- Turbulence. A measure of calm has returned to financial markets, but uncertainty and volatility remain high. The increase in risk aversion was, however, not the result of a reassessment of the fundamental outlook but rather the result of a sudden loss of investor confidence – a typical, temporary bull market correction therefore.
- US recession. Greenspan may have put the topic back on the table, but we do not expect a recession in the US! Its probability has not really increased recently, and there would have to be a massive deterioration in fundamentals to signal a back-to-back contraction in US GDP.
- Carry trades. Nor do we see any indications of an abrupt end to carry trades as interest rate differentials will remain wide enough to permit profitable trading strategies.
- Recommendation. Investors should, therefore, start buying risky assets on further dips in the weeks ahead. We would, however, focus here on liquid equity as well as liquid carry assets.
Further topics:
- European Central Bank: The triumph of the hawks.
- Germany: Considerable decline in energy outlays.
- Italy: Public finances - too early for the all-clear.
- Data outlook: Further improvement in ZEW expectations, Italian industrial production will shrink; US core inflation should remain moderate.
- Market outlook: Hawkish ECB points to rising Bund yields again; EUR-USD remains well supported.
A CLASSICAL BULL MARKET CORRECTION: BUY INTO FURTHER WEAKNESS!
Financial markets seem to have calmed down after a few days of significant turmoil. But we expect increased volatility and uncertainty to continue over the next few weeks.
But we also believe that the correction was driven by a sudden loss of confidence rather than by a reassessment of the fundamental outlook. The correction was not the beginning of a structural and durable repricing of risk.
The recent substantial spike in volatility across all asset classes is, therefore, only of a temporary nature and not a trend reversal.
Hence, we recommend to start buying risky assets on further dips in the weeks ahead and would focus on liquid equity markets and liquid carry assets.
VOLATILITY RETURNED TO THE MARKE T S . . .
... with a vengeance last week: the VIX took one of its highest jumps in percentage terms, credit spreads widened rapidly (cf. chart) and brutally, equity markets dropped, most risky and high-yielding assets suffered, and the traditional funding currencies for carry trades, JPY and CHF, suddenly strengthened.
Not a bloodbath – in fact, the correction was not as bad as the one we witnessed last May – but still a loud wake-up call for the markets. After a few days of significant turmoil, the markets seem to have calmed down, and we have already seen signs of recovery in equities and other risky assets, and renewed signs of weakness in the JPY. Uncertainty remains high, however, and this seems a good time to take stock of what happened, what we can expect going forward, and how we would play it in terms of key investment strategies and asset allocation.
WHAT TRIGGERED THE INITIAL SELL-OFF?
Nothing concrete, really. Neither the 9% drop in China’s stock market, nor Greenspan’s (then repeated, cf. Research Note by Harm Bandholz) mention of the word “recession”, nor even the largerthan- expected drop in US durable goods orders were reason enough to justify the sudden movement which quickly reverberated across asset classes.
We believe that the correction was driven by a sudden loss of confidence rather than by a reassessment of the fundamental outlook. Heavy positioning and a widespread and growing feeling that valuations were stretched across the board had made markets increasingly vulnerable. In addition, there seemed to be a glaring contradiction between the extremely low level of market volatility and the still significant level of uncertainty surrounding the macroeconomic outlook. The conviction that a correction was inevitable and would indeed be healthy created the ideal conditions for a significant sell-off.
The relative intensity of the sell-off across markets and assets also supports the view of a shortterm re-assessment of risk/reward profiles: The pullback has been particularly pronounced in higher risk/ higher yield assets and markets which had seen especially strong inflows of late, notably in emerging markets and in the equity and credit universe.
Moreover, the marked strengthening of JPY and CHF, the main funding currencies for yield hunters, was also indicative of some unwinding of carry trades (cf. chart).
There is no doubt that the focus in this latest sell-off is on growth, unlike last May when the focus was on inflation risks. But already here we can see a key difference between this sell-off and the previous one: In May last year, US inflation figures had indeed given reason to fear that inflation might be on the rise, and that the Fed might find itself behind the curve and forced to tighten policy a lot further, possibly pushing the economy into a recession. This time around, recent data on activity are at worst mixed, and still fully consistent with a soft-landing scenario; moreover, should growth decelerate more sharply than expected, the Fed would be in a favorable position to respond promptly with interest rate cuts. The market has in fact suddenly priced in a 60% chance of a Fed rate cut by June, seemingly spooked by the weak durable goods figures, with the deterioration in subprime mortgages and Greenspan’s remarks as additional concerns. But if the trigger had really been a spike in worries over the US growth outlook, one could have expected a continued market weakness in response to the surprisingly weak ISM nonmanu- facturing and factory order data early this week. This, however, did not happen.
WHAT COMES NEXT?
We do not see anything at this stage which would lead us to fundamentally reassess our growth picture.
In regard to US growth, we were probably right to be somewhat more bearish than the consensus, and we remain confident in our call that the US economy is experiencing a soft landing and will settle at sub-par but still healthy growth for a few quarters more. Here our view is shared by the Fed: Chairman Bernanke stepped in to reassure markets, arguing that the latest data did not change the benign assessment of the economic outlook he had presented to Congress just two weeks earlier, and that the deterioration in subprime mortgages, while serious, showed no signs of infecting the main mortgage market. We would also stress that weakness in US growth is at this stage compensated by the robust dynamics in the eurozone (confirming the decoupling story we have been highlighting for some time), the very cautious and growth-supporting stance of the Bank of Japan, and the seemingly unstoppable momentum of emerging market giants like China and India. We therefore stick to our baseline scenario, and re-affirm our central bank calls: the Fed on hold throughout the year, ECB raising the key rate to 4% in June, the BoJ delivering just one more 25 bp hike before year-end.
We therefore do not believe that we are seeing the beginning of a structural and durable re-pricing of risk. The pricing of risk depends to a large extent on liquidity and macro as well as micro fundamentals.
Liquidity remains abundant and, as we argued above, the underlying picture on fundamentals for the global economy has not changed. Moreover, there is no evidence that companies will start an aggressive re-leveraging trend comparable to the late 90s despite record share buy-backs, dividend payouts and M&A activity. The focus clearly has returned to the shareholder, but companies' balance sheets are still widely underleveraged following years of balance sheet repair, while profitability and cash flow generation are at record levels. Moreover, the financing mix for transactions in the current M&A boom has not been particularly aggressive with some exceptions on the LBO side. While idiosyncratic risks due to rising LBO and M&A activity are certainly increasing, it is (in our view) premature to expect a significant and sustainable increase in systematic risks from the micro side. Our view is therefore that the recent substantial spike in volatility across all asset classes is only of a temporary nature and not the beginning of a new trend. When looking at the volatility spikes in the VIX since the early 90s, defined as moves larger than 3 standard deviations of daily changes in the VIX, the average duration of elevated volatility levels was around 38 days in the period of 1992-1995 and 31 days in the period of 2003 to 2007, both periods where the overall trend in volatility moved rather sideways. In contrast, it sometimes took months or even years before the pre-spike vola level was reached again in periods with an underlying upward trend in volatility experienced, for example, from 1996 to 2002 (cf. chart).
A word of caution: We cannot entirely rule out the risk that the sell-off turns into a self-feeding crisis of larger proportions. This could happen if widening credit spreads started triggering deleveraging on a wide scale, accompanied by a string of failures in hedge funds and other financial institutions. We have been pointing out for some time now that credit markets are probably the weakest link in the chain, and this is indeed the focus of the most serious concerns of investors, partly because of the “black box” nature of the risk: given the very limited information available on the extent and structure of leveraging, it is extremely difficult to quantify the risk. Note that this is also the area where the concern about the subprime mortgage market might be justified: it is through this channel that it could inflict serious damage. We strongly believe, however, that this fullfledged crisis scenario is highly unlikely. Daily available data of hedge funds' performance over the last few trading days (cf. chart below) and the lack of newsflow of serious knock-on effects at least suggest that so far risk control mechanisms have prevented major earthquakes.
We expect volatility and nervousness to continue over the next couple of weeks, until the price adjustment allows investors to regain confidence in the valuations. The focus will remain on US growth, and the market will remain more sensitive to negative than to positive surprises. Our analysis is also supported by recent discussions with clients. Investors, including those with the strongest risk appetite, seem to have come out of the last few days with a few scratches but no deep wounds, and we have seen no signs of panic or any sense that we might be seeing a true turning point. The sentiment remains constructive, and many seem to welcome both the correction and the resurrection of volatility.
Opinions differ significantly, however, on how protracted the current correction is going to be. This sanguine assessment is, we believe, also borne out by market developments of the last few days. The sell-off has not worsened and spiraled out of control, as some had originally feared. On the contrary, buying interest has cautiously returned, and we have already seen stabilization and in some cases recovery of equities and other risky assets. Notice also that the reaction in emerging markets has been limited, concentrated especially on FX, and by and large proportional to the underlying macro vulnerabilities (especially large current account deficits and financing needs), suggesting a rational short-term repricing of risk rather than panic and contagion.
Greed, we believe, is set to eventually triumph over fear thanks to the supporting role of fundamentals. It would be premature, however, to assume that we are out of the woods already. This is partly because the re-pricing of assets has so far been relatively benign, buying interest in the coming days will remain cautious, and we believe we are in for another 2-3 weeks of high volatility and occasional bouts of weakness.
STRATEGY IMPLICATIONS: BUY ON DIPS AND FOCUS ON LIQUID RISKY ASSETS!
We recommend to start buying risky assets on further dips in the weeks ahead, especially for investors who can afford to live with more elevated levels of volatility. Although markets already started to stabilize after the recent sell-off, there is, in our view, a chance that we will experience another final dive in equities before embarking on a trip to new highs.
The downside potential in such a final shake-out from current levels is, in our view, maximum another 3%-5% for developed equity markets and 5% to 10% for emerging equity markets, which implies that at least two thirds of the correction already lies behind us. The chart below, which shows the average performance of the bull market corrections in the high beta German DAX index since 2003 in comparison with the recent sell-off, underpins our reasoning.
The downside is, in our view, also limited by high dividend yields. The dividend yield on the Euro STOXX 50, for example, currently stands at 3.6%, only 30 bp short of the 3.90% offered by an investment in the 10Y German Bund.
We recommend to start buying into weakness and would focus on liquid equity markets as we believe that G-3 equities will take the lead in the turnaround.
We see particular value in the S&P 500 at 1330 or a P/E ratio below 14 (actual P/E ratio at 14.6), in the Euro STOXX 50 at 3900 or P/E ratio of 11.4 and the broad STOXX 600 at 340 or P/E ratio of 12 (actual 12.8). Similarly, we recommend to increase exposure in German equities at a DAX level approaching 6400 (P/E of 12.2) and in Japanese equities at the TOPIX approaching 1625 (P/E 16.9) (see table below). Emerging Markets equities will probably lag the turnaround, and our EEMEA strategists recommended an asset allocation shift out of the high beta market Turkey into Russia which offers ample domestic liquidity, positive debt dynamics and the predominance of several oil & gas plays that have not performed well in recent weeks and months (see CAIB Equity Strategy Flash Note on Emerging Europe Country Allocation, February 28).
For carry assets, we also recommend buying into weakness, and would focus as well on the more liquid markets. We see particular value in Emerging Markets hard currency debt should the EMBI+ spread index widen by another 10 bp, i.e., reaching 200 bp over US Treasuries. On local currency Emerging Markets, we basically mirror the strategy on the equity side and recommend to underweight high beta countries like Turkey and overweight Russia.
On the corporate credit side, we see value in the iTraxx Crossover again at levels of 250 bp if investors can withstand the extreme levels of volatility.
Indeed, spread volatility has risen in the iTraxx Crossover from around 40 bp annualized to well over 100 bp in the recent sell-off. The iTraxx Europe and High Vol have been less affected in bp terms, but annualized spread volatility has still increased by 100% from 4 bp to 8 bp in the iTraxx Europe and from 7 bp to 15 bp in the High Vol (cf chart below).
In the latter indices, we do see value in case spreads widen another 5 and 10 bp, respectively.
While it is probably too early to start shortening duration given that government bonds still profit from their ultimate safe-haven status in a volatile environment, we definitely would position for such a move if signs of a final shake out emerge. Indeed, we still expect yields on USTs and Bunds to drift higher for the remainder of the year: we still target 5.25% on the 10Y UST and 4.40% on the 10Y Bund.
