Fading the ‘risk on’ launch

Market optimism about the direction of trade and Brexit has cooled a touch after some time for reflection over the weekend. 

A retreat from last week’s big rally in equities, rise in sovereign bond yields and recent sterling strength is hardly a surprise. Markets need conviction to really engage the risk-appetite engines, and when it comes to negotiations over trade and Brexit, flickers of optimism have a tendency of being followed by frustration over the finer points.

The latest stop-go sequence for risk appetite emerged on Monday on the news that China wanted to talk more before completing “phase one” of last week’s tentative trade deal, which is slated for being signed at the Apec summit in Chile in mid-November. That was followed by Steven Mnuchin, the US Treasury secretary, warning that a new round of tariffs set for December 15 on $156bn of Chinese goods would be triggered if Beijing failed to comply with “phase one”. 

This leaves markets rangebound, awaiting clearer signs over trade and Brexit (addressed in Quick Hits below). But the details about last week’s limited or “phase one” deal remain sketchy to say the least.

Here’s a longer-term take from Citi’s economists:

“Intellectual property protection, technology transfers, and industrial subsidies will remain major points of contention through the next phases of negotiations. The recent cycle of swelling trade tensions followed by positive rhetoric may very well continue through the US election cycle. Uncertainty is likely to continue to have an impact on investment plans and could lead firms to diversify their supply chains.”

European equities retreated on Monday after outpacing Wall Street last week. US shares were little changed, with the S&P 500 index holding above key levels of support — the 50- and 100-moving averages — at 2,966. 

The S&P 500 also faces the start of the quarterly earnings season, where trade should certainly feature as a topic of concern on plenty of company calls. The US equity strategy team at Morgan Stanley is not buying optimism over the latest trade tidings, with its weekly note packing a bearish message:

“The bottom line for us is that without a significant roll-back of existing tariffs, we don’t see how a ‘mini-deal’ will change the currently negative trajectory of growth in both the economy and earnings. In fact, we have long held the view that the threat of a deal has been keeping fundamental investors from selling bad news for fear of missing out on a trade deal rally.”

As for Monday, US Treasury futures (the bond market is closed for Columbus Day) were firmer, reflecting a rally in prices for UK gilts and eurozone government debt. The US dollar was generally higher, with plenty of attention now focused on news on trade and Brexit in the next few weeks. 

This year’s pronounced drop in global bond yields across the 10- to 30-year sector alongside a stronger US dollar certainly stand out as important narratives for 2019. Last November, the 10-year US Treasury note peaked near a yield of 3.25 per cent; now it’s about 1.70 per cent.

A sustained trade truce, alongside the US Federal Reserve buying a lot more short-term Treasury bills, suggest there is scope for a steeper Treasury yield curve. That implies a test of 2 per cent on the 10-year yield. Such an outcome would likely reignite the equity market shift towards cyclicals, a trend we saw a flicker of late last week when yields were rising. 

Analysts at BTIG note that S&P 500 defensive sectors — the only ones to hit new highs since the broad market set its record peak in late-July — are under pressure from the rise in bond yields. Higher bond yields means a “further rotation out of defensives and into cyclicals, especially financials, can be expected”, adds BTIG. 

Another key barometer is broad sentiment towards the US dollar versus those of emerging market currencies. A weaker dollar versus EM would suggest a better appetite for risk and supports the belief that trade tension is shifting towards the rear-view mirror. 

In a nutshell, rising risk appetite would be signalled by steeper yield curves and a weaker dollar, led by EM currencies, while across equities, cyclicals, or companies in sectors exposed to economic activity in Europe, Japan and EM, should also lead the way higher. 

Such an outcome likely remains a counter trade and ultimately risks fading as the bigger macro story is how trade friction only partly explains weaker global activity of late and casts doubt on prospects for a firm rebound.

Neil Shearing at Capital Economics estimates trade and tariffs have “been responsible for perhaps one-quarter of the slowdown in global GDP over the past couple of years”.

He adds:

“The lagged effects of earlier policy tightening in the US and China, problems in the European auto sector and the unwinding of a particularly large inventory cycle in the electronics sector have been [a] bigger drag on growth.”

Quick Hits — What’s on the markets radar

Market jitters are never far from the surface when Brexit is mentioned. Michel Barnier, EU chief Brexit negotiator, said the revised deal from Boris Johnson, the UK prime minister, was complex and needed more time to be resolved. That has knocked the pound, but the currency has bounced from its low on Monday of $1.2516 and stands more than 3 cents higher from its low on Thursday. 

Michael Metcalfe at State Street says the pound is undervalued based on the bank’s purchasing power parity indices from PriceStats and that means “should, against all recent expectation, a deal get agreed” he thinks: 

“A knee-jerk move to at least fair value, currently 1.36 against the US dollar, seems probable. At least until the transition period hits its first roadblock.” 

China’s disappointing trade figures for September, showing a drop in both exports (down 3.2 per cent year-over-year versus a forecast drop of 3 per cent) and imports (down 8.5 per cent y-o-y, and beyond a forecast 5.2 per cent drop) show how friction with the US and a weaker domestic economy acts as a one-two punch.

Mitul Kotecha at TD Securities writes:

“The data reveals yet more evidence that 1) US tariffs are having a growing impact on Chinese trade and 2) Weakening Chinese growth is also weighing on imports demand.”

The lacklustre performance of recent tech listings on Wall Street comes after a long period whereby investors have placed a premium on growth companies. Signs of investors focusing on profits explains the harsh verdicts imposed by the public markets on newly listed companies. A shown here, via Bank of America Merrill Lynch:

“The proportion of IPOs with negative ebitda or EPS has reached Tech Bubble levels, with over 70% of IPOs not yet profitable.”

Proportion of unprofitable IPOs has reached tech bubble levels

The situation, argues BofAML, may well spur bigger ripples. Here’s one potential outcome:

“Tech innovation has been one of the biggest deflationary factors and if companies start focusing more on profitability via pricing, we could start to see an upward pressure in inflation.”