Appetite for risk shows signs of indigestion

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February is ending with the appetite for risk showing a degree of indigestion.

After disappointing data from Japan and China, the US produced a fourth-quarter GDP number that beat expectations, arriving at 2.6 per cent. Still, Q4 was slower than prior quarters (3.4 per cent for Q3 and 4.2 per cent in Q2), so the trend of a moderating economy framed the start of 2019.

The Conference Board sets the stage for a US soft landing:

“During 2019, growth is likely to slow down towards the economy’s long-term 2.0 per cent trend as support from fiscal policy is reduced, but more gradually than anticipated at the beginning of the year.”

The US data pushed Treasury yields a touch higher and leaves the S&P 500 near the 2,800/2,810 area — a ceiling that capped the market’s rebounds last October, November and in early December. 

Equities have the support of a Federal Reserve policy pause, low bond yields and slumbering market volatility, but they have rallied a fair way already this year. March should mark a period of digestion given the double-digit gains notched by a number of benchmarks. 

The FTSE All World equity index is up 10.5 per cent this year and higher by 9.2 per cent, once you exclude the US market.

Looking at the US, David Bianco at DWS says:

“Now that both the S&P 500 and Russell 2000 are within shouting distance from their previous peaks, an examination of the macroeconomic backdrop, earnings-growth outlook, balance sheets and valuations causes us to return to our small underweight we had before late 2018’s sell off.”

Another reminder of the recent past — or how things looked last September and early October — is shown by equity volatility for the S&P 500 and Europe’s Stoxx 50. More broadly, market volatility (for bonds and currencies) has eased sharply, reflecting the cooing of dovish central banks. That’s not good news for investment banks and their trading operations, a point raised this week by JPMorgan.

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Slumbering market volatility does not mean there is less risk. The steady rise in value for risky areas of the market, akin to climbing a series of steps, has a flip side. When the alarm resonates, equities and credit take the elevator down as seen so dramatically last year in February and then December.

Growing evidence of a synchronised slowing global economy, means we are nearing an important juncture. Here, China looms large and follow-through from its recent stimulus is one catalyst that will probably guide broader investor sentiment from here.

Here’s Pimco with an interesting observation: 

“Unlike past Chinese approaches, which were more focused on demand (“shovels in the ground”), this stimulus is supply side driven, so it’s hard to know what the ultimate multiplier effect might be as there are no precedents.”

Indeed, Jaisal Pastakia at Heartwood Investment Management cautions:

“While signs of overall credit expansion in January are welcome, investors should watch out for evidence of sustainability, and furthermore for proof that credit expansion is impacting economic activity.”

A definite shift from China’s focus on “deleveraging” its financial system is what markets have priced in. Now they need to see some real evidence that the broader economy is benefiting. 

Quick Hits — What’s on the markets radar

Trump diplomacy and markets — The abrupt end to the US-North Korea summit in Hanoi, marked by President Trump walking away after US demands were rejected, hit South Korean equities, with the Kospi falling 1.8 per cent. Beyond that the ripples are contained and Brown Brothers Harriman notes:

“The summit itself was hastily planned and so the outcome does not come as much of a surprise. As with all things North Korea, any market impact is likely to be short-lived.” 

For markets, the worry is a repeat performance once the US and China try and formalise a trade agreement.

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Marc Chandler at Bannockburn Global Forex says:

“US President Trump’s willingness to walk away from the talks is important in and of itself, but it also sends a warning not to go all in on a US-China trade agreement that could also sour at the last minute.”

UK homebuilders are a play on Brexit — That’s the view over at BCA Research, who note the sector will benefit should the UK parliament eliminate a no-deal outcome, rather than just delay matters. 

That entails “a sustained rally in the pound” argues BCA, who believe “in this event, UK exposed risk-assets would also outperform” and “investors should focus on: the FTSE 250 and the FTSE Small Cap, but the best play is the UK homebuilders”.

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