“Bond yields are unlikely to spark a new risk-off, and our baseline is for an eventual drift up in risky assets”, Barclays writes, in a note dated Monday.
That’s the good news. The bad news is … well … the bad news is that there’s a lot of bad news.
“There has been a steady drip of bad news from the rest of the world, including growth disappointments in Europe and China, the Italian budget trade-off, and the lack of a Brexit agreement”, the bank goes on to lament, in the very next sentence from the above-cited note.
Needless to say, the “bad news” did not abate on Monday.
For one thing, Angela Merkel announced she’ll step down as CDU party leader and will not seek re-election in 2021. That’s a huge story that, frankly, didn’t get enough attention from U.S. investors.
The news comes at a particularly inopportune time. Friday’s benign S&P decision sparked a Monday rally in Italian bonds and equities, but those assets are likely to remain vulnerable to negative headlines for the foreseeable future. Meanwhile, the ECB is of course set to wind down asset purchases at the end of the year, and while Mario Draghi’s imposition of state-and-date dependent forward guidance in June generally means pricing in a more hawkish rate path isn’t possible in the near-term, the fact remains that the ECB policy “put” is set to fade. At the same time, the Brexit situation remains tenuous at best, further clouding the European political outlook. The last thing anybody needs given all of that is for Germany to become a source of additional uncertainty.
Hours after the Merkel story hit, U.S. markets were forced to swallow a rather bitter pill in the form of news that should Donald Trump and Xi fail to break the trade stalemate at the G-20 next month, the administration in Washington will go ahead with tariffs on the remainder of Chinese imports.
For Barclays, the steady “drip” of negative news means that “rather than catching a falling knife, it would be prudent to miss the first leg of any equity rally and initiate longs once actual signs of stabilization emerge.”
The bank’s rationale for not expecting further rate rise to catalyze further equity weakness is based on the assumption that there’s little scope for a further selloff in the long end. “Nominal 10y Treasury yields have typically not gone above the terminal fed funds rate in prior hiking cycles, 1994 being the exception”, the bank notes, adding that “with term premia much lower this time than in prior cycles, the room for a significant sell-off in longer rates sparking a new risk-off move seems limited.”
They also flag credit’s relative resilience during the October equities rout, something more than a few folks have suggested is indicative of the non-systemic nature of the recent selloff. They do caution, however, that if equities don’t stabilize, spread widening in credit could materialize in earnest, further denting risk sentiment. “The risk is that the equity and credit markets get into a self-reinforcing loop if stocks keep falling”, the bank warns.
As far as the tug of war between negative news flow and limited scope for a rates tantrum, Barclays says it’s a “close call”, but ultimately, they’re cautious. To wit:
So which narrative is correct? If the US economic outlook has not changed materially, a move higher in longer yields is unlikely, and valuations are reasonable, is this a buying opportunity? Or are investors supposed to exercise caution, given problems around the rest of the world and the Fed’s recent rhetoric? It is a close call, but for now, we advise caution.
One reason for the cautious stance revolves around the now consensus view that the Fed sees the equity correction as somewhat desirable to the extent it tightens financial conditions that have refused to respond to rate hikes. We’ve been over that ad nauseam.
Beyond that, though, Barclays warns that investors are becoming particularly sensitive to the “peak earnings story” (i.e., the notion that the effects of the tax cuts and stimulus are set to fade going forward), and the bank expresses consternation about “how poor equity price action has been in recent weeks.”
Next, Barclays runs through some familiar themes, not the least of which is the underperformance in Growth stocks. This has dominated the discussion of late. Wild swings between Growth and Value over/underperformance are becoming the norm. As we wrote last week while documenting disappointing guidance from Amazon and Alphabet, “this month has provided stone, cold proof that this is a market which depends almost entirely on what’s been working (Growth/Tech) continuing to work.” Have a look at this:
Barclays looks at this through the lens of their “business cycle stage optimized portfolios”. The chart below shows “portfolios designed to do well during the early recession stage have gained in value [while] the others are relatively flat to down.”
The bank goes on to suggest that folks have no capitulated yet. For one thing, ETF and mutual fund outflows have totaled a comparatively measly $18 billion over the past four weeks, which Barclays calls “much smaller than in past sell-offs of a similar magnitude”. The implication is that the retail crowd isn’t running screaming to the exits just yet.
Barclays also observes that “investors do not appear to be scrambling to buy downside protection as Skew has actually declined, and the ratio of put and call volumes has not spiked.” Here’s the visual on that:
In short, there’s still plenty of scope for retail de-risking and panicked hedging, suggesting we’re a long way away from anything that approximates capitulation.
But for all the dip buyers out there, don’t worry. Because if the last couple of days are any indication, the President is pretty keen on inciting a panic about something, whether it’s Fed policy or a migrant invasion or an all-out trade war with the Chinese.
So if it’s a buying opportunity you’re after, you might not have too long to wait.