We have been looking for the end of the risk rally for a few weeks now. US equity and credit markets have been the most robust and have so far refused to rollover. Elsewhere, we believe the risk off signs are developing as we expected.
We reiterate our view of two main scenarios for financial markets. Either we see a repeat of 2015, in that returns across markets will mostly be close to zero, or there will be periods of heightened volatility followed by quick upside reversals. The alternate scenario is that equity markets suffer a bear market, the US then enters a recession, the credit default cycle worsens dramatically and we end up in a repeat of 2008. So let’s have a look at some markets that are catching our eye.
First off, Japanese markets are not going in the right direction. Chart 1 below shows the equity market and the USD/JPY exchange rate. It appears that the early success of Abenomics was almost entirely down to the massive depreciation of the Japanese Yen. Foreign investors (who remain important investors in Japanese equities) are beginning to give up on Abenomics and are actively selling. Normally, fleeing foreign investors would be negative for a currency, but as many have hedged their currency exposure, this is simply not the case for the Yen. In fact they may even be under hedged as equities fall, and so it becomes a vicious circle whereby falling equities creates demand for Yen, which then encourages more selling of equities.
At the moment, with Abenomics failing, we see little need to dip a toe into Japanese equities. Indeed, it may be worse than that. If the Abenomics is failing narrative becomes more widely accepted, that may well discredit the ZIRP/NIRP/QE policies that Central Banks have been pursuing in recent years. And if Central Bank credibility fails, then financial markets could fall a long way.
Chart 1 – The Japanese Equity Market and the USD/JPY Exchange Rate
Looking at Europe, the major effect of negative interest rates and QE has been to push bond yields further into negative territory. Not only are negative bond yields a sign that the reflationary policies from the European Central Bank are at risk of failing, we are extremely worried that these policies are creating a massive mis-allocation of capital.
In chart 2 below, we show the EuroStoxx 600 index as a measure for European equities, and in the lower panel, the ECB’s deposit rate and balance sheet. The fact that the equity market is lower than at the time the deposit rate was first cut into negative territory, and the expansion of the balance sheet has not helped, should be a major worry to both the ECB and investors.
Chart 2 – European Equity Market vs The ECB’s Deposit Rate and Balance Sheet
In the US, it can be argued that yields are just too low given the performance of the economy and the potential normalisation in Fed policy. In our opinion, US yields are either being supressed by low global yields which make the US appear relatively attractive, or the market is sending a message that recession risks are very real indeed.
In chart 3 below, we show the 10 year US bond yield versus inflation expectations and the price of oil. As can be seen, the 10 year bond yield is approaching the recent low near 1.6%. Unless recession risks are about to increase quickly, then we see little value in being aggressively bullish bonds. That said, we expect oil to remain low for a long period of time, and so we are not bearish either. For the time being, we are fairly neutral on US rates and bonds and will wait to see how economic and financial trends develop in the near future.
Chart 3 – US Bond yield versus oil and inflation expectations
In the Foreign exchange markets, we are seeing some changes from the last two months of risk on. First, the Japanese Yen has been extremely strong against all currencies. We think this may have a bit more to go, but of course Bank of Japan intervention may never be far away. We are also detecting signs of stabilisation in the Dollar against commodity and some emerging market currencies. If we are correct that the near term vulnerability is for markets to revert to risk off mode, then we see a hierarchy developing, whereby safe haven/current account surplus currencies are the strongest, commodity and emerging market currencies are weakest with a middle pack with the Dollar near the top of that.
What that means is that we are short Canadian and Singapore Dollars versus the Japanese Yen. As can be seen chart 4 below, the rally in commodity and EM currencies that began in February has clearly ended and appears to have been nothing more than a bear market rally. Although both currencies pairs have moved quite a long way in the past few days and are approaching recent lows where some support may reside, we do expect lower lows over time.
Chart 4 – Canadian and Singapore Dollars v. Japanese Yen
Of course, the Bank of Japan will not stand by and watch the Yen strengthen too aggressively, and so we need to be attentive to that risk. So, we are now monitoring signs that the US Dollar is beginning to stabilise against commodity and EM currencies, and it may be that we have to switch from being long Yen to long the US Dollar. In chart 5 below, we show the US Dollar versus the Canadian Dollar and how support sub 1.30 is kicking in. If we are right about a move towards risk aversion, coupled with the oil rally stalling out, then we think the US Dollar will rally against its Northern counterpart.
Chart 5 – The US Dollar versus the Canadian Dollar
One more chart before we sign off. A couple of weeks ago we showed a chart of the S&P 500 with a rounding top pattern, and said that we felt the reflation trade was over and it was time to be bearish of equities again. That week, the S&P closed at 2049 points, and last week, it closed at 2047 points. We update that chart below, and in our opinion, the rounding top pattern remains valid. The last two weeks has seen a lot of gnashing of teeth and no net progress made. We see this as further evidence of a market that has stalled ahead of falling hard in the weeks ahead.
Chart 6 – The S&P 500 with a rounding top
Overall, it appears to us that the flashy rally in risk assets seen in recent weeks is faltering. The bearish macro story that we have been discussing for a long time remains in place, and it appears that investors are losing their faith in central bank policies. There are quite a few signals that risk assets are beginning to rollover, and we think that this weakness is spreading to all risk assets. The talisman for risk assets remains US equities, and even here the rally has stalled in the last two weeks. If US equities crack and start falling, global markets will be back to the risk off scenario that played out in the first six weeks of the year. To put it simply, the next few weeks are crucial.
Stewart Richardson
Chief Investment Officer
