Macro optimism can spur a faster rotation

  • September 11, 2019

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The interest rate, value, growth and momentum cogs are whirring as investors assess whether hopes of a brighter economic outlook, or confirmation that the worst of the global slowdown is in the rear-view mirror, has foundation.

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Beijing made all the right noises on Wednesday if its goal was to lift market sentiment. In a gesture of goodwill, China would for one year suspend tariffs on 16 types of US imports, which included cancer drugs, lubricant oils and a handful of chemicals. In effect, these were US imports China needed. Nevertheless, it was still a step that would nurture the recent recovery in risk appetite.

In that vein, data showing a big rise in Chinese lending activity during August also reinforced hopes of stimulus lifting the global economy. But given the rebound in credit was driven by the shadow banking sector, some caution is required, as noted by Marc Chandler at Bannockburn Global Forex:

“It is another sign that China is more serious about arresting the economic slowdown than addressing excesses in the credit and the moral hazards that are present.”

This sets the tone ahead of Thursday’s meeting of the European Central Bank and the release of US consumer price inflation data for August. Both have the potential to either stem the recent climb in sovereign bond yields or intensify selling pressure.

That said, no asset class operates in a silo as seen in the connection between bond yields and investing styles in equity markets of late. A further rise in bond yields is seen spurring more rotation away from low-volatility and defensive shares towards “value” and cyclical stocks.

This shift has been playing out for nearly a month. In the S&P 500 and the Euro Stoxx 600 indices, previously unloved sectors such as energy, banks and industrials have enjoyed substantial rallies. But ahead of Thursday’s ECB meeting, banks were under pressure as lenders need relief from negative interest rates to sustain their rebound from last month’s multi-decade low.

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Rotations are a regular feature of markets so it’s hardly surprising that at some point beaten-down sectors such as eurozone banks and other cheap equities become too appealing, particularly when winners such as utilities and quality defensive stocks attain Icarus altitude.

The rebalancing of portfolios between growth and value assets usually runs for a while. As Goldman Sachs notes, there have been 13 long-term secular shifts since 2008, or about one or two a year:

“They tend to be relatively short, lasting about four months, with an outperformance of cyclicals vs defensives of 16% on average.”

Goldman also highlights the other important aspect of such shifts:

“During these rotations, we find that bond yields tend to rise and economic growth improves.”

That point is illustrated by Citi and its chart package:

While value has been picking up since mid-August, the shift against momentum has become a lot clearer since early September, the starting point for the rise in global 10-year yields.

Expectations for a rebound in growth, nurtured by a combination of central bank easing, fiscal stimulus, credit expansion and a thaw in Sino-US trade relations, is a tonic for risk appetite that is being led by cyclical and value stocks. It’s a reflation trade that also pushes real and nominal bond yields higher. While the shift has scope to run, the big structural trends of low yields and modest growth will limit the rise in bond yields and eventually trigger a move back towards growth stocks.

Quick Hits — What’s on the markets radar

The euro traded below $1.10 on Wednesday, nearing its floor from May 2017. The single currency’s reaction to the ECB policy meeting may well depend on the return of quantitative easing as the interest rate divergence between the US and Europe is mapped out for the coming months.

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TD Securities says the return of QE from the ECB “is a different matter” and makes the point:

“Relative balance sheet developments have previously corresponded reliably with directional trends in EUR/USD, especially during periods of expansion by one or the other.”

Another issue from renewed QE is that it “may reverse — or at least slow — recent improvements in the eurozone’s capital flow dynamic. This could develop into a significant structural headwind for the EUR once again, particularly if the ECB ultimately delivers several rounds of increased asset purchases.”

However, a less than comprehensive easing does raise the prospect of a firmer euro, as noted by FT Markets.

Wednesday’s sale of $14bn in reopened 10-year notes sold at 1.739 per cent. It turned out that demand from investors was marginally weaker than recent auctions. It’s worth noting that in spite of a rise from a recent low of 1.45 per cent, the Treasury benchmark has only been sold below a yield of 2 per cent on two occasions since October 2016. Another factor to bear in mind was that a deluge of corporate bond sales this month would tend to hurt Treasuries, as investors rotate towards higher-yielding paper.

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