Risk sentiment ignores flesh wounds

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November is ending on cautious note for financial markets today, but one that barely dents a strong month for European and US equities. In contrast, emerging markets are not quite affirming the optimism that pervades developed world equities.

R00C79 Monty Python and the Holy Grail  Year : 1975 UK Director : Terry Gilliam Terry Jones Graham Chapman. Image shot 1975. Exact date unknown.
© Alamy

November will finish with global equities recording a third straight month of gains, with any setbacks being viewed in Monty Python terms as mere flesh wounds for now. 

The bullish macro argument rests on expectations of a global economic upswing looming in early 2020, but another view (and one hard to dismiss) is that rallying equities reflect expanding central bank balance sheets in Europe and the US. Central bank liquidity gains credence as the principal driver of sentiment, once you dig deeper into the recent performance of global equities and also take note of growing risk aversion among emerging market currencies. As the chart below highlights, Wall Street leads the way, with global equities sans the S&P 500 up less than 1 per cent in November. A similar story defines EM equities.

Line chart of MSCI indices rebased showing Wall Street sets the pace

The dip in equities today, with Wall Street edging back from record territory in an abbreviated trading session after Thanksgiving, is modest. Much can be discerned from market retreats and in this case, the underlying message for Wall Street and European equities is that their rallying trend since early October retains support. A bull run is noted for limited pullbacks as buyers quickly reload on weakness. Not so good for the patient buyer of the dip, still waiting for a classic 10 per cent correction. That will ensue at some stage, but a lagging performance by hedge funds and other investors implies pushing a stretched market only higher as the final month of 2019 beckons. 

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Elia Lattuga, cross asset strategist at UniCredit, says positioning matters: 

“The beta of hedge funds’ performance to S&P 500 returns remains very low. This is the case across several sub segments (strategies) of the industry. Hence, if the rally continues, there might be some forced buying.”

Still there are red flags fluttering, and in that regard, Elia notes: 

“A raft of technical indicators suggest that equity indices look overbought (on charts), and this applies to both US and European indices. Finally, implied volatility and related measures (skew, put/call ratios, etc) point to a very relaxed picture of risk aversion in the system.”

Disappointing economic data in the coming weeks may clip sentiment, although it appears equities will not really react to signs of weaker US and eurozone growth prospects until January. That focuses attention upon current trade negotiations and here, a record breaking Wall Street may well encourage the White House to drive a harder bargain. Particularly as China’s equity market has been lagging the US in recent months and credit strains are becoming more notable. 

Mark Dowding at BlueBay Asset Management notes that a current price/earnings ratio of 21 times for the S&P 500 entails a market vulnerable to negative headlines, and he writes:

“In this regard, we would assess that stocks are taking quite a lot on trust at the current time and were a US-China trade deal to disappoint, or presidential impeachment to spook overseas investors, then a material retracement remains a real possibility before the year comes to a close.”

Signs of pressure are rising elsewhere, with equity market performance for South Korea, Hong Kong and China during November turning negative. This helps explain why the MSCI EM equity index rose less than 1 per cent this month and has retreated 2.2 per cent over recent weeks. Financials, the largest EM equity sector at a weighting of one quarter, were a laggard in November and for the year are up just 3 per cent. It’s never a good sign for an equity market when lenders are struggling. 

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EM equity performance this year (the MSCI EM index is up 8.8 per cent) trails an index of US dollar-denominated debt sold by emerging economies (plus 11.4 per cent), another sign of investors taking a more circumspect approach in their portfolios. In the currency sphere the mood is far from comforting, with Brazil and Chile at the forefront. The pressure on Latin American currencies amid social unrest is starting to weigh on the Mexican peso, a more liquid proxy vehicle for EM risk. The Polish zloty is another liquid EM currency that in recent weeks has traded as a barometer of risk aversion. 

Bar chart of Worst-performing emerging market currencies in November (% change v US$) showing EM basement dwellers in November

Two important factors explain the lagging performance for EM this year. Expectations for a weaker US dollar and Chinese stimulus that benefits the sector more broadly have not materialised during 2019. This weekend China reports its official November purchasing managers’ index figures and expectations are for a modest improvement, and that likely affirms Beijing’s current strategy of selective stimulus measures. 

Flesh wounds for risk appetite at the moment could well become a lot more serious once 2020 gets going and this year’s market gains require validation from stronger earnings and macro activity. 

Quick Hits — What’s on the markets radar 

Trading among the major currencies has been very sleepy of late, highlighted by the world’s most active pair, the euro versus the US dollar, experiencing its slowest week in its lifetime. The FT’s Adam Samson writes that over the past five days the euro’s difference between its highest and lowest points against the dollar has been a mere 0.38 per cent, marking the quietest stretch for the euro since it was introduced in January 1999.

Column chart of Difference in high and low in euro-dollar pair (%) showing Euro: Steady as she goes

Expect more of the same argues UniCredit and its analysts note how against a backdrop of ample available liquidity, and major central banks remaining accommodative, “a high degree of synchrony in economic cycles and in monetary policies worldwide will likely keep volatility low”.



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