Summertime, and the tradin’ ‘aint easy

Are we mere weeks away from a global recession, or is the recent price action just another example of summertime markets? On Tuesday the markets were in high spirits, hoping that the impasse between the US and China trade war was finally reaching a resolution. However, some weak economic data out of Germany and China have sent traders running for the exits, with oil down some 4% on Wednesday, the Nasdaq down 3% and the Dax down more than 2%. As we move into the latter part of the week, the question is will the sell-off continue, or have markets over-reacted? 

Bonds – the King of markets 

To answer this question, it is worth taking a look at the bond market. The next few paragraphs come to you courtesy of john Murphy, who’s book ‘The Technical Analysis of Financial Markets’, is one of my favourite books/ guides to help shed light on how financial markets work. I won’t give you a 101 of the entire book, it is very  long, however, his central theory is that bond markets move first, followed by stocks, currencies and commodities. When Murphy first wrote the book, trading and the flow of information was not as fast as it is today, however, his theory still stands – the bond market remains king. A Murphy-esque way to explain the wave of negativity that spread across risky assets today is this: the contraction in German GDP and the very weak industrial data out of China caused a global reaction in the bond market. Yields fell sharply across the world, so much so that we saw a number of yield curve inversions, when the benchmark 10-year yield falls below the 2 year-yield, which is an historical signal that a recession lies ahead. This occurred today for the first time since the 2008 financial crisis in the US Treasury market and in the UK’s Gilt market, which has been considered a bad omen for the future of risky assets. 

How likely is a global recession? 

To give some context to today’s move in the bond market it is worth looking at the US 10-year yield, which is considered a global benchmark.  The 10-year US yield has been falling consistently since November last year. Back then it was above 3.2%, today it is 1.5%. This coincides with the last time the Federal Reserve hiked interest rates. Since then, the US -China trade war has notched up a gear and concerns about weaker global growth have forced the Federal Reserve to start cutting interest rates. Currently, there is a 40% chance of three further rate cuts from the Fed this year, which is up from a 31% chance a mere 24 hours ago.

The Fed to the rescue? 

The US yield curve managed to move back into positive territory by the end of Wednesday, but only just. This suggests that the market is fairly convinced that the Fed will cut rates fast enough to ward off another recession, but not overwhelmingly so. This suggests that the US yield curve remains vulnerable to further inversion, and weaker economic data from the US this week, including retail sales, industrial production data, labour costs and productivity, all due for release tomorrow, will be closely watched to see if a recession really is lurking in the wings. Any development in the US-China trade war is potentially more important than economic data in the current market climate. The US-China trade war tends to have a binary outcome for risk sensitive asset prices – a negative development is negative for risky asset prices and sends safe havens soaring, while a positive development has the opposite effect.

Is the market sell off justified?  

There is a confluence of risks for financial markets right now that are swirling round to create the perfect storm – trade wars, weakening economic growth, Brexit and geopolitical tensions including Hong Kong and China and India and Pakistan. These issues are real, and do not seem to be going away any time soon. Thus, market jitters seem to be justified. Added to this, some asset prices were at, or close to record highs, so a sell-off at this stage would be natural. After today’s sharp decline, the S&P 500 is roughly flat over the last 12 months.  Although this index has erased some fairly substantial gains from earlier in 2019, if the economic and geopolitical outlook don’t start to improve soon, then investors could talk themselves into sending the US index even lower. 

US indices could be particularly at risk since they have held up better than most European ones in recent months, however they are now starting to look expensive. For example, the FTSE 100 is down 6% in the last 12 months, while the German Dax index is 7% lower. Thus, if you believe that US stocks will start to play downhill catch up with their European peers, then an arbitrage strategy – going long a European index and short a US one – may gain traction. 

Trade wars and Brexit, yet again… 

The two events that could have the biggest impact on short-term risk sentiment, in our view, would be a resolution to the US-China trade war and a Brexit deal between the UK and Europe. Both things seem very unlikely to happen any time soon, if at all, however, politicians have a way of surprising markets. This is why we believe that the pound is starting to look very undervalued, although we remain wary about taking a long position at this stage. Interestingly, as other risky assets fell sharply, the pound attempted a recovery, but GBP/USD faltered ahead of resistance at $1.21. Every time the pound tries to make a recovery, it is thwarted by the market. The reason for this is he continued Brexit uncertainty, which is the overarching theme for sterling right now. As we have said since 2016, until Brexit is done and dusted, the pound is likely to remain vulnerable. However, there does seem to be some hesitancy to push GBP/USD below the $1.20 mark; we will watch this level closely, as it suggests some selling fatigue, thus before GBP falls below this critical level we may need to see another big Brexit development. 

All eyes on Jackson Hole 

Overall, markets remain in a jittery mood, and the sell-off may have further to go, unless we see a breakthrough in the US-China trade spat. Next week’s Jackson Hole central bankers’ conference will be critical and the key question for the conference: can central bankers’ save the day again?