Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Australian Market Strategist
Summary: Fresh of a series of record highs last week, the risk rally and recent reflation focus has hit pause. The epic short squeeze and subsequent bout of deleveraging across key players is causing pain at an index level, we muse on what could follow.
Fresh of a series of record highs last week, the risk rally and recent reflation focus has hit pause. The week prior saw all-time highs for US indices, the small cap Russell 200, S&P 500 and the NASDAQ. In Asia, the TAIEX also reached a record high and the ASX was trading at an 11 month high prior to Friday’s risk off moves.
With the recent rally reaching overextended levels, the correction to the downside is correspondingly sharp. In today’s trade, regional indices are trading lower following the sharp plunge overnight and US futures are in the red, although recovering off lows. The ASX 200 on track for its worst session since September last year, as the risk asset complex shakes out crowded USD shorts and reflation longs providing opportunity to reload and re-establish longs in preferred stocks, sectors and geographies. Bitcoin plummeting ferociously, although if history is any guide a dip buying opportunity emerging below $30,000.
Overnight volumes were up significantly, NASDAQ up 65% vs. last 10-day average, S&P 500 up 50% vs. last 10-day average. The volumes and price action signalling an unwind/de-grossing reducing exposure on both the long and short side. Covering shorts to hold winners and vice versa, forced selling to cover losses on shorts etc. More typical of a positioning shake out and market clearing event over a trend change.
The historic short squeeze has been widely covered in the financial media and we won’t add to the noise for the purpose of today’s note. My colleague Peter Garnry has covered the key items off with some informative links in his piece, which can be found here.
The long and the short of it, hedge funds are hurting, according to Bloomberg data from Morgan Stanley’s prime brokerage show Monday and Tuesday ranked among the top five de-grossing days for its hedge fund clients over the past decade. The problem from here, whether the initial bout of deleveraging causes a chain reaction of squeezed positioning. Harking back to February 2018’s “Volmageddon” event should be ample reminder of the pain that can be felt across financial markets once a painful deleveraging process is underway. Although the panic in 2018 also coincided with an underlying macro trend change, which is not part of the current setup, hence we err on the side of this event being a positioning shake out and market-clearing event over a trend change.
Although the correction has been sharp, particularly in contrast to the recent acceleration of upside moves, it may prove to be as short as it has been sharp. In the US Q4 earnings have continued to surprise to the upside, across the broad S&P 500 earnings growth has increased sequentially 8.42%, the bottom in the earnings cycle is behind us, with the global cycle now in an early expansion. The earnings surprise vs. expectations for the 134 companies that have reported sitting at 20.55%. The upturn in the earnings cycle, in combination with the setup of growth rebounding and inflation picking up alongside epic amounts of liquidity, excess net savings and incentivised risk taking (intervention incentivising less cash on hand) is inflating asset prices. The long/short deleveraging process undertaken by hedge funds has not changed this regime. Yes, there is a great deal of speculation and many signs of excess, but given the aforementioned, we prefer to remain cautiously long of our preferred "reflation trades” as economic recoveries resume into Q1. Particularly against the backdrop of more fiscal stimulus and free flowing central bank liquidity.
Emerging markets, Asia, Commodities and bets on higher yields and higher inflation (base effects, pent up demand and supply crunches) are the place to be. Alongside a shift in market leadership toward more cyclically orientated stocks, sectors (energy, materials, miners, industrials, financials and travel and leisure stocks, small caps – IWM), and geographies (emerging markets – e.g. EWZ, EWT, THD, etc.). For more on mounting inflationary pressures and the commodity bull trend our Q1 outlook can be found here.