Following a 2019 in which risk and interest sensitive assets rebounded after a severe global bear market in 2018, is 2020 the year of reflation? Before answering this question, a review of 2019 is necessary.
January 2019: Correction or just the first leg of a big bear market?
"...whether global equity markets have already put in their respective lows for prolonged period or if panic does occur, this environment has the potential to wrong foot inflexible bulls and bears alike creating the tinder for explosive moves in either direction."
April 2019: Global bonds continue their rise as the Fed pauses
"...current market conditions still requires that market participants remain flexible even if a bias toward optimism continues to be favorable."
June 2019: What a difference a year makes
"...unlike much of 2018, the necessary conditions for a sustained breakout and uptrend in risk assets are in place today."
Oct 2019: On the Cusp of Recession or Recovery?
"Overall, the current intermarket relationships discussed in this post resemble 2012 & 2016. The global monetary stance has eased and financial conditions have loosened with US equities near highs and credit spreads tight. The dollar has appreciated while treasury yields have essentially collapsed. Although the trends in the USD and US long rates are still in place, they are both showing signs of exhaustion. A reversal in each could easily undermine the current pessimism among global asset managers who have crowded into US fixed income and negative yielding debt around the world. In hindsight, the pessimism in 2012 & 2016 proved to be the wrong stance."
As is now well known, January 2019 did usher in an explosive rally characterized by a breadth thrust that lifted risk assets off their December 2018 cyclical lows. With the Fed beginning to ease through their communication and guidance, a global bond rally saw yields and credit spreads decline massively. Importantly, this spread tightening amid a forceful bounce in equities off of a cyclical bottom should have signaled that a bullish bias was now required. The June through October 2019 period did see risk assets consolidate their gains from the first part of the year. Although pessimism was still running high, as highlighted by both posts, the conditions for a breakout similar to 2012 & 2016 were in place. Therefore, market participants should have used the summer consolidation to increase their exposure to risk assets.
This proved to be the correct stance seeing as risk assets ramped up into year end. None of the above would have required an excessive amount of data, news (noise), or pontificating gurus, only that astute market participants pay close attention to the price action in a broad range of assets and securities. Now with all that said, what are the major market signals as we begin 2020?
1.) Treasury yields are confirming the breakout in global risk assets.
2.) The USD's broken uptrend strongly suggests that inflation expectations have bottomed.
3.) Relative Strength is pointing toward reflation.
With treasury yields potentially forming a multi-year triple bottom denoted by the horizontal colored lines, since the fourth quarter of 2019 market participants have started to favor inflation-sensitive securities over their interest-sensitive counterparts.
January 2019: Correction or just the first leg of a big bear market?
"...whether global equity markets have already put in their respective lows for prolonged period or if panic does occur, this environment has the potential to wrong foot inflexible bulls and bears alike creating the tinder for explosive moves in either direction."
April 2019: Global bonds continue their rise as the Fed pauses
"...current market conditions still requires that market participants remain flexible even if a bias toward optimism continues to be favorable."
June 2019: What a difference a year makes
"...unlike much of 2018, the necessary conditions for a sustained breakout and uptrend in risk assets are in place today."
Oct 2019: On the Cusp of Recession or Recovery?
"Overall, the current intermarket relationships discussed in this post resemble 2012 & 2016. The global monetary stance has eased and financial conditions have loosened with US equities near highs and credit spreads tight. The dollar has appreciated while treasury yields have essentially collapsed. Although the trends in the USD and US long rates are still in place, they are both showing signs of exhaustion. A reversal in each could easily undermine the current pessimism among global asset managers who have crowded into US fixed income and negative yielding debt around the world. In hindsight, the pessimism in 2012 & 2016 proved to be the wrong stance."
As is now well known, January 2019 did usher in an explosive rally characterized by a breadth thrust that lifted risk assets off their December 2018 cyclical lows. With the Fed beginning to ease through their communication and guidance, a global bond rally saw yields and credit spreads decline massively. Importantly, this spread tightening amid a forceful bounce in equities off of a cyclical bottom should have signaled that a bullish bias was now required. The June through October 2019 period did see risk assets consolidate their gains from the first part of the year. Although pessimism was still running high, as highlighted by both posts, the conditions for a breakout similar to 2012 & 2016 were in place. Therefore, market participants should have used the summer consolidation to increase their exposure to risk assets.
This proved to be the correct stance seeing as risk assets ramped up into year end. None of the above would have required an excessive amount of data, news (noise), or pontificating gurus, only that astute market participants pay close attention to the price action in a broad range of assets and securities. Now with all that said, what are the major market signals as we begin 2020?
1.) Treasury yields are confirming the breakout in global risk assets.
- Treasury yields are in the process of making their third major monthly low (yellow line, September 2019) following the Global Financial Crisis of 2008-2009 (purple line in July 2012 & blue in July 2016).
- In each instance, risk assets exemplified by the high yield bonds (HYG), US indices and international equity markets all put in a cyclical bottom prior to the final low in treasury yields.
- As long as the current bottom in treasury yields continues to hold, this will mark a cyclical shift away from risk-free treasuries in favor of risk assets.
- Although the current rebound in risk assets began a year ago, the breakout only just started in Q4 2019.
- Will corrections occur along the way? Absolutely. However, the current conditions favor a continuation in the direction of the breakout that is likely to persist for the balance of 2020.
- Unsurprisingly, volatility trended lower during this recent phase. The multi-month consolidation in VIXY, a short-term VIX futures ETF, broke down violently in October 2019 and began it's downtrend. This serves as another indication that market participants should maintain a riskier portfolio in the months and possibly years ahead. Again, this does NOT suggest that short-term corrections will not occur, but that the intermediate and long term trend in risk is up.
2.) The USD's broken uptrend strongly suggests that inflation expectations have bottomed.
- The spring of 2018 saw the dollar begin a multi-year uptrend that caused (or at least coincided with) a cyclical decline in international equities and inflation expectations. Fast forward nearly two years, UUP's uptrend has likely ended. Although it remains to be seen whether the dollar is set to trend lower or consolidate from here, these outcomes should provide relief for foreign economies, equities, and their respective FX rates.
- For the most part, inflation expectations and the USD exhibit an inverse relationship with one another. As long as global growth improves and broad risk taking returns, the USD's safe haven bid should subside. Should a dollar downtrend in fact materialize, look for market based inflation expectations to improve in the months ahead.
- The rebound in high yield credit also suggests that inflation expectations are bottoming. Simply, a stronger nominal growth environment will benefit the riskiest parts of credit at the expense of safe haven government bonds. On the other hand, if growth fails to bottom in 2020, high yield and inflation expectations would be at risk of moving south together.
3.) Relative Strength is pointing toward reflation.
With treasury yields potentially forming a multi-year triple bottom denoted by the horizontal colored lines, since the fourth quarter of 2019 market participants have started to favor inflation-sensitive securities over their interest-sensitive counterparts.
- TIPS Bond Fund ETF put in a low relative to IEF, the 7-10 year treasury bond fund, each instance where investors began to anticipate rebounds in yields and inflation.
- To support this story, inflation-sensitive copper has start to outperform rate-sensitive gold.
- This developing environment should bode well for emerging market assets relative to safe-haven treasuries. These above relative strength ratios as well as the breakdown in the UUP strongly suggest that the present breakout in EEM may be the start of a renewed up leg in a global cyclical recovery.
- Throughout much of 2018 and into 2019, investors were already frontrunning the current global easing cycle by bidding up government bonds along with interest-sensitive utilities. This came at the expense of commodity markets. With the global growth cycle making it way through the trough, commodities have now started to outperform treasuries and utilities. Should this persist, this provides another clue that a reflationary growth rebound in 2020 may be in the cards.
4.) Long term relative strength ratios provide perspective that the Fed should be on hold for a while.
- Although TIPS and basic materials outperformed IEF (treasuries) and utilities in the fourth quarter, the current relative strength readings are still near lows that are typical of weak growth environments. The Fed along with global central banks did well to respond to such concerns by easing their respective monetary stances over the last twelve months. However, such relative strength readings indicate that there is much more room to remain accommodative before inflationary pressures become problematic. Simply put, the Fed should maintain an accommodative stance for the time being otherwise they risk pushing a growth slowdown into recession. If that were to unfold, treasuries and utilities would almost certainly trend higher against TIPS and basic materials.
- To add further evidence that the global cycle is in the process of rebounding, consumer staples (XLP) have also just recently started to lag the broader consumer goods sector (IYK) after leading during the two year slowdown phase. Importantly, this provides yet another clue that treasury yields may be on the cusp of moving higher in 2020 as market participants price in higher nominal growth.
Summary:
After a tumultuous market environment in 2018 that arguably caused the third global economic slowdown since the 2008-2009 Global Recession, the Fed immediately kicked off 2019 by pivoting away from their hawkish policy stance. Frontrunning rate cuts, global bond markets were bid up aggressively as yields fell sharply while credit spreads tightened. To start 2019, global equities led by interest-sensitive sectors first rocketed off of what now appears to be a cyclical low made in December 2018. The summer then saw risk assets consolidate these gains before finally breaking out of their two year range in the fourth quarter of 2019. The Q4 breakout in risk assets has been global in participation and in part led by the reflationary sectors mentioned above. Importantly, given the two-year decline in inflation-sensitive sectors as well as inflation expectations, the reflationary forces are nascent at best. This suggests that the Fed and other major central banks can remain accommodative for some time before excessive inflation becomes a problem. This changing market picture is exemplified by the breakdown in the US dollar index that came at the very end of 2019 after its two year rally against a broad range of currencies. Should the greenback's weakness persist, this will likely provide another big reason to remain bullish risk assets over the intermediate to long term.
After a tumultuous market environment in 2018 that arguably caused the third global economic slowdown since the 2008-2009 Global Recession, the Fed immediately kicked off 2019 by pivoting away from their hawkish policy stance. Frontrunning rate cuts, global bond markets were bid up aggressively as yields fell sharply while credit spreads tightened. To start 2019, global equities led by interest-sensitive sectors first rocketed off of what now appears to be a cyclical low made in December 2018. The summer then saw risk assets consolidate these gains before finally breaking out of their two year range in the fourth quarter of 2019. The Q4 breakout in risk assets has been global in participation and in part led by the reflationary sectors mentioned above. Importantly, given the two-year decline in inflation-sensitive sectors as well as inflation expectations, the reflationary forces are nascent at best. This suggests that the Fed and other major central banks can remain accommodative for some time before excessive inflation becomes a problem. This changing market picture is exemplified by the breakdown in the US dollar index that came at the very end of 2019 after its two year rally against a broad range of currencies. Should the greenback's weakness persist, this will likely provide another big reason to remain bullish risk assets over the intermediate to long term.
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