LONDON (Reuters) - The halfway point of the year is when investors take stock, reassess their positions, and decide where to put their money for the next six months. This year, it could be a tipping point.
Emerging markets are under heavy and mounting pressure, credit markets are crumbling, the U.S. bond yield curve is barely 30 basis points from inverting, which may portend a recession. Tech and bank stocks, which led Wall Street’s rally earlier this year, are also wobbling.
Add to that a sharp slide in the Chinese currency and rise in global trade war fears, and it’s not hard to see why some investors might want to throw in the towel completely.
It’s clear that stock market investors are now getting nervous. No corner of the investment universe seems immune from the growing list of concerns, topped now by trade wars.
Top U.S. officials, from Treasury Secretary Steve Mnuchin to Commerce Secretary Wilbur Ross, are appearing regularly on business TV channels, apparently to calm investors rattled by President Donald Trump’s trade rhetoric.
Chinese and Brazilian stocks are in bear markets, India’s rupee is at a record low, and according to Bank of America Merrill Lynch, global equity funds posted their second biggest ever weekly outflow last week ($30 billion) and U.S. stock funds their third largest redemption ever ($24 bln).
Of course when sentiment, pricing and flows are so concentrated and one way, the greater the likelihood of a reversal. BAML’s ‘bull & bear’ indicator is “teasingly close to a ‘buy signal’ and contrarian rally in credit & stocks.”
And as long as global growth holds up, then corporate profit growth should continue to hum at a decent clip and financial market volatility should remain relatively contained.
Low volatility provides investors the confidence to put money to work and take risks, usually to the benefit of most asset. Buoyant profit growth supports equities in particular.
Yet credit and emerging market spreads are widening, long positions in tech and financials look crowded, and sensitivity to higher U.S. interest rates is rising. No wonder volatility is beginning to creep up, no matter how slowly.
Strategists at BAML note the parallels between now and 1998, when the Asian crisis and LTCM crash plunged world markets into turmoil: Fed tightening, U.S. decoupling and dollar strength, flattening yield curves, and emerging market weakness.
Between July 1997 and October 1998 emerging market equities fell 59 percent in dollar terms, and between July and October 1998 developed markets capitulated: the S&P 500 fell 22 percent, the Nasdaq 33 percent and U.S. bank stocks 43 percent; the Japanese yen surged 30 percent; equity and bond market volatility tripled.
There’s no suggestion declines and swings of this magnitude are imminent, or even likely. Investors still expect stocks to end the year higher, according to the latest Reuters poll of fund managers.
But they’re getting defensive, cutting equity exposure to the lowest in almost a year and raising cash holdings to the highest in over a year. There’s little doubt that investors are, at the very least, pausing for thought.
There’s also little doubt that the flattening yield curve is generating a lot of heat, even if there’s considerable debate on whether it is signaling a looming economic slowdown. Or worse.
The benchmark U.S. yield curve, the difference between 10- and two-year Treasury yields, is the flattest in over a decade and only 30 basis points from inverting. Almost all inversions in the last half century have preceded recession.
Morgan Stanley analysts say investors should continue to buy 10-year Treasuries, and look to profit from curve flattening trades in the United States, France, Britain and Japan.
“Our view is supported by expected strength in the U.S. dollar, weakness in emerging market equities, an escalatory dynamic in trade tensions (and) continued hawkishness from the Fed despite tighter financial conditions,” they wrote in a research note.
Hardly a show of confidence that growth and risk appetite will recover.
Markets will almost certainly tip if the simmering global trade and currency tensions don’t cool off. This is increasingly being played out in the Chinese yuan/U.S. dollar exchange rate, which Beijing is deliberately allowing to weaken.
The Chinese central bank chose not to follow the Fed when it raised rates last month. Pointedly, the PBOC eased policy by cutting banks’ reserve ratio requirements, and this divergence can have only one consequence on the exchange rate.
The ‘official’ and ‘offshore’ yuan rates are both falling but the offshore rate is weakening more quickly, suggesting international investors are growing increasingly worried about trade and FX wars, the hit to global growth, capital flight from China, or all of the above.
— The opinions expressed here are those of the author, a columnist for Reuters —
Reporting by Jamie McGeever; editing by Emelia Sithole-Matarise