LONDON, Oct 19 (Reuters) – Another striking rebound in global equities could be just another bear market rally – but investors are feeling the end of a dark road, albeit with work still to be done.
The dominant theme for the past week has been how Britain’s bizarre fiscal prodigality and turnaround in just one month marks the limit of how much borrowing governments can amass in an inflationary environment. At face value, it now seems clear that this is merely forcing a more brutal monetary tightening and instilling fear in bondholders.
If this cautionary tale is adopted by other economies, some of the more extreme concerns about how much interest rates may need to rise this cycle may now be eased – particularly if the severely reduced fiscal space deepens the recessions ahead.
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Returning from the International Monetary Fund’s annual meetings last week, Goldman Sachs strategist Kamakshya Trivedi said the UK shock “sucked a lot of air out of the meeting” and there is a focus on whether the UK experience compares to “other jurisdictions with limited fiscal leeway would be restricted”.
Societe Generale contrarian strategist Albert Edwards said Britain’s resurgence of the fabled ‘bond vigilantes’ “will resonate in financial markets for years to come”.
For others who have focused heavily on easing central bank liquidity as the main reason for this year’s plunge in global asset prices, signs of extreme stress in bond markets and dysfunction in a G4 economy were a warning shot of central bank plans to bring down the COVID-19 pandemic -bloated balance sheets seriously.
Reports this week, later overturned, that the Bank of England will again postpone its “quantitative tightening” (QT) of active bond sales due next month have only fueled speculation as to how far this liquidity pull may progress, before anything collapses — much like the Federal Reserve’s last QT spell in 2018.
And many continue to look to the dwindling liquidity in US Treasury markets to gauge Fed parameters.
CrossBorder Capital’s liquidity specialists believe policymakers want to avoid the potential ‘loop of fate’ between debt accumulation, rising interest rates and long-term fiscal pressures. “This means that quantitative easing will return, albeit most likely in the modified form of (Japanese-style) yield curve control.”
Of course, the year-end stress in choppy, inflation-ridden bond and currency markets is hardly an ideal backdrop for sustained market rallies – not least when there are few signs that central banks are done with huge rate hikes, let alone that they are close are the maximum interest rates.
And looser financial conditions at this stage might even prompt policymakers to stomp harder to ensure inflation is licked — as they did this summer.
While the disappearance of year-over-year oil price gains and rising global recession forecasts can be seen as positive twists on this inflation horizon, the geopolitical forces that still dictate much of this outcome are hardly clearer.
Bank of America Fund Cash Holdings Survey ChartS&P 500’s Failed Rallies
‘MAX FEAR’?
So are these jumps a wise second opinion or just wishful thinking?
There are other sparks beyond politics hitting the buffers, and several near-term factors have been blamed for the 6-7% bottom-to-top surge in world stocks over the past week – the third such rally in just six weeks.
Chart patterns and favorable seasonal flows in mid-October are some of the reasons given.
But extreme portfolio positioning is the most compelling.
Other investors returning from last week’s IMF meeting were slightly overwhelmed by the sheer gloom in Washington and tended to look beyond.
“The recalcitrant in me walked away from the meetings thinking that the consensus may have gone too bearish now and that we may be at or near ‘peak fear’ in the markets,” said Pimco economic adviser Joachim Fels.
The Bank of America’s October survey of global fund managers, released on Tuesday, certainly bears this out.
The survey showed funds this month continued to bring cash holdings to their highest level in 21 years – and “screams macro capitulation, investor capitulation (and the) beginning of political capitulation,” according to the BofA analysts who compiled the survey. adding that portfolio positioning remained tight at ‘maximum bearish’.
Among the detailed results, four things stood out.
First, the global funds’ overall underweight in equities was now a full three standard deviations from the average positioning over the past 10 years.
In second place was a near-record net worth. 72% of funds expect a weaker economy over the next 12 months – strong even if high-frequency economic surprise indices remain positive.
Third, the shift in views on interest rates and yields, with more than half narrowing over the month to a net 30% expecting higher short-term rates over the next 12 months, while 38% expected lower long-term bond yields, nearly matching the 41 % they expect higher.
Finally, respondents expected the highest risks to financial stability in the history of the survey — even greater than at the peak of the pandemic or during the 2007-2008 crash.
There’s a lot of fear in there – but also a lot in portfolios that go with it.
On the other hand, overextended positions in unsafe environments can last longer than you think. The BoA survey has named “long US dollar” the “busiest trade” for the fourth straight month this month – and it’s getting more crowded every month.
The VIX is above the long-term median but below levels achieved in other bear markets. S&P 500 forward PE falls below the 10-year moving average
The opinions expressed here are those of the author, a columnist for Reuters.
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by Mike Dolan, Twitter: @reutersMikeD. charts by Bank of America, Vincent Flasseur and Lewis Krauskopf; Editing by Josie Kao
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Mike Dolan
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