While Goldman’s clients are growing increasingly concerned about the narrow breadth in the market and the S&P500 leadership where a handful of stocks are responsible for all the gains, Goldman itself is not too worried, and as we reported over the weekend, the bank responded to concerns about about excessive concentration and “bad breadth” that while “in the past, sharp declines in breadth have signaled below-average 1-, 3-, and 6-month returns for the S&P 500 as well as larger-than-average prospective drawdowns” however, “relative to history, the recent narrowing of market breadth has not been sharp enough to trigger alarm.”
Not everyone agrees.
In a note released this morning by Citigroup, the bank warns that investors are once again becoming complacent even as fundamentals do not “support an enduring move” to the upside. In the latest warning to watch out for growing idiosyncretic risks, Citi’s Mark Schofield said that the risks that led to several rounds of selloffs earlier in the year, have not abated and that the growing risk of tighter monetary policy may be what knocks markets off course, according to the FT.
But what, according to Citi, explains the lack of any selling, and in fact quite the opposite: continued market levitation?
In one word: Herding, or the same market phenomenon dismissed by Goldman, which is far more sanguine about the “herding” by most investors in just a handful of stocks, such as FaceBook.
“It may be that easing trade tensions and China’s policy response are comforting investors, but the move has the hallmarks of herd instincts at work” warns Schofield.
What Citi believes the herd is missing, is that while “the global economy looks to be riding the tailwinds of easy policy and
fiscal stimulus” these drivers are fading.
“Meanwhile storm clouds are gathering and risks look biased to the downside.”
Of course, no risk is greater than the potential collapse of trade, following growing trade tension between the US and China, coupled with fears of a possible economic slowdown in China. But while the market casts a concerned eye into the future, last Friday we showed that global trade has already posted a sharp slowdown and is now negative on a 3M annualized basis, which historically has preceded a drop in global EPS.
In addition to trade worries, the rise in bond yields also sparked a drop in equities prices earlier in 2018, however that move – which we now know was at least partially a function of Russia’s record Treasury liquidation – is now over, with the 10Y Treasury trading in a range between the mid 2.80s and 3.00%.
Meanwhile, even as trade tensions continue to escalate, with the US now widely expected to launch another $200BN in Chinese tariffs in the coming months, the S&P 500 has jumped nearly 10 per cent and is close to its January all-time high, while Europe’s Stoxx 600 index has risen nearly 8 per cent over the same period.
But the “news has not really justified the latest moves” and “fundamentals are vulnerable to longer-term headwinds” amid “rising risk of higher rates in three of the larger central banks, that have hitherto been the anchor as the Fed has started to raise rates”, he said cited by the FT.
Recent news-flow has been heavily skewed towards the intertwined risks of escalating trade wars, potential retaliation in currency markets and the possibility of an economic slowdown in China. These have combined to create a narrative of a global economy riding the last tailwinds of accommodative policy and financial conditions, against a backdrop of threatening storm clouds and market risks that are increasingly skewed to the downside
Which brings up back to the risk of herding behavior, and the Citi strategist writes that while he adheres “to the view that the business cycle is increasingly mature and that the risks are becoming far more skewed to the downside” yet the “timing of an inflexion point in the cycle and indeed the central bank policy responses to a shift in the data, remain unclear.” Until then, investors find confidence in numbers, and conflate positioning with fundamentals:
Absent a catalyst, herding behavior can be very persistent and can feed on itself.
So what could shake the herd’s confidence and serve as a trigger for a risk-reversal? Schofield writes that it is idiosyncratic events that deliver the necessary impetus for investors to reappraise broader risks, and while “it is not always clear where unexpected come from” he believes that this week’s trio of central bank announcements from the BOJ, Fed and BOE could be just such a catalyst, of which that from Japan would be most troubling.
We expect the Bank of Japan to leave monetary policy unchanged at this week’s meeting; however we expect it to make its JGB purchase operations more flexible in order to accommodate modestly higher long-term interest rates. We do not expect any move higher in JGB yields to be large, but we would point out that the JGB market has a considerable track record in triggering broader reactions in global bond markets.
Putting all of this together, Citi warns that it still sees “plenty of reason not to get too complacent over the recent rally in risk assets.” Of course, the bank is also taking on a “herd” which for the past 10 years has been conditions not only to buy every dip, but – more recently – never to sell. Citi may find that changing a decade of behavior ingrained by the Fed will be very difficult to achieve.
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