10 signals that dictate markets
WHILE we are fixated by economic data points, earnings reporting season, daily movement of the bond, equity, forex and commodities markets, trade and currency war, the most important element of the market’s future direction is, in actual fact, investors’ sentiment.
How do we gauge investors’ sentiment and how is this sentiment formed by investors? To answer that we look at what is called “market signals”. What are these market signals?
The first signal is indeed non other that the US yield curve. Investors are keeping a watchful eye on not only the US yield curve inversion between the 3-month and 10-year as well as the 2-year and the 10-year US treasuries (Chart 1) and the depth of this negative inversions but also yield curves in other markets. The UK 10-year minus the 2-year yield curve too has inverted while the entire German yield curve has now inverted. Inversion of yield curve is the first sign that equity markets start to react as it signals recession on the horizon, typically 6-12 months down the road. While the current spread (at the time of writing) is still +1bps, the 10-year minus the 2-year went into the negative zone momentarily on Wednesday. The 10-year minus the 3-months US Treasuries has been in inversion mode for a while now and it was last seen at 31bps. Interestingly is the fact that the US 30-year treasuries has fallen below the 2% mark on Thursday – which is new all-time low.
The level of total debt that the whole world is in today is another worrying signal, thanks largely to easy money policies by the US Federal Reserve, European Central Bank and Bank of Japan as well as People’s Bank of China’s efforts in providing liquidity. According to statistics from Institute of International Finance (IIF), although off the recent highs, the total global debt stood at some US$246 trillion as at 1Q of 2019 and as a percentage of GDP – a staggering 320%! This can be seen from Chart 2.
Measured over time, the global debt level has expanded by some US$150 trillion since 2003 and almost half of it just in the past 10 years – again, thanks to the Quantitative Easing (QE) programs that we had experienced in the aftermath of the GFC. By sectors, debt to GDP is highest for non-financial corporates at 91.4%, Government debt to GDP is at 87.2% while corporates and household makes up 80.8% and 59.8% of GDP respectively.
The third signal is an interesting chart as we plot the US Federal Reserve Fed Fund Rate against events that had unfolded soon after the Fed cuts rates since 1975. The chart basically shows that recession occurred in last four out of the six occasions when Fed is on an easing mode and only escaped recession when in the mid-1980s and in another cutting cycle in mid-1990s. Will this time be any different? After all, in Fed’s view the recent 25bps cut was only a mid-cycle adjustment and not a signal that the Fed is on an easing mode.
As we know, the US economy remains on a growth cycle and the fourth signal of significant importance shows that the US economy is now on an unprecedented 122 months of positive growth. This is the longest cycle in history and indeed every month adds to the record. The longer this cycle extends, the likelihood grows that it will falter sooner or later.
The fifth signal is all about probability – many US brokers have called on the probability of “a recession in the US within the next 12 months”. Among the recent reports are a report from Bank of America, which predicts 30% chance, a survey by Bloomberg among economist was tagged at 35% and JP Morgan calls it at 40% probability. Jeffrey Gundlach, the CEO of DoubleLine Capital, believes that there is a 75% chance of a recession happening before the US Presidential elections in November 2020 while according to New York Fed last month, the probability of a US recession occurring by June 2020 is approximately 1 in 3 chance – which is already a 12-year high. The most pessimistic opinion comes from Rabobank, who sees an 81% chance of a US recession by the end of next year. Their model even suggests that the coming recession is going to be the worse than the GFC. Rabobank even expects that the Fed Fund Rate will be back to near zero by the same time horizon. Effectively, Rabobank sees eight rate cuts between now and end of next year!
The sixth signal is the volatility index that we can observed from charts – be it stocks (as measured by the VIX index), currency, commodities and bond markets. Market volatility has escalated to the extent that we are seeing market swings on almost daily basis since the start of this month or since President Trump announced his 10% tariff on US$300bil worth of Chinese goods that are exported to the US.
The seventh signal is Donald Trump’s tweets – one can’t imagine if one is not following his twitter account as policy announcements, especially in relation to trade war as well as the way the Fed is handling the US Fed Fund Rate remains the most important platform to know what is next on his agenda. His tweets can dictate market’s immediate response to his rantings!
The eights signal is the Fed Fund implied probability of a rate cut and this has been a daily signal for markets. As of now, the market is implying two more rate cuts this year and another by Jan 2020. The probability of a Sept-19 25bps cut is now at 77%, while for Oct-19 and Dec-19 FOMC meeting, the market is looking at 60% and 40% probability of 25bps each. Any improvement or deterioration to these expectations could also have impact on markets as investors react to growth expectations of the US economy and other signals that dictate Fed’s move.
The ninth signal that is of significance is a survey among global fund managers as compiled by Bank of America Merill Lynch (BofAML). In its August report, the survey found that corporate bonds were seen as most vulnerable to “a classic investment bubble” by 33% of those surveyed. This was followed by government bonds at 30% and US equities at 26%. What is also interesting is that only net 5% of investors expect value to underperform growth over the next one year – this is the lowest since GFC, which basically reflects extremely bearish inflation and growth expectations. According to the August survey, investors allocation to bonds climbed 12 percentage points (pps) to net 22% saying they are underweight, while allocations to global equities fell 22 pps to net 12% underweight. With recession fears rising, investors’ concern on valuation increases.
A safe haven asset would likely be bonds as some 43% of those surveyed expect lower short-term yields over the next 12 months, while only 9% expect higher longterm rates. This can be seen from Chart 3.
The final signal is the size of the balance sheet of the central banks. While the Fed is now expected to stay put, there are still bullets left for ECB, PBoC or even BoJ to continue to expand their respective balance sheet to ensure liquidity remains as can be seen from chart 4. Any move to retract this liquidity from the market will create another round of uncertainty for markets and the bearish undertone will dictate market direction.
There you have it! Ten signals that investors need to be keep an eye on and that will likely cause either the markets to recover from its recent pullback or whether we will be in for larger market correction over the short and medium term.
The views expressed here are solely that of the writer.