Seeking calmer waters

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There’s some relief as a turbulent week for markets draws to a close, with global equities rallying and bond yields rising. 

Enjoy the calmer risk waters, but prepare for negotiating more stretches of rapids and rocks. The thin trading conditions that typically define August still have a couple more weeks left to run. Next week may well see China unveil its response to pending US tariffs, irrespective of President Donald Trump’s latest sound bite about a “fairly short” trade war, and only intensify the anxiety among investors about the outlook for the global economy. 

One proxy of growth expectations, the US 10-year real yield (adjusted for inflation) shows how it has returned to negative territory for the first time since the last big global growth scare peaked during the summer of 2016. As this chart shows, the real yield is testing the zero bound and that should mark a floor for now. 

But the dramatic rally in major bond markets reflects not just a gloomy prognosis for the economy and little respite from the US-China rivalry. There’s also a message that monetary policy has limited scope, raising the concern that a new round of currency depreciation against the US dollar beckons. 

Bill O’Donnell at Citi says:

“Markets are running with this notion, pricing out the ability for central banks to influence economic outcomes or achieve inflation targets, while political appetite for fiscal stimulus in developed markets remains low.”

Currency weakness as a default stimulus option for many economies entails greater market volatility. A climate of competitive devaluations suggests a stronger US dollar, an outcome spelling trouble for a global financial system stuffed with debt denominated in the reserve currency.

The market response has been logical against this backdrop, a pronounced investment portfolio shift over the past month has sought long-dated government bonds. Strong demand for owning long-dated government debt has triggered a pronounced flattening in major yield curves, as shown here via Marshall Gittler of ACLS Global. 

The jury remains out on whether inverted or flat yield curves signal a recession beckons over the coming 12 to 18 months. The drop in 10-year yields below those in the two-year (a sector that is strongly influenced by central bank policy) does tally with contracting global manufacturing and stalling earnings growth in broad terms for major equity markets.

Where things become a lot tougher to ascertain from here is whether the “unintended consequences” of inverted yield curves gain ascendancy, and that list via Bank of America Merrill Lynch includes: “volatility, the risk of systemic accidents & deleveraging across asset classes”.

Such outcomes can threaten the broader economy and a still resilient consumer. And here’s some concern as the University of Michigan consumer sentiment index for August on Friday was the lowest reading in seven months at 92.1, below a forecast 97. 

As August rolls on, the past month has shown that holding a diversified portfolio including equities, credit and long-dated Treasury bonds, is ticking along.

So far this year, the FTSE All World equity index is up over 9 per cent, while an index of long-dated Treasury bonds has generated a total return of 23 per cent. But over the past month, as the All World has dropped 5.5 per cent, long-dated Treasuries have gained close to 13 per cent. In this case, having ballast in the form of long duration bonds helps keep the boat afloat as its runs the gamut of the rapids. 

Here’s a table of performance for the year to date and the past month for various equity sectors. While gold and silver miners have built on an already solid 2019 performance, European banks, global oil and gas equities, and US transports are not looking so good. 

That leaves many in the market questioning whether the big moves across various sectors in the past month have reached a limit. 

Mark Dowding at BlueBay Asset Management makes the point that present trends can run further: 

“Fundamentally speaking, we see no value in G3 government bond yields and we believe that far too much monetary accommodation is priced into futures markets. However, it seems that market technicals are dominating fundamentals and with central bankers too scared to push back on market expectations, it is hard to rule out recent trends persisting a little longer.”

Quick Hits — What’s on the markets radar

Follow the money — Fixed-income mutual funds and exchange traded funds added $11.5bn for the week ended Wednesday, the biggest weekly figure since early June and the fifth-largest on record, according to data from EPFR Global. The mood in equities remains defensive and EPFR note:

“For retail investors, Utilities, Consumer Goods and Real Estate Sector Funds remain the groups they are most comfortable with. Utilities Sector Funds have recorded retail inflows 18 of the past 20 weeks, Real Estate Funds 13 of the past 20 and Consumer Goods Funds 17 of the past 20.”

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