After a year of very little volatility in 2017, the first half of 2018 has been far less easy to navigate. With that in mind, the following seeks to outline the bull and bear case for the remainder of the year. The points listed below represent signs that one would expect to see when the financial markets finally break one way or the other.
Bull Case:
Which way are markets presently leaning?
From an individual perspective, for the time being a neutral stance with a bias toward risk-taking in US equities remains favorable until the first quarter lows are breached. Should this occur alongside falling treasury yields, rising credit spreads, and decelerating NGDP, a greater emphasis on capital preservation would be warranted at that time. From the Fed's perspective, if the bearish scenario takes hold this would serve as a warning that monetary policy has become too tight. This would certainly be the case should a yield curve inversion occur alongside falling long term treasury yields. Again, this negative outcome has yet to play out or show clear signs of doing so. Given the strength of the global risk assets that occurred between January 2016 & January 2018, the current environment more closely resembles a pause in global risk-taking rather than the beginning of risk aversion.
As for foreign currencies and assets, both will very likely underperform their US counterparts until the USD begins to weaken materially. Whether the USD's rise is the cause, effect, or a symptom of potential troubles in the rest of the world, market participants have a tendency to bid down the currencies, equities, and bonds/debts of foreign economies whenever the greenback trends higher. This is particularly the case for economies that either are the most leveraged in dollars (a high degree of dollar denominated debt), run large current account deficits, and/or have the worst reserve positions. In essence, these countries are "short" dollars at precisely the wrong time. Therefore, it should come as no surprise that news stories about financial turmoil in foreign economies tend to break following a persistent bout of dollar appreciation.
As always, it's important to remain open-minded and flexible during this moment of indecision.
Bull Case:
- Long term treasury yields continue to climb signaling improving expected nominal growth (rising inflation and aggregate output).
- US equity markets end this period of consolidation following the Q1 intermediate price peak by making new all-time highs as investors price in improving future earnings. This would confirm the ongoing strengthening in aggregate nominal growth.
- High yield credit spreads remain narrow which show little indication of distress in debt markets. This again is consistent with a stable economic and financial backdrop.
- The USD weakens after eventually hitting resistance. Foreign currencies and risk assets especially in emerging markets find a bottom and trade higher.
- Long term treasury rates reverse and begin to decline as market participants price in the increasing possibility that growth and inflation expectations may have at least temporarily peaked.
- Equity markets break their first quarter lows after three to six months of sideways price action. This would signal caution and perhaps indicate that the earnings picture going forward may be weaker than currently anticipated.
- Credit spreads start to widen after compressing for over two years.
- The USD's ongoing rebound marks the start of a new intermediate uptrend rather than simply a correction in the downtrend that began following the December 2016 peak. Foreign currencies and risk assets remain under pressure. Eventually the dollar's ascent begins to weight on commodity prices and by extension inflation expectations.
Which way are markets presently leaning?
- Since the beginning of September 2017, 10 year treasury rates have resumed their climb which first began in July 2016 following the Brexit referendum. This supports the bull case. On the other hand should this devolve into an episode of market turmoil, May could mark an intermediate high in long term rates. It should be noted that the 3% level on the 10 year treasury rate terminated its August 2012 - January 2014 advance and risk assets peaked shortly afterwards. Therefore, a repeat of this cannot be ruled out.
- With that said, US equities are still only in a period of sideways price action. As long as this is the case with index prices staying above the first quarter lows, this price movement may simply be serving to digest the rampant 2017 gains that occurred on low volatility. Furthermore, the corporate earnings picture remains very positive.
- As mentioned above, corporate bond spreads have yet to meaningfully widen in any way. If market participants were growing fearful, one would suspect that pessimism would be manifesting itself in the form of widening spreads. This is simply not the case yet. It's important to keep an eye on this given that credit spreads have had a tendency to widen in anticipation of risk-off episodes.
- The Q1 year-over-year growth rate of nominal GDP has yet to top out. This tends to occur months prior to financial market stress.
- Despite the many positives, as expected the dollar's rebound has been a negative for foreign currencies and assets. It has also coincided with subdued US equity market performance (see the February 2018 post). If this USD strength persists (the greenback made a six month high in the middle of May 2018), this should start to negatively affect commodity prices as well. Thus in order for global risk-taking to regain strong footing, it would likely require that the dollar's recent strength be nothing more than a countertrend rally in an ongoing downtrend.
When the dollar rises, SPY tends to outperform EEM.
From an individual perspective, for the time being a neutral stance with a bias toward risk-taking in US equities remains favorable until the first quarter lows are breached. Should this occur alongside falling treasury yields, rising credit spreads, and decelerating NGDP, a greater emphasis on capital preservation would be warranted at that time. From the Fed's perspective, if the bearish scenario takes hold this would serve as a warning that monetary policy has become too tight. This would certainly be the case should a yield curve inversion occur alongside falling long term treasury yields. Again, this negative outcome has yet to play out or show clear signs of doing so. Given the strength of the global risk assets that occurred between January 2016 & January 2018, the current environment more closely resembles a pause in global risk-taking rather than the beginning of risk aversion.
As for foreign currencies and assets, both will very likely underperform their US counterparts until the USD begins to weaken materially. Whether the USD's rise is the cause, effect, or a symptom of potential troubles in the rest of the world, market participants have a tendency to bid down the currencies, equities, and bonds/debts of foreign economies whenever the greenback trends higher. This is particularly the case for economies that either are the most leveraged in dollars (a high degree of dollar denominated debt), run large current account deficits, and/or have the worst reserve positions. In essence, these countries are "short" dollars at precisely the wrong time. Therefore, it should come as no surprise that news stories about financial turmoil in foreign economies tend to break following a persistent bout of dollar appreciation.
As always, it's important to remain open-minded and flexible during this moment of indecision.
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