Risk Off? Not Really
The recent strength in the U.S. dollar and stock market weakness has the media believing we are in “risk-off” mode. However, the reality is quite different. We are far from capitulation, or even significant risk reduction.
It is true that we have seen record outflows out of equity funds recently, but that is more a function of the Federal Reserve reducing its balance sheet and raising interest rates. But outflows are not a complete signal of risk-off mentality. They show mostly a modest reduction in excessive optimism.
What we see is a classic “wait-and-see” strategy. Most investment funds remain surprisingly upbeat about global growth, earnings estimates, and the impact of rising rates on company’s ability to repay debt.
So investors are building liquidity, they are not buying the dips but wait to do so when they have new information. But they also keep a very high overweight to cyclical, emerging markets, and high-beta stocks. As we have seen, inflows into value or defensive names are very limited.
A clear example is also the weakness of gold relative to the U.S. dollar. Markets are discounting a low inflation, moderate slowdown, short-term repricing of risk. But not a crisis. Gold would not be where it is in that case, especially when its fundamentals, supply limited, demand rising above expectations, are robust.
Another example is the overweight of institutional investors to growth, emerging markets, and Europe, which remains at multi-year highs. Hedge funds also own more stocks than at any point during the recent decades. This, combined with record margin debt, show there is no real risk-off, just moderation of excess.
The average investor’s strategy seems to be to hope the tide turns and we resume a bull market in the most leveraged asset classes. If the economy strengthens, these will do well eventually, and if the economy sinks, central banks will pump money in to save us from our losses.
This strategy that worked wonders in the past 10 years—let’s be honest here—needs three things to work:
- Central bank support: Low rates and high liquidity are not enough. Markets need additional boosts in money supply above and beyond the average. Like a heroin addict, another dose does not do it, it merely allows you to survive another day without pain.
- Earnings estimates rising and buybacks soaring, particularly the latter. Again, this is a case of the marginal positive piece of news, not the confirmation of what everybody knows. As such, when estimates are being trimmed and buybacks end or slow down, the exposure to “buy the dip in cyclicals” strategy generates diminishing returns.
- Global underweight growth positioning. Markets need marginal buyers when the strategy is to hold and expect a bounce. This can only happen when marginal investors are clearly underweight growth and beta. That’s not the case now.
In summary, markets are almost unanimously hoping and praying that the U.S. dollar strength ends, that central banks become dovish again and that the next-year-earnings mirage returns.
Not Going to Happen
But central banks do not react to market turmoil as rapidly as investors would like. We look at screens all day every minute, they read FT headlines and discuss it in a summit in three months’ time. More importantly, by now everybody should be mindful of “buy the junk” moves based on the idea that bad news in the economy means good news in more money supply.
Jerome Powell at the Federal Reserve is very detached from the fear of market volatility that informed the decisions of the Fed during Janet Yellen’s mandate. Rates will continue to rise and the outflows from emerging markets and Europe into the United States will likely resume.
Earnings estimates are not helping. As we have seen in recent market reactions, it is not enough to provide decent results, in line with consensus or maintain guidance. Valuations reflect much more optimistic scenarios. And earnings revisions are mostly negative, particularly in Europe, China, and stocks very sensitive to the economy in general.
The elephant in the room is credit. While rates rise globally and risk appetite moderates, solvency and liquidity ratios of issuers have been weakening significantly, something that Moody’s and the Bank for International Settlements (BIS) have warned about on numerous occasions.
As the massive wall of debt coming due not far ahead in the future rises to the center stage, companies and governments will only pay attention to one thing: the bond market. They will do anything to refinance and pay bonds. This inevitably sends ripple effects to equity markets and the higher-risk part of the fixed income universe, high-yield. When expensive bonds from investment grade issuers and sovereign states come up for refinance—nobody is capable of actually retiring debt—credit demand is absorbed by these names and there is less money left for equities.
Finally, we forget that we have not even started to see the impact on Europe and emerging economies of the repatriation of capital into the United States after the tax reform.
It is difficult to change the “buy risk on dips” mentality of the market when two generations of traders have seen nothing but stimuli and rising valuations. But when it happens, it happens quickly. Central banks decided to pump $20 trillion into the economy expecting that this time it would be different. It is not.
Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP.