New York: When it’s all done, when the bulls have been broken, historians will look back and have something definitive to say about this rally’s causes and consequences. Until then, we must settle for theories.
In a baffling week, oil tankers were attacked in the Arabian Gulf, America blamed Iran, and US stocks rose. President Donald Trump threatened to slap sanctions on a fellow Nato member and the fourth biggest economy in the world, and the riskiest US debt hit a record high. For the second week running, Treasuries and the S&P 500 rose in lockstep.
Academics will have the benefit of hindsight when they figure it all out. The rest of us will have to make do with hypothesis.
First, those resilient stocks. In spite of the miserable headlines, the S&P 500 climbed 0.5 per cent in the five days. The easiest conclusion is that equity investors are betting on supportive central bankers helping juice either economic growth or asset values or both, and there’s plenty of evidence to support that.
Something else to notice. The ratio between an index of safer, low-volatility US shares and riskier value shares has been testing its all-time high for a week now. The equity rally has not been created equal. Amid the broad updraft investors have also been girding themselves for a slowdown.
“This isn’t the improvement in equities that’s fuelled by growth, just by central bank policy,” said John Roe, the head of multi-asset funds at Legal & General with a combined £1 trillion (Dh4.63 trillion) under management. “I expect bond proxies to perform well in a scenario where government yields fall.”
The resulting defensive bias also means investors are perhaps better positioned for shocks, like the geopolitical incidents which cropped up in both the Arabian Gulf and Hong Kong last week.
In the credit market, the riskiest US debt seemed to defy everything this week, from Trump’s trade brinkmanship to a precipitous midweek plunge in oil prices — a commodity it has long had a relationship with. Bloomberg’s high-yield bond index closed at a record Tuesday.
Again, is it all about those central bankers? As junk debt hit a record it seemed no one in the market so much as blinked, and that makes sense with a mountain of negative debt out there and the tightening cycle likely over. It can last for now, but the Fed isn’t the only determinant of credit prices.
“An earnings slowdown will be the catalyst for wider spreads,” Peter Cecchini, the global chief market strategist at Cantor Fitzgerald LP wrote this week. “And we expect earnings to decelerate further in Q3.”
If stocks and credit are not so crazy, maybe it’s Treasuries that are wrong. The yield on 10-year US notes closed the week 2.08 per cent, which makes sense against the backdrop of macro worries. Beyond Trump’s German barbs, the accusations against Iran and clashes in Hong Kong, President Xi Jinping still hasn’t confirmed a G-20 sit down with the US president, meaning a trade war escalation remains on the table.
Yet with an American election looming and both economic data and markets stuttering, a trade breakthrough looks very much in both US and Chinese interests. Meanwhile, the Federal Reserve’s apparent reactive posture could mean any easing is well-timed, successfully softening a slowdown. The market for Eurodollar futures this week showed some traders have already begun pricing for when rates start rising again.
“The Fed has shifted from being patient to being prepared,” said Brian Jacobsen, a senior investment strategist of multi-asset solutions at Wells Fargo Asset Management. “We could see an extension of this economic and market cycle. Yields might have overshot on the downside.”
There’s one big headwind to that argument, however, and it’s a key ingredient to the current bond rally. Wednesday’s price data showed core US inflation trailed forecasts in May, reinforcing the case for Fed cuts. Inflation expectations of both consumers and traders have been sliding, too.
It’s all another reason why defensive, bond-like stocks have been in demand, according to Evercore ISI. The markets believe in the central bank put, but aren’t fooling themselves about looming risks.
“Investors see a sharply increased need to hedge their portfolios against recession/deflation risk,” Krishna Guha and Ernie Tedeschi wrote in a note.