What started as a bond selloff infected US equity markets and triggered a liquidation across all global asset classes. We look forward to a more sane week as markets digest the flows from last week.
Rising Rates Triggers Bond Selloff
Many of our readers know that we have been bond bears for quite some time, and we will continue to be for the foreseeable future. We advise our clients against going long duration. We have been stressing the global monetary policy tightening, the rising yields, and rising inflation. We have been bullish on US equities, and we have written about our expectations for more Fed rate hikes to come. With the Fed’s hikes, the rest of the world has no choice but to follow.
News to refute our argument was piling up in the last few months, but we maintained our position in the face of piling evidence to the contrary. Bond bulls were buying the long-end, and the flattening of the yield curve was signaling the end of the bull market. Frequent references to the large short position in the bond market were interpreted as a “crowded trade” that risks a violent liquidation that inverts the yield curve and seals the fate of the US stock market.
The selloff in bonds was the bond market’s blessing that the expansion is nowhere near its end. It steepened the yield curve at a time when bond bulls were doubting the longevity of the equity bull market. They were buying the long-end for many reasons: the unusually long economic expansion, the Fed raising short-term rates, and the looming trade war. Now, none of these factors matter as much as the evidence of the continuing strength of the US economy.
US Expansion Not Over
Despite the panic that ensued in equity markets in the last 2 weeks, we have not changed our bullish view on US equities. We continue to believe that the Fed will have to accelerate its rate hikes and that yields will have to be much higher than they are today before the economic expansion ends. This is a market that rallied 9% after Trump announced the tariffs on $200 billion.
Trend following quant strategies like volatility targeting exacerbated the selling pressure and caused a lot of distortions. This is Soros’s Reflexivity Theory in action: volatility targeting strategies causing more selling and therefore more volatility and more selling. Risk assets were being sold everywhere faster than the market had time to digest the facts. We are not convinced that this US equity panic will last, and we expect the market to retest the highs as dip-buyers show up in time for earnings season.
Emerging Market Rotation
We kept our clients underweight Emerging Markets since the beginning of 2018. However, even a long-term bear market will have many significant rallies and opportunities for capital deployment. China was the first such opportunity, which came to our attention as the media began focusing its attention on the negative aspects of the trade war. We are now beginning to see more opportunities in this allocation. In the next few weeks, we will be looking at ending our underweight Emerging Market allocation as we see more evidence of market rotation.
Trends are much easier to detect than turning points. The easy money was made, and calling bottoms is no easy task because turning points are messy. They typically exhibit high volatility and high volume as bears and bulls fight for control of the narrative. China is a perfect example: The CSI 300 rose 7.8% in the days after the tariffs were announced, and fell 8.7% a week later as the US selloff infected all markets.
Let’s start with some basic facts. The S&P 500 was down 7% before recovering to its 200-day moving average. The US selloff triggered a bearish mood across all global assets, including Emerging Markets. In the meantime, China reported some positive trade data, and more stimulus measures were announced, with more to come as Chinese power brokers are meeting in Hong Kong at the Belt & Road Finance Forum.
The Week Ahead
Populism will be back in the news this week on the European front. This is the week Italy officially submits its budget to the EU. With Brexit negotiations heating up and populists gaining ground in Bavarian state elections, the EU is fighting multiple fires.
Of note are the Indian wholesale prices and trade data coming out early in the week, which should give markets some indication on further depreciation in the Indian rupee.
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