“Market participants are somewhat split between pricing an economic Armageddon scenario and willful ignorance of the issues in the underlying economy”, SocGen’s cross-asset quant team writes, in a note dated Tuesday.
That assessment captures an apparent “contradiction” that’s been variously debated for most of 2019. Bond yields have plunged, but equities have remained buoyant, ostensibly indicating a bit of schizophrenia among market participants.
Of course, there was never any real “mystery”. Equities moved higher on the promise of central bank accommodation and bonds rallied (yields fell) in recognition of the factors that made the dovish policymaker pivot necessary in the first place. In the final analysis, more liquidity is the rising tide that lifts all boats, and so, stocks, bonds and credit all surged (with the latter benefitting mightily from the reinvigorated hunt for yield), in stark contrast to 2018, when USD “cash” outperformed some 90% of global assets.
“Performances in 2019 have been the mirror image of 2018, with one factor behind it all: central banks”, SocGen goes on to say, in the same note cited here at the outset.
The bond surge is reflected in equities, something we’ve been over on countless occasions here. It’s actually an extension of a long-running dynamic. As bond yields declined over the post-crisis period and central banks persisted in accommodation, investors crowded into bond proxies. Have a look at the following chart which shows record ETF creation in Low Vol. products and redemptions in Value:
As Marko Kolanovic put it in his latest, “low volatility crowding turned the conventional economics upside down: instead of high-risk stocks leading to higher returns, low-risk stocks consistently produced higher returns”.
“With rates being pushed lower, investors have been forced into chasing the trend in bonds markets. In equities, funds have loaded up on Quality and Low Volatility”, SocGen goes on to say, adding that “CTA Trend funds have been allocating massively to bonds”.
That “massive” legacy long is starting to get unwound as the reflation narrative gathers steam amid trade optimism and the assumption that sooner or later, this year’s coordinated easing will manifest itself in better growth outcomes (ideally, in an inflection higher in global manufacturing PMIs).
If the narrative stays rosy and trade progress continues, crowded positioning in bonds could continue to come off and the “bubble” in bond proxies may burst in earnest as cyclicals and value rally.
But that’s still a big “if”. As noted on Monday “good” is a relative term when it comes to describing the US economy, and although the data continues to come in better than expected (with Tuesday’s ISM non-manufacturing beat being the latest example), things are still decelerating on balance.
That speaks to the “split between pricing an economic Armageddon scenario and willful ignorance” point made by SocGen, whose Sandrine Ungari writes that “while the stock market as a whole has held its ground over the past year, things are much more disparate at the stock level”.
Cyclicals are obviously trading at a big discount to bond proxies. That, Ungari goes on to say, “tends to signal an economic downturn and a bear market”.
“Things have not turned out quite that way, so now the question is which one will play catch up: equities or bonds?”, the bank goes on to ask.
Here’s the thing: There’s a fine line between recession risk gradually fading, yields moving slowly higher and stocks rallying on a “benign” rotation as market participants embrace the reflation narrative in an orderly fashion and a tantrum scenario where rates rise too far, too fast.
With positioning still stretched, a sudden steep bond selloff could be highly disruptive. “There’s bond risk everywhere”, SocGen remarks.
The perceptive among you might have noticed that we got a very small taste of equities’ aversion to rapid rate rise on Tuesday.
“I guess you can have too much of a good thing. The robust services ISM has heaped further pressure on the bond complex, with yields ratcheting even higher across the curve”, Bloomberg’s Cameron Crise said. “That, in turn, has dampened equity enthusiasm, if only temporarily”.
SocGen reiterates the point rather forcefully.
“If recession risk vanishes, or if the pessimism is overdone, rate risk would be key, leaving equity and fixed income investors alike in a fragile position”, the bank warns, noting that this “is true for equity investors, who piled up bond proxies in their portfolios, systematic trend followers who tend to be long duration across government bond markets, and even bond investors who are being forced into squeezing the last drop of yield from the most illiquid segment of the corporate bond market given the plethora of negative-yielding debt in the market”.
In the end, the ideal scenario is that the growth outlook improves, inflation remains subdued enough to keep central banks from rolling back recent easing and long-end yields rise gradually to reflect the better economic outlook, but not fast enough to trigger a disorderly unwind in all of the trades tethered to the duration infatuation which now seems to be waning after hitting a crescendo in August.
What could go wrong?