Since Christmas Eve, global financial markets' sentiment turned and investors embraced a "risk-on mood." In 2018, markets became concerned about global trade, political tensions in Italy, Brexit, the message by the Fed and, recently, the U.S. government shutdown. Combined with a downgrade of earnings and forecasts for the global economy in 2019, markets became very pessimistic about the outlook.
And perhaps they became too pessimistic and hedge funds and others reduced risk positions too quickly. When a few data points in the U.S. and Europe (Payrolls, German GDP) surprised positively and the trade talks between the U.S. and China appeared to advance, investors saw "value" in sectors like High Yield, Emerging Markets and Small/Mid-Cap equities. But to fully reengage risk-taking, investors needed to see more evidence for a "risk-on" rally to justify coming off a dismal final quarter of 2018.
One piece of evidence is the Chinese yuan. The currency has appreciated since January 3rd by 1.5 percent. Investors see this as a positive sign that the Chinese economy may be slowing but it is not contracting as a result of the trade war. Notably, as the yuan appreciated, global financial conditions indices - a weighted composition of equity, interest rate and volatility measures - began to improve. More importantly, the correlation between the yuan and global financial conditions has turned positive - a sign markets see a strengthening Chinese currency as an "elixir" for still bruised sentiment (see Fig. 1). The more the yuan appreciates, the more likely global financial conditions become easier, bolstering market confidence.
Figure 1: Yuan and Global Financial Conditions
(Source: Bloomberg. "Global Financial Conditions" is the average of U.S., Europe and Asia financial conditions)
Another important factor influencing market psychology is the Federal Reserve. In December, the market responded negatively to Chair Powell's testimony because there was an expectation the Fed would deliver a more moderate message about its plan for future tightening. Ironically, the market priced in a "rate cut" by 2020. This was a signal the market believed that if the Fed were to continue tightening the way it did in 2018, the odds of a recession would go up significantly.
Indeed, the probability of a rate cut derived from Fed Funds futures rose to near 25 percent. The odds of a recession as early as 2018 calculated by the NY Fed was close to 15 percent (see Figure 2). Fed speakers have come out in droves to communicate that rate hikes will be put on hold for a while because the Fed can be "patient" to watch incoming data. Markets have begun to reduce the probability of rate cut, thereby reducing the odds of a recession near term. This too helped markets to sustain a more positive view about the economy.
Figure 2: Odds of a Recession and Probability of a Rate Cut
Lastly, global inflation is showing signs of moderation. The sharp fall in energy prices in Q4 2018 is showing up in lower headline CPI readings. The decline of inflation puts off rate hike expectations as central banks get cautious. That could result in a resumption of central bank balance sheets expansion. The first sign of this was the large liquidity injection by the PBOC in the past week. Moderating inflation provides central banks flexibility in their tightening plans. More importantly, should there be more downward pressure on global inflation, central banks like the ECB and BoJ would restart asset purchases to prevent deflation in their countries. Easier monetary policy means more liquidity returns to markets, supporting a "risk-on" sentiment.
These three reasons operate as an “elixir” because they take away the fear of a global recession, while at the same also avoiding a global overheating. As a result, investors feel upbeat and "risk-on" even though uncertainty is high and economic data is sluggish. And as the “risk-on” tone firms, the equity rally has spilled over to higher yields and a stronger dollar.
Figure 4 shows three “V-shaped” rallies/bottoms; first equities, followed by yields and now the dollar. This was formerly known as the “Trump Trade”, where markets price in strong growth across major asset classes. There are reasons to be concerned about the Trump Trade, as Cohen’s Congressional testimony could be damaging and the shutdown counting 28 days has some economists pencil in up to a point of drag on GDP. Yet, the market is shrugging off these issues specifically related to Trump.
For one, the Trump Trade went global by staging a trade war with China. Yesterday’s news about Mnuchin easing tariffs on China and Europe’s blueprint today for a free-trade deal have far more attention from the market than Trump’s legal/shutdown challenges. Second, the threat of impeachment and a prolonged shutdown can cause chaos. But so far markets see these risks as having limited economic impact. There is no sign of foreign investors fleeing U.S. capital markets out of concerns over heightened U.S. political risks.
Thus, the V-shape bottoms forming in the S&P, Treasury yields and dollar go against a "consensus" that the U.S. may face a recession, first in earnings in 2019 and then the economy in 2020. In a way, if the current V-shape bottoms hold, markets are slowly pricing in the prospect of "a recession that never came." The diminished prospect of a (global) recession is positive for equities, emerging markets and high yield. Expect these sectors to deliver outperformance relative to cash and government bonds.
Figure 4: V-Shape Bottoms
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.