Our work indicates that financial markets are at a tipping point and policymakers are probably getting very worried. After significant downward moves for equity markets and bond yields in the first two weeks of the year, we would not be that surprised to see a relief rally develop quite quickly. The main question for investors now is whether markets remain in a broad trading range or a new bear market. For policymakers, they have to work out whether markets are sending them a valid recessionary signal that would require the Fed to stop raising interest rates and other central banks to consider further easing. Interesting times indeed.
We will try and cover a lot of ground this week including some thoughts on the FX and bond markets. Opportunities in FX are clearly important for RMG as we have recently launched the RMG FX Strategy (see details HERE).The simple question that investors need to know the answer to is whether the US economy sinks into recession this year or not. This seems to be the dividing line between markets that could muddle through like they did last year and an equity bear market, collapsing bond yields and heightened volatility everywhere.
The first chart below shows US inflation expectations as measured by the 5 year 5 year forward rate together with the price of US Oil. The Fed have previously told us that they do monitor market based measures of inflation and we assume that the collapse back to last Summer’s lows will be setting off some alarm bells. Of course, the Fed will try and spin the narrative that markets are getting overly pessimistic because of the collapse in the price of oil which in their opinion is “transitory”.
All we can say is that the market is becoming much more concerned about recession risks and a potential Fed policy error. We all know about the over-supply of oil which has been a major cause of the oil bear market. In the event of a US and Global recession, demand will fall as well which will perpetuate low prices. If inflation expectations continue to decline, we will take this as the market signal that recession risks are elevated enough that the Fed will move to the side-lines relatively quickly, perhaps at the March meeting.
Chart 1 – US Inflation expectations and the price of oil
In an unfettered market, the price of US Dollars dominates, price being measured in both US interest rates and via the level of the US Dollar in the foreign exchange markets. To say that we are intrigued by the pricing in bond markets is to put it mildly. With the ECB stretching policy to ludicrous levels of both QE and negative deposit rates, we can just about understand why shorter dated German bonds trade with a negative yield. However, we still believe that driving yields into negative territory is plain bad policy and will end badly for those chasing yields in Europe.
The fact of the matter is that US and European core inflation rates, measured on the same basis, are both around 1% or so. With short-term real growth in both also about the same, we have to conclude that it is only the divergent central bank policies that are leading to the historically wide difference in yields on the respective US and German 5 year bonds. The chart below shows the historic picture of the 5 year yields for each in the upper panel, and the difference or spread in the lower panel.
In the event of a US recession, bond yields in the US will fall, and most likely the spread between US and German yields will narrow quite dramatically. If the US averts recession, then we would expect Europe to be ok for a good few quarters yet, and German yields may actually stop falling and even rise a bit. Either way, we think that owning US 5 year bonds whilst being short German 5 years is a good risk/reward trade and we get paid a positive carry of 1.6% per annum to hold the trade.
Chart 2 – US and German 5 year bond yields and the spread between them
Watching the spread relationship between US and German bonds may well be key to the performance of other markets as well. If US yields decline rapidly in the event of a US recession, clearly that should make the US Dollar less attractive to investors, all other things being equal. The next chart shows the relationship over the last 12 months between the EUR/USD exchange rate and the spread between US and German 5 year bonds. We think it reasonable that the spread narrows towards 1%-1.25% in the event of a US recession (probably lower), which would correlate to a EURUSD exchange rate in the 1.15 to 1.20 range.
Chart 3 – The US/German 5 year yield spread and EUR/USD exchange rate
Although a weaker US Dollar may well give some respite to the US economy, we think that the risks of recession are already high enough, and relief from a weaker Dollar could well come too late. In fact, a weaker Dollar could well cause further damage to investor sentiment as many have positioned for a stronger Dollar. In particular, the Japanese Yen is testing very important support as indicated in the chart below.
With the weak Yen (and the advantage that it brought to Japan in the beggar-thy-neighbour currency wars that continue to percolate) being the only part of Abenomincs (the three arrows) that actually worked, the Bank of Japan will descend into panic if the Yen breaks below support in the 115.50 to 116.20 range. With the Yen being viewed as a risk off currency, a break lower would be a bad sign for global equities and all risk assets.
Chart 4 – The Japanese Yen (with 40 week moving average) is testing critical support
Outside of the G3, we think that the US Dollar can continue to make gains against most currencies, especially selected emerging markets. There is basically a massive shortage of US Dollars as offshore US Dollar borrowing (mostly by non US corporates) approaches US$10 trillion. Dollars need to be bought to service this debt, which obviously becomes more expensive the stronger the US Dollar becomes and the weaker global growth becomes.
And on to equities. Despite some markets already down more than 20% from the cycle high (the accepted definition of a bear market), the S&P 500 is clinging on for dear life. The chart below shows how the S&P 500 managed to cling onto support at the 1870 area this week. Our view is that a break below 1870 would be a hammer blow to the bullish crowd and will usher in significantly lower prices.
Chart 5 – The S&P 500 with 40 week moving average
As noted at the beginning, we would not be surprised if markets try and bounce from what is undeniably a very oversold short term condition. However, with many markets already below critical support, and US recession odds shortening dramatically, we believe a break below critical support will occur at some point quite soon. Indeed, the MSCI has already broken down below support (after forming a bearish “head & shoulders” pattern), as can be seen in the next chart below.
The MSCI Global Equity Index (Total Return)
We had intended to be a bit more analytical this week looking at the fundamentals, however, with so many markets at a critical juncture, we felt we had to have a broader market roundup. Indeed, as well as many markets sitting on critical levels, we have seen a potential sea change in market expectations for US interest rates, and this could have a profound effect on markets this year.
Although there is still the potential for markets to muddle through this year and the US and Global economies to escape recession, we handicap this as about a 1 in 3 chance. Our base case is now for a bear market in risk assets as the US slips into recession.
2016 is likely to be very difficult for buy and hold investors, possibly a bit of a disaster. At best, a more tactical approach would offer the chance for some outperformance. Under our base case scenario, we believe investors should be holding large cash reserves. Traders can look to position bearishly on market rallies.
Stewart Richardson
Chief Investment Officer
