The Big Conversation
Episode 142: Will a rally prevent a pivot?
This week we're asking the big question on everyone’s lips right now: “Are we about to see capitulation in markets?" With the help of Refinitiv’s exhaustive data, the answers lie in keeping a close eye on measurements such as unemployment, consumer sentiment and the ISM. But keep an eye too on the correlation between assets, because that can be a very good sign that we are teetering on the edge.
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Jamie [00:00:00] The dollar is soaring. Global bond markets are imploding. And commodities, which were at one point the highflyers of 2022, well they are now rolling over in dramatic fashion too. But perhaps even more worrying than that, correlations between asset classes are rising, which may mean that people are starting to sell not what they want to, but what they can. And that's typically a sign that things are becoming unstable. Frankly, stress has been building ever since Jerome Powell's infamous speech at Jackson Hole a month ago, but the question we need to ask ourselves is, 'have we finally reached the breaking point?' Because that's this week's Big Conversation.
Jamie [00:00:46] There's no question that it's been one hell of a week in financial markets. Just look at some of the currency moves we've had between the Japanese Yen and the British Pound. Last Friday, the British Pound fell almost 3.6% in a single session. It's almost a daily occurrence where at least one developed market currency is falling anywhere between 1 and 3% against the US dollar. And to be clear, that is not normal. Now, what's crucial during a time like this is to make sure you don't lose your shirt, which would then affect your ability to go on the attack when opportunity comes knocking. Stay patient. Watch. Listen to the events that are unfolding around us. So let's take a look across the financial system and see what's going on and what matters most. I assume most people watching, especially in the U.S., care most about equity markets. And yes, they are sitting right around year-to-date lows. Many of you will see that as cause for alarm, and yes of course, it's a reflection of the challenges facing corporations during these highly uncertain times. But having said that, believe it or not, equities are acting rather resilient when compared to the fixed income, or some of the developments in currency markets. What's the scoop here? Well, in normal times, the resilience in equities would make sense when you look at things like the ISM Manufacturing Survey. You see the ISM tends to have a decent track record as a leading indicator, so the fact that it just posted its 27th consecutive month above 50, which is the threshold that separates expansion and contraction, could be viewed as reason for optimism. Offsetting that optimism, though, are other indicators like consumer sentiment and various investor surveys, such as the American Association of Institutional Investors. And they show an alarming level of negativity. Right now, the AAII survey shows the fewest number of responses as bullish since April of this year. Okay. Yes, I'm being a tad facetious, but seriously, the readings this year have far surpassed the depths of the global financial crisis. In other words, people are saying they are downright terrified. Now for some good news. Sentiment surveys tend to act as an excellent contrarian indicator. When people expect the world to end, it's not all that difficult for future developments to seem, let's just say not so dire. But this brings me to another point worth exploring. Judge a person not by what they say, but by what they do. And have we seen major retail outflows yet? Not really. According to FactSet, U.S. ETFs have drawn in $332 billion through the first half of this year and have exceeded full-year flows for every year between 1993 and 2016. We can also look at the drastic divergence between AAII's own data. If we look at the survey data, investors say they're extremely bearish. But if we look at the asset allocation data, investors still hold equity allocations above the long-term average. So why are investors so calm in an otherwise terrifying world? Well, as we just mentioned, some leading economic indicators like the ISM aren't all that troubling. And secondly, employment, which is such a crucial pawn in all of this, it's still not crumbling, despite corporate commentaries of impending layoffs. So, yes, equities haven't been all that stellar year to date, but really we haven't seen a big puke or true panic. So when will that happen? I hear you ask. Well, a lot depends on unemployment. You see, major equity drawdowns don't typically occur until we see a meaningful rise in the unemployment rate. Will we see a dramatic rise in the number of unemployed persons here in the United States? Well, that's a big question. But for those of us watching and listening for the clues, we should be monitoring initial jobless claims, which is a higher frequency data series and tends to give an excellent lead for the headline unemployment rate. So there are reasons to be optimistic and there are reasons to be more cautious. But again, all of this is predicated on normal times. And as I said right at the outset, what we've seen in the past couple of weeks is certainly not normal. Following the Federal Reserve's decision to raise the Fed Funds Rates by 75 basis points, the Bank of Japan walked, in fact, ran in the opposite direction. Not only did they not raise interest rates, leaving their benchmark rate in negative territory, but the central bank reiterated its commitment to yield curve control. And with the rest of the world firmly in tightening mode, this divergent policy stance has sent the Yen tumbling, forcing Japan's Ministry of Finance to step in with its first direct forex intervention since the late 1990s. Now, some suggest this temporary manoeuvre won't be effective because the BOJ is still running full steam ahead with its QE programme. But therein lies the issues facing many central banks around the globe. As the Federal Reserve pushes interest rates higher here in the United States, those yields become more attractive to foreign investors. Foreign investors pour capital into the United States to capture the higher rates, creating upward pressure on the US dollar and downward pressure on their local currencies. And a depreciating currency tends to fuel further inflationary concerns and thus even more capital outflows and the cycle repeats. In the case of Japan, this circular reference, where global rates are surging, only creates further headaches for the Bank of Japan. As capital flows out of the Japanese government debt stuck at zero, it only makes things more difficult for the BOJ that now needs to buy more debt in order to maintain current yields. So what will they do? Continue with QE in the face of rising rates and risk a disorderly decline in the Yen? Or abandon existing yield targets? Well, in the case of the latter, surging Japanese yields that serve as the basis for many carry trades is certainly one of the many lurking tail risks across the global landscape. And then there's the situation over in the UK where the pound has come under significant pressure this year, not only due to surging inflation, but the lack of an aggressive policy response to it from the Bank of England. To combat the rising cost of living, the Conservative Party recently announced a fresh round of stimulus efforts. However, much like the initial COVID response, deficit spending is often viewed as inflationary. And in response, the pound fell precipitously, while U.K. government bonds, popularly referred to as gilts, also tumbled. Again, we can think of this in terms of that circular dollar reference where investors flee a weakening currency, accelerating the decline, which only exacerbates inflationary pressures. Naturally, all eyes have turned to the BOE. That's right. If it hasn't happened already, by the time this show airs, watch out for the Bank of England hiking rates in an effort to stabilise the pound. The point in all of this isn't to scare investors. It's to highlight the many tail risks lurking in the weeds. And while the current narrative around bearish sentiments is catching all the headlines, positioning data suggests equities could be at risk of a larger unwind. Between the dislocations in the bond and foreign exchange markets, as well as the Fed's stated mandate to fight inflation by slowing demand, likely through a rise in the unemployment rate, there are a lot of headwinds facing equity investors today. And keep your eye on correlations, too. The higher the correlation, the more the panic is inferred.