‘In Late January A Client Called Us With An Exasperated Query’: Why Barclays Sees A ‘Bumpy Road Ahead’

If you had to pick one simple chart that poignantly illustrates the whole “regime change” narrative, this would probably be it:

If there’s elegance in simplicity, then that’s pretty goddamn elegant. 1% moves in either direction were the exception in 2017. Now they’re more the norm.

Global equities stormed out of the gate in 2018 and in January, equity funds saw a veritable avalanche of inflows.

In a testament to the notion that we had reached peak euphoria, E*Trade added 64,581 gross new brokerage accounts in January, the most for a single month since September of 2016:

That as search interest in “how to buy stocks” spiked (this is obviously anecdotal, but often it’s the anecdotal evidence that’s the most entertaining):

On the economic front, we seemed to have reached “peak Goldilocks” – the synchronous global growth pillar was intact as was the still-subdued inflation narrative. The tax cuts in the U.S. seemed to telegraph more optimism ahead as long as late cycle fiscal stimulus didn’t end up supercharging wage growth and inflation, but even that worry was summarily relegated to the backburner because after all, the old models are all broken, right? Cyclical dynamics don’t work like they used to and Steve Mnuchin swears we can have wage growth without inflation.

As one Barclays client asked, “what could possibly go wrong given strong global growth, non-existent inflation pressures, and a spanking new US tax cut?”

Well as it turns out, a lot. All it took was one above-consensus AHE print to ignite inflation worries and because real rates had effectively become a function of inflation expectations (to the extent rising price pressures tipped a more hawkish Fed under Powell), the stock-bond return correlation flipped positive in early February leading to a drawdown in risk parity and balanced portfolios. Then came the doom loop which was activated on February 5 when the inverse and levered VIX ETP rebalance risk was realized, leading to the largest VIX spike in history and promptly triggering some $200 billion in systematic de-risking.

No sooner had the market recovered from all of that than trade war “threat” became trade war “reality” sending stocks plunging anew. Last week turned out to be even worse for U.S. equities than the week of VIX-pocalypse.

That’s the setup for the following letter by Ajay Rajadhyaksha, Head of Macro Research at Barclays. It serves as the foreword to the bank’s Q2 outlook piece. Enjoy…

Via Barclays

In the last week of January, as equities went on yet another run, a client who had been waiting to buy the dip called us with an exasperated query. What, he asked, could possibly go wrong given strong global growth, non-existent inflation pressures, and a spanking new US tax cut? Sure, markets seemed too complacent, but there didn’t seem to be a plausible catalyst to shake that equanimity, especially given how calmly investors had reacted to event after event in recent years. How, he wondered, does one buy the dip if stocks only keep rising? We haven’t checked back with him, but we assume market complacency is no longer his biggest concern.

It is not that year to date returns look terrible. Yes, bond markets have started the year poorly. But 10-year US Treasuries traded below 3 percent all through March, and 10-year bunds are back below 60bp. Meanwhile, global equities are only down 2-3 percent despite recent declines (and after a very strong 2017), and corporate credit and EM excess returns are roughly flat. The main issue is the violence with which markets corrected after an ebullient January, first on an inflation scare and then on fears around US trade policy. But these same investors calmly stared down the Brexit vote, the surprise Trump win, N Korean sabre-rattling, and Fed balance sheet tightening. What changed?

Let us dismiss one suspect. To misquote James Carville, it’s not the economy, stupid. Global growth remains both broad based and balanced, with US fiscal stimulus yet to make its presence felt. If markets are nervous, it is not about a recession. On the flip side, those worried about the US overheating at least have a talking point. Governments do not usually pass fiscal stimulus at a 4 percent jobless rate. But both inflation and wage growth have disappointed for years, and every major central bank is currently failing to fulfill its inflation mandate. Even if US fiscal stimulus ends up being hugely inflationary (and count us sceptical), we are many moons away from a hyper inflationary scenario. If anything has changed over the past two months, it’s not the data but investors’ reaction function to any hint of a bump in the road.

We believe two other factors are at play. First is the resumption of historically normal levels of volatility. 2017 was the aberration — 14 of the 20 lowest closes on the VIX index occurred last year. Second are the recent US tariffs. The first order economic impact is eminently manageable. Even if tariffs are imposed on $60bn of Chinese exports to the US (assuming no exemptions) and China reciprocates in kind, consider this: China’s global exports in 2017 were $2.2 trillion, and US imports from the rest of the world were $1.8 trillion. The tariffs shouldn’t knock off more than a few tenths of a point of growth from each economy.

The bigger concern is uncertainty about what comes next. How do foreign governments credibly offer to reduce their trade surplus with the US by specific amounts, which is what the US apparently wants? If reciprocal tariffs by China and Europe hit parts of the US that are politically important to the Trump administration, does the US up the ante further? Are the exemptions offered so far temporary and will they expire if negotiations fail? These and related questions could hang over financial markets for a while. Headline risk should be especially elevated for the next few months, for a market that is suddenly acutely sensitive to such risks.

That means investors are likely to face a bumpier road ahead.