Rolling the risk boulder up the incline

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A weaker US dollar and rising 10-year government bond yields are emerging trends and illustrate a little more optimism about the prospects for global trade and, yes, even the UK’s never-ending story of Brexit.

B4EJK9 Oklahoma City, Oklahoma, USA. Sisyphus Rolling the Stone, Bricktown. Titled
© Alamy

The process of a bottom being carved by financial markets takes time and there is certainly debate as to whether August marked a nadir for leading 10-year government bond yields. For now, risk appetite sits in a sweet spot while the government bond market adopts the role of Sisyphus. A look at the trading range over the past three months show 10-year yields in the UK, Germany, Canada and Japan sitting at their highs. The US Treasury benchmark has backed up towards 1.8 per cent, marking a new high so far this month, with traders expecting at a test beyond 1.9 per cent as the trade temperature between the US and China becomes a little warmer.

Chart showing how international bond yield are at their higher end of their three month trading range

Higher long-dated yields help steepen yield curves and for equities, that ticks the box for the rebound story when it concerns financials and other “cheap” sectors within the market. Better vibes on global trade and a falling risk of a no-deal Brexit is good for eurozone equities, and today’s leading sectors within the Stoxx 600 are basic materials, banks and autos. So far this month banks and autos top the list of winning Stoxx 600 sectors with gains of 5 per cent and 4.5 per cent respectively. That’s why markets view today’s blurb from the Bundesbank, that Germany may have entered a recession, as “old news” with the focus very much on ascertaining the scale of a potential rebound in activity heading into 2020.

Indications that a phase-one trade deal between the US and China are moving along has also registered in the currency market. After closing below its 200-day moving average on Friday, the dollar index (heavily weighted towards the euro) remains on the defensive. Another sign of dollar-negative positioning is highlighted by how the cost of euro calls has jumped over those of puts for the next one and three months. This measure known as a risk reversal has turned positive during October and it suggests that the currency market is seeing heavier flows to protect portfolios from the risk of a stronger euro into January.

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The next test for the euro looms when Mario Draghi helms his final European Central Bank meeting on Thursday. A push back from within the ECB against further easing has been a driver of higher yields in recent weeks, but details of €20bn in monthly bond purchases starting in November are expected from this week’s meeting.

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Anxiety over trade hitting the global economy drove bond yields down sharply over the summer and bolstered the US dollar. Now there’s some push back and as that trend picks up, there are more calls for a bigger rotation from defensive equity sectors towards those more exposed towards economic activity.

The FT’s Laurence Fletcher writes that Lansdowne Partners is just one influential hedge fund that reckons “financial markets are on the brink of a reversal that will see a big fall in ‘idiotic’ bond prices, a slump in technology stocks and a revival in UK equities”.

Citi’s Private Bank notes:

“An eventual rebound in global trade activity would favour certain emerging markets and European equities. These have lagged the US rally. However, we don’t dispute that notable policy-driven risks remain.”

Over at Bank of America Merrill Lynch, its analysts are flagging how this year’s “downturn phase” appears on the cusp of shifting towards an “early cycle” period, whereby smaller companies and deep value tend to prosper.

Optimism over Brexit also reigns, although the market reaction of relief is more about the ebbing prospect of a “no deal” divorce by the UK from the EU. The political circus in Westminster keeps rolling along, with Boris Johnson set to seek a parliamentary majority for his deal when legislation implementing it in the form of the Withdrawal Agreement Bill is put to a vote in the House of Commons on Tuesday. Should the WAB pass, the next stage entails whether parliament attaches amendments such as backing Mr Johnson’s deal, but only if the UK remains in the EU’s customs union. A general election is the most likely outcome, once this week reveals whether an orderly departure looms at the end of the month or not.

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Saxo Bank ranks its scenarios as follows:

“Pass of withdrawal deal and amendments before October 31 (50 per cent); extension to January 31 deadline (25 per cent); and general election including extension beyond [January] 31st deadline (25 per cent).”

True, the pound briefly topped $1.30 today, a level not seen since May, and while there is scope for the rally to extend, breaching $1.40 remains the litmus test for the UK after its departure from the EU. The $1.40 level was the floor for much of the modern currency era (aside from the strong-dollar era during the Reagan boom) until June 2016.

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A hard Brexit (with Northern Ireland enjoying a softer version) raises tough questions for the rest of the UK.

Erik Nielsen, chief economist at UniCredit, pens a very interesting weekly note and here’s how he describes the UK’s divorce bill:

“The lack of clarity imposed by the Brexit vote in 2016 for trade investment between the UK and the rest of the world have only just begun. We are in for a decade of ongoing uncertainties, and that’ll almost certainly cause the UK to underperform its peers in growth terms for years to come.”

Erik adds this kicker:

“As often quoted, it took Canada and the EU seven years to negotiate their trade deal (and another year to ratify it), and that doesn’t even include anything on services.”

Quick Hits — What’s on the markets radar

The S&P 500 earnings season picks up the pace this week and what stands out so far is the pressure on margins. DataTrek notes how amid the headlines of companies beating their forecasts so far during the current results season, the overall pace of earnings for the third quarter versus the same time a year ago, has dipped further, now running at a year-over-year pace of minus 4.7 per cent, from minus 4.1 per cent at the start of October. The culprit is margin pressure as revenues have exceeded forecasts to date for the previous quarter (at plus 1 per cent) and that DataTrek says “means analysts’ margin expectations were too high coming into the quarter”.

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The focus on Wednesday and Thursday is firmly on four big companies — Microsoft, Amazon, Visa and Intel — that together comprise 9 per cent of the S&P 500 through their weighting within the benchmark. But as DataTrek notes, it’s a mixed call. While MSFT and V are expected to show earnings growth of 9 per cent and 18 per cent, respectively, AMZN and INTC “are the problems, with earnings expectations of minus 20 per cent/minus 11 per cent”.

The bigger story for now is when do 2020 earnings expectations get a dose of the smelling salts (they are still seen expanding at a 10-plus per cent pace) and clip a broad market flirting with record territory.

DataTrek believes:

“2020 earnings that essentially mirror 2019, at $163 per share. Revenue growth will look more like 3-4 per cent, but margin pressures will eat up those gains. That’s been a reliable storyline all through 2019.”

Oil prices loiter near the lower boundary of their 2019 price range, with Brent crude above $58 a barrel. That’s been the story for much of October and shows how plenty of global supply is capping any bounce for crude from better trade news.

Canada’s currency has strengthened notably of late, breaking its usual relationship with oil prices. A narrowing interest rate gap with the US has played a bigger role while today’s close general election is also not expected to weigh on the “loonie”. Analysts at TD Securities “think a minority government is likely” and that domestic data are a more influential driver of the Canadian dollar, “though a break below C$1.30 might be a step too far”.

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