week, signaling that firing rates are not accelerating. The supportive backdrop was also confirmed by the FOMC minutes, with most participants viewing the economic outlook as strong enough to warrant further policy normalization. Furthermore, corporate fundamentals remain similarly strong, as earnings growth for the S&P 500 was up almost 15% for the quarter, capping off a solid 1Q earnings season.
While we expect credit valuations to remain stable overall, we see potential for significant weakness in certain parts of the market. As we have highlighted in past reports, the retail sector could come under significant pressure from the move to e-commerce. And there is growing concern about whether it could affect the credit markets in a way similar to the energy sector from 2015 to 2016. Aside from any economic consequences, we believe that retail should have a limited effect on overall investment grade and high yield bond market performance, primarily because of its relatively small weight in the cash indices. However, it could have a greater effect on derivatives, which might have implications for investors that use the indices as a way to manage credit risk. Similarly, the retail exposure in loans is nearly double that of high yield, giving us some cause for concern in the loan market.
While US markets have rebounded from the sell-off last week, Brazilian credit remains under pressure, as the political turmoil has raised concerns about a double-dip recession (Figure 2)