Head of Saxo Strats
Summary: In today's equity update we sum up a hectic trading session seeing a steep selloff in global equities driven by concerns over Evergrande which will hit judgement day on Thursday with two bond payments due. We argue that the selloff was long overdue driven by a self-reinforcing 'buy-the-dip' winning strategy that had caused a strong rally with low drawdowns. It was unsustainable and now the Chinese housing market situation became the excuse for selling equities. The question is now how deep we can go in S&P 500 futures?
For over a week I was on the telephone with journalists talking about Evergrande and whether it could turn out ugly for global financial markets. I kept arguing that under the reasonable assumption that financial markets are efficient there were few signs that Evergrande had the potential for global contagion. But what if nobody has seen it coming was the quick follow-up question. Well, financial markets consist of millions of professional and retail investors analyzing markets, and their judgement has been so far that this is a Chinese self-contained problem. Even after today’s heavy selling in equities, credit markets in the developed world is barely budging.
China has the ressources to manage a deleveraging of its housing market
While the six largest Chinese real estate developers have interest bearing debt worth $291bn and total liabilities of $1.06trn, it is still manageable for the Chinese government. China managed the NPL crisis of large Chinese banks in the 1990s and this potential crisis is on the same scale. China’s credit market and housing market is not interconnected enough with global financial markets to cause a contagion effect as far as I can see and judging from market reaction. If China does not succeed in a controlled deleveraging of the housing market and an orderly nationalization of failing real estate developers then it could severely cut into the growth outlook which is negative for equities and global growth, but we are not talking about a new global financial crisis. The current energy shock in Europe, which we wrote about last week, makes us more nervous as it has the potential for knock-on effects into 2022 hitting food supplies and prices.
Biggest selloff since October 2020 and VIX jump
Many have pointed to the fact that the 50-day moving average has been broken. I subscribe to the view that it is a random number – why not the 48-day moving average? But technically, the 50-day moving average has been the area when S&P 500 futures have bounced many times since October last year and thus require some more analysis. As of this writing, S&P 500 futures are 2.3% below their 50-day moving average, the biggest spread since October last year, and given the success of ‘buying-the-dip’ over the last 11 months the question is whether the cavalry is coming again. It is quite clear in today’s session that the last 20 minutes of the cash equity trading session has attracted the ‘buying-the-dip’ crowd given the sizeable 1.3% bounce into the close.
Financial markets are like a biological system with its own evolutionary dynamics. The constant rebounds at even the smallest dips in equities have steadily become a reinforced winning strategy adding more dollars behind it. The MSCI World Index was as of last Friday in a rally over 229 trading days without a drawdown of more than 5%. As we warned about already in late August, investors seemed to have become blind to risks given this dynamic and the VIX Index had yet become compressed to historically low levels. VIX is trading around the 26 level around the cash equity close in the US down from the intraday high of 28.79. This level in itself indicates that the sell-off may not be over yet and the market is anxiously waiting for mainland Chinese investors to come back from holiday on Wednesday and Thursday judgement day for Evergrande with two bond payments due.
The distribution of the S&P 500 futures price to the 50-day moving average is very negatively skewed for negative values (when the price is below the average) of this spread. The current -2.3% spread is roughly around the 45 percentile of the distribution and thus we could easily go down a couple of percent more from here, and down 10% from the recent highs if the Chinese housing crisis escalates further with minimal support from the Chinese government. The selloff is amplified somewhat due to the duration of the rally and the way drawdowns have been compressed. However, we remain positive on equities given the fiscal support and current trajectory for earnings, but we are ready to revise our view if inflation shows more signs of becoming more sticky at higher levels.
2024: The wasted year
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
