Brace for a Bumpy Ride Ahead?

August 12, 2019

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10 min read

Image: iStock.com/Saro17

Fred Imbert of CNBC reports that stocks fall on renewed trade war fears as Wall Street concludes volatile week:

Stocks fell on Friday as Wall Street concluded a wild week amid trade war fears and worries over the global economy.

The Dow Jones Industrial Average closed 90.75 points lower, or 0.3% at 26,287.44. The S&P 500 dipped 0.7% to 2,918.65 while the Nasdaq Composite pulled back 1% to 7,959.14.

President Donald Trump told reporters on Friday the U.S. is not ready to strike a trade deal with China. “China wants to do something, but I’m not doing anything yet,” Trump said. “Twenty-five years of abuse. I’m not ready so fast.”

Chris Gaffney, president of world markets at TIAA Bank, said Trump is digging in on the U.S.-China trade war. “He believes the trade war impacts China much more than the U.S. In his mind, you can close up the U.S. economy,” he said. “At the same time, you’ve got China doing the same thing.”

“The reactions in the markets this week are maybe more of a realization that this trade war is not going to come to a quick end,” Gaffney said.

On Wednesday, stocks resumed their sell-off as investors loaded up on traditionally safer government bonds and gold before staging a sharp comeback. By Thursday’s close, the indexes had recovered most of their losses from Monday’s drop.

Trump also said the U.S. will not do business with Huawei. However, stocks came off their lows after Fox Business reported the White House clarified Trump’s statements on Huawei, highlighting it is only the U.S. government that is not buying Huawei products. CNBC’s Ylan Mui confirmed the clarification.

Chipmakers Micron Technology and Skyworks Solutions both closed more than 2.5% lower.

This comes after China decided to stop buying American crops and after the U.S. officially declared China a currency manipulator earlier this week. The U.S. designation came after China let its currency, the yuan, fall to its lowest level in a decade relative to the dollar, sparking the biggest sell-off of 2019 for stocks.

“If there was any doubt, President Trump has clearly moved from trade wars to currency wars,” said Harvinder Kalirai, chief fixed income and FX strategist at Alpine Macro, in a note. He said the Federal Reserve will be pushed towards aggressive easing measures if President Donald Trump keeps pressuring China. “Investors should incorporate intrinsic hedges to ride out market volatility and protect themselves from policy errors.”

Stocks had a wild week, with the major indexes recording their biggest one-day sell-off of the year on Monday. The indexes recovered some of those losses on Tuesday.

The Dow ended the week on Friday down 0.75%. The S&P 500 and Nasdaq lost 0.5% and 0.6%, respectively.

You can say that again. pic.twitter.com/dRDIaglOTn
— Bespoke (@bespokeinvest) August 8, 2019

Traders also kept a close eye on the bond market, where the recent appetite for U.S. debt has pushed a bond market recession indicator close to a warning zone. If investors trigger a recession warning in the bond market that tends to be negative for stocks.

In Europe, bank stocks led markets lower Friday as Italian lenders tumbled on political uncertainty in the country. Italy’s coalition government imploded on Thursday evening, as deputy prime minister and leader of Italy’s ruling Lega party, Matteo Salvini, declared the arrangement unworkable and called for fresh general elections.

It was another wild week in the stock and bond market, with wild gyrations in equities and bonds.

Two weeks ago, I pondered whether we’re headed for a summer melt-up in stocks, mostly tech shares which were on fire led by semiconductor stocks.

Last Friday, I discussed how renewed trade tensions are slamming stocks but the big story was the massive rally in US Treasuries as long bond yields plummeted close to 2016 lows.

US long bonds rallied again on Monday as the 10-year Treasury yield fell to 1.59% but ended the week largely unchanged at 1.73%.

Still, since hitting 3.25% last November, the yield on the 10-year US Treasury has fallen by almost half which is an incredible rally:

The same goes for the 30-year Treasury bonds, they too have rallied a lot. Do you remember when Buffett was baffled by 30-year bonds two years ago stating: “It absolutely baffles me who buys a 30-year bond. The idea of committing your money at roughly 3 percent for 30 years … doesn’t make any sense to me.”

Well, it made perfect sense to me, and Buffett and a lot of other gurus bearish on bonds have once again been proven wrong. I’ve long warned my readers deflation is headed for the US and rates around the world are going negative.

Jim Bianco of Bianco Research recently posted this on LinkedIn: “Negative debt expanded by a record $650 billion on Friday (Aug 2). Total negative debt is a new record at $14.52 trillion. Negative debt is now 26.3% of all sovereign bonds, also a new record.”

If you want to understand the main reason US long bonds are rallying so much, just look around the world, economic weakness persists, rates on sovereign and corporate debt are negative, so where do you think global investors are looking to buy positive yielding safe assets? Good old Treasuries, that’s where.

In fact, according to a calculation by Bank of America Merrill Lynch, which uses average yields from a host of countries — the U.K, Australia, Japan, Switzerland, France and the U.S. — global bond yields have fallen to a 120-year low:

These low yields are the talk of the market as strategists wonder whether the bond rally will ever run out of stream. Prices and yields move inversely.

“With a substantial amount of central bank easing already priced, in our view, a marked deterioration in economic data would be required for the rally to continue. We believe the risk of a reversal has risen, and [we] turn neutral on duration,” strategists at Goldman Sachs said this week.

J.P. Morgan strategist Marko Kolanovic pointed out that the S&P earnings yield is 5.9% while the global 10-year bond yield is at 0.59% — with that wide spread being in the 95th percentile in data going back to 1985.

Early on Friday, the yield was 1.61% on the U.S. 2-year Treasury, 1.7% on the 10-year Treasury and 2.22% on the 30-year Treasury.

Bond yields for leading G-7 rivals were even lower, with Germany’s 10-year in negative territory.

Perhaps the most incredible story in the last three years has been the rally in US long bonds. Chen Zhao, Chief Global Strategist at Alpine Macro, posted this on LinkedIn on Gibson’s Paradox:

I replied: “The real answer is short stocks and bonds and focus on alternative investments, but I think all the idiots proclaiming the bond bubble will burst over the last ten years were proven completely incompetent. One deflationary shock out of China and US long bond yields will hit a new secular low and might go negative. It’s not right around the corner but I wouldn’t be surprised if bonds outperform stocks on a risk-adjusted basis over next five years.”

Paul Winghart, adjunct lecturer of economics at Northwestern replied: “Treasury market is correct. The economy is fine in terms of positive GDP growth but sorely underperforming relative to its increasing potential. Therefore, the economy is not in a depression or recession, but in a procession ( like a graduation or funeral procession); continually creeping along at a pace way below what it should be doing. Economic congealing to this degree always has much more deflationary consequences than inflationary ones.”

Remember, I still regard US Treasuries as the ultimate diversifier but I must admit the recent rally is a bit overdone, probably more a function of CTAs than economic fundamentals.

Still, if something blows up in China, then you will see the yield on the 10-year Treasury bond go below 1% and if another financial crisis hits us, you will see rates go to zero or possibly negative depending on how bad it gets.

We’re definitely not there yet but this week reminded us that as rates go lower, we will see a lot more volatility in risk assets.

In terms of stock market sectors, here were the top-performing sectors this week:

As you can see, high yielding REITs (IYR) and Utilities (XLU) outperperformed all sectors but Materials (XLB) and Healthcare (XLV) also posted some gains. Not surprisingly, Energy (XLE), Financials (XLF) and Technology (XLK) shares were the worst performers this week.

Anyway, brace for more volatility to come next week as worries over trade and the economy linger but Sam Stovall, chief investment strategist at CFRA, said he believes the worst is over and stocks could trade at their highs again by the end of the month:

“I think what we went through was a retest of the May pullback and it ended up being successful,”he said. Stovall said he has been watching the sub industries of the S&P 1500, and as of July 12, 91% were above their 50-day moving average, an unusually high number.

But as of Monday, when stocks were cratering, just 10% were above their 50-day moving average.

“That to me was an indication of a washout,” Stovall said. He added that it was also a rapid move to the 5% decline level from the peak, indicating the market could make a quick comeback.

“We are probably coming out of this pullback, and we’ll probably get there quickly. History says we’ll get there by the end of the month, meaning by the end of the month we’ll probably close with a new all-time high,” he said.

We shall see but I’d keep my eye more on the bond market than the stock market in the weeks ahead.

Below, after a wild week for Wall Street, Matt Maley of Miller Tabak and Steve Chiavarone of Federated Investors lay out what comes next, stating the market selloff is just getting started.

Second, Ed Yardeni believes Treasury yields won’t tear apart the record bull market, stating recession fears are overdone.

Third, Barbara Doran, BD8 Capital Partners, and Jeff Sherman, deputy chief investment officer of Doubleline Capital, join ‘Closing Bell’ to discuss how bond yields and US Treasurys did this week.

Fourth, Sebastien Page, head of global multi-assets at T. Rowe Price, joins ‘Squawk Box’ to explain why he says the markets are in for a bumpy ride.

Lastly, earlier this week, CNBC’s “Closing Bell” spoke with with Kyle Bass, founder and chief investment officer of Hayman Capital Management. I think it’s worth listening to his insights even if he’s talking up his book.

Update: Following my comment, an astute blog reader of mine noted the following:

“If Treasuries are signalling economic weakness to the extent suggested in your post, why aren’t credit spreads blowing out? Is it possible they are just signalling low inflation and reflecting panic buying out of a fear we’re going the way of Japan and Europe?”

I agree, credit spreads haven’t blown up yet but as I mentioned to him by the the time they do, it’s too late and when credit markets seize up, they freeze up and wreak havoc on markets.

Another top global macro trader I know shared this with me:

“Amazing rally indeed (in bonds). The problem is not many caught it except for CTAs. Bullishness is very high, however, I do not get a sense that positioning is as extreme! A lot of stop outs last week. Hence consolidation but the sell off will get bought as in any trendy market. Pension deficits are increasing again! What will it take for the market to sell off? A very aggressive Fed which I don’t see or more fiscal stimulus. Go Bernie Go!”

I doubt the bond market will “feel the Bern” in 2020 but you never know, it might be an upset surprise. One thing he’s right about, pensions, especially underfunded US pensions are in big trouble as rates plunge around the world.