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Stretching the risk bands

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A couple of areas in the vast global currency market attracted attention on Monday, with China’s renminbi extending its recent rally and bolstering sentiment for emerging markets in general. Meanwhile, the UK pound slipped on economic weakness and further easing talk by officials at the Bank of England. Outside of currencies, the debate about warning flags fluttering as equities hovered near multiyear highs also hogged some of the limelight.

© Sarinya Pinngam | Dreamstime.com

Deutsche Bank’s latest weekly update on investor positioning and flows made this blunt assessment:

“Equity positioning, like the market itself, has run far ahead of current growth as investors price in a global growth rebound.”

This was duly highlighted when glancing at a dashboard of futures markets, with DB noting:

“Equity futures long positioning for asset managers and leveraged funds combined is near record highs, driven by a broad-based rise in longs across the S&P 500 and Nasdaq as well as the small-cap Russell 2000 futures. Longs in EM futures have risen to record highs. Call/put volume ratios are at the top of their historical range; short interest in single stocks is near record lows; and that in ETFs has fallen to a new low.”

Such positioning also reflects the power and presence of so-called “systematic trading strategies” that thrive against a backdrop of low and falling market volatility. It’s hardly a surprise that equity exposure is near a peak for those that embrace strategies such as risk parity and volatility control or among commodity trading advisers. These type of asset managers transact in managed futures.

The last time equity exposure was this high was two years ago when equity volatility abruptly surged and without warning, sparking plenty of pain. So is this time looking any different?

JPMorgan reckons the risk of a repeat “vol shock” is low for now, as two years ago extremely crowded equity markets were also accompanied by similar positioning in other assets, such as the euro, oil prices and government debt, led by the 10-year US Treasury note.

“The extremities in momentum signals are concentrated on US equity futures, rather than a wide range of asset classes.”

And Deutsche make this interesting observation about volatility:

“Vol control funds are usually the first to sell equities when vol rises, but with volatility having been subdued for an extended period of time, [we] would need to see a large and sustained spike in vol for their selling thresholds to be hit.”

That leaves catalysts for a possible equity correction stemming from disappointing earnings news, which is tough to see as the final quarter of 2019 is shaping up reasonably well. Or from the upcoming US primary election cycle in the form of a strong showing by a progressive candidate. Failing that, perhaps a significant macro shock could trigger a correction.

As JPM notes, an equity correction over the coming weeks could arise from “how high the equity exposures by . . . institutional investors are at the moment”, but it appears unlikely to stem from the kind of momentum reversal that typified the early-February 2018 rout.

The flip side of any possible correction is how long it could last. The tide of central bank liquidity remains high running into April and, as seen before against such a backdrop, dips in equity prices are usually shallow.

Playing an important role in soothing global investor sentiment at this juncture has been the steady appreciation in the renminbi, with the currency back to May levels and firmly inside the line in the sand at Rmb7 to the dollar.

Line chart of Renminbi per dollar showing Renminbi claws back losses from August trade tensions

The rallying renminbi, ahead of this week’s US-China “phase-one” trade deal being signed, helps support greater exposure towards other high-yielding EM currencies. Here, the latest BNY Mellon iFlow data show “investors are aligned with a long carry trade by selling G10 currencies and buying EM currencies”.

Prospects of stronger Chinese demand (via domestic stimulus efforts) and a firmer currency could well boost global exporters such as Japan, Taiwan and Germany. Equity sentiment doesn’t need much of a nudge to climb on that trade. Reports that as part of a trade deal the US Treasury will no longer designate China as a currency manipulator is a cosmetic flourish on the agreement, but does have some traders seeing a test of Rmb6.7 on the horizon.

Alongside a firmer renminbi, there is the question of whether the yield on the US 10-year note will climb back towards 2 per cent. The Rmb/10-year yield relationship does look a little out of sync at the moment.

Quick Hits — What’s on the markets radar

The pound is below the $1.30 level as economic data and chatter from the Bank of England becomes a bigger driver for sterling than even Brexit.

Line chart of $ per £ showing Sterling’s recent performance

UK GDP data for November showed the economy contracted 0.3 per cent. Not good news, although these figures span a period before the general election handed a bigger majority to the Conservatives of Boris Johnson. With fiscal spending in focus, selling the pound may not appear quite a one-way bet.

Indeed, a trigger for the pound falling though $1.30 was an FT interview with the BoE’s Gertjan Vlieghe, who indicated he would vote for lower interest rates if data didn’t show the economy picking up. The key point is whether there will be a pick-up in the data after last month’s election, dubbed the “Boris bounce”.

Investec’s Philip Shaw observes:

“Our baseline case is that the MPC will avoid cutting rates this year and maintain the Bank rate at 0.75 per cent throughout 2020. Some committee members have warned that an absence of evidence of stronger economic activity will result in their support for easier policy. Anecdotal evidence has been consistent with a ‘Boris bounce’ in the economy. For example, surveys last week by REC and Deloitte suggested firmer hiring and a rebound in CFO confidence. In the same vein, there has also been a flurry of positive investment news.”

US financials have lagged the S&P 500 over the past month (up 0.4 per cent versus a 3.1 per cent rise), so the onset of the quarterly earnings season this week looms as an important event for this sector. Financials is forecast to have one of the better growth rates for profits over the previous quarter, but clearly investors also want to know the outlook for 2020 and just how the consumer and business sectors are faring. An update on troubled auto loans against the backdrop of slower earnings growth is one area to watch.

Indeed, as DataTrek points out, financials need some upside for this year:

“Right now, analysts have just 5 per cent earnings growth baked into their models for the financials sector for 2020. That is worse than the S&P 500’s aggregate expected earnings growth of 9.4 per cent.”

Results from JPMorgan, Wells Fargo and Citi on Tuesday kick off the earnings parade, with the US bank outlook for 2020 from S&P Global Ratings noting:

“We expect relatively flat revenue and earnings, as banks will be pressured by low rates but should find support from fee income and expense cutting.”

Japan’s financial markets were closed on Monday but the yen’s weakening trend leaves the currency just shy of testing ¥110 versus the dollar, a level not broken since May. Only last week, haven demand propelled the yen briefly through ¥108, so there has been quite a shift in tone with some, such as Deutsche’s George Saravelos, bearish. He expect ¥112 over the coming months.

The rationale is that beyond a more positive global backdrop, Japan’s biggest pension fund, the GPIF, will shortly complete a five-year review of its asset allocations, with expectations of a bigger shift towards owning foreign bonds.

As George writes:

“If the GPIF reallocated to foreign bonds (currently 25 per cent of total assets are in domestic bonds), other pension funds would likely follow suit, just as they did after the GPIF’s momentous review in 2014. With Japan’s pension funds holding an estimated ¥125tn of domestic bonds, even a 10 per cent reallocation to foreign assets would imply $125bn of outflows and yen selling.”

A weakening yen may also register with gold as the two assets have generally enjoyed a robust negative relationship. Gold bugs can only hope that a yen slide is a false signal, but, as seen here, the metal has broken ranks with other haven assets of late.

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