« Tranquilo »…

Date: 5 December, 2019 - Blog

The relationship between the economic and financial spheres is complex and non-linear

In the summer of 2018, for example, the cyclical upturn and the acceleration of inflation had provoked a significant upsurge in volatility. Clearly, the (potentially too important) improvement in fundamentals had made the stock markets tumble. In recent weeks, investor psychology has clearly recovered despite the global economic slowdown and the conservative forecasts of the major supranational institutes (IMF). This upturn follows liquidity injections from central banks and some “soft” macroeconomic data, i.e. from surveys (leading indicators and other ISMs). Risky assets rebounded, including the more cyclical (economically sensitive) sectors, such as banks and industry. Nothing new in fact, since the financial markets reflect above all the reflection of the expectations of operators. In order to assess the validity of this renewed optimism, it is worth wondering what is expected in current prices?

Looking closely, we conclude that a majority of investors now table, for 2020, on a remake 2017-2018. Indeed, the latest surveys of fund managers confirm that a majority of professionals have reinvested large amounts of dormant capital in equity markets in recent weeks. The mechanics of sector rotation – with the outperformance of the value / small cap segment – foreshadows a successful reflation. Sophisticated investors such as CTAs and hedge funds have amplified this latest move. The very popular short selling strategies of volatility on a very large scale have resurrected, despite the 2 to 3 serious accidents of the past two years (Vix-mageddon). The current level of net short positions on the VIX is unprecedented … The significant rise in equity markets foreshadows the mid-cycle slowdown (a 95-97 redux), or even a remake of the 2017-18 episode. But this time, China will not save the global economy by a spectacular growth of credit, and the United States, entangled in a very divisive election year, will not be able to boost their growth with a massive recovery plan. Complacency?

At the level of good news

Published earnings of US companies in the third quarter did not collapse as was feared for a moment. Similarly, private investors have not returned to the markets in droves. They are often a good indicator of end of trend … But the consensus of analysts in terms of earnings growth for 2020 – a figure approaching 10% – remains (too) ambitious. Especially if the pace of economic activity does not resume significantly. Some segments of the capital markets (high-yield loans / leverage loans) remain under stress. Commodities have not rebounded as they should if we were at the dawn of renewed growth. Long-term rates – such as the 10-year US Treasury Reference Borrowing – remain cautious and narrowed below 2%. Schizophrenia of investors.

In summary

The strength of the stock markets is largely driven by high expectations, which are not supported by other asset classes. One of the main drivers of stock market enthusiasm comes from the famous FOMO syndrome (fear of missing out) of large institutional investors. Let’s hope they are right and that we escape the recession. Lack of monetary ammunition, indebtedness and lack of international cooperation would make recovery difficult. The risks of recession have probably dropped a little bit recently. Good! In the very short term, a (new) surge of volatility due to excessive complacency and the speculative behavior of many investors is not at all excluded …