Semiconductors Oversold, Bond Market Too Bearish

by: Greenwood Investments

A bad, bad week for global trade tensions - US-China relations at rock-bottom, while hapless Mexico is dragged into the picture.

The "smart money" bond market has been right so far in anticipating stress in the equity markets. US Federal Reserve rate hike probabilities have collapsed.

Key equity markets/ETFs firmly in the epicenter of the global trade war are starting to see early shoots of demand. Investor sentiment could be overly bearish now.

A bad, bad week for global trade tensions

Enter, Mexico. After the Trump administration placed its cross-hairs firmly on China's crown-jewel, Huawei, China raised the possibility of weaponizing its dominance in rare earth materials - used in smartphones, military equipment, driverless cars, etc., to hit back against the US. Hapless Mexico was then dragged into the picture, with the Trump administration announcing plans to impose 5% on Mexican exports, with the potential to rise to 25% by October.

All within a week.

Markets now pricing in collapse in Fed rate hike probabilities

This year saw a complete about-turn in market consensus towards the US Dollar (USDU) (UUP). In 2018, the Federal Reserve diligently and methodically raised interest rates 4 times from 1.50% to 2.50%. 2019 was supposed to be more of the same till Fed Chair J. Powell surprised the market by declaring the central bank would hold back from raising rates this year. What was most surprising was that the decision came at the start of the year, effectively taking away the Fed's flexibility to raise rates even once during the year.

What did the Federal Reserve see that was so compelling that they had the conviction to do a complete about-turn from their rate-hike strategy? Presumably they were acting solely on what they felt was best for the economy, and not taking into consideration Trump's personal preference for lower interest rates. Nevertheless, the Fed pivot has been a mystery, and if it was borne out of concern that the global economy was on the verge of contracting, perhaps they were right then - for trade tensions between the US and the rest of the world have since hit a nadir, threatening to bring down global trade.

At the end of Q1 this year, the market had started to price in a 25 bps rate cut by the Fed by the end of the year. Currently, the market is pricing in a 37% probability of 2 rate cuts by the end of the year. This has been in line with US government bond yields. In just a span of 8 months, the US 10-year yield has collapsed by close to 100 bps, while the US 2-year yield has collapsed 40 bps. So often labeled as "smart money", the bond market appears to be pricing in extreme stress in the markets going forward and so far, the bond market appears to be vindicated, taking down equity markets in May with a ferocity comparable to last October's sell-off.

The key questions now, is whether too much negativity is being priced into the financial system.

US Government Bond Yields have led the S&P 500 lower


Emerging Markets and Semiconductors starting to find a footing?


There are some signs that equities may be starting to find a near-term bottom. While the S&P 500 (SPY), Nasdaq 100 (QQQ), and Semiconductors (SOXX) (SOXS) have been consistently forging new lows in the past week, 3 key equity indices curiously ticked up higher - the iShares MSCI Emerging Markets ETF (EEM), the Taiwan Taiex Index (EWT), and South Korea's Kospi (EWY).

Emerging markets should be the hardest hit during a slowdown in global trade volumes, and yet EEM closed higher for the week while US equities struggled. Taiwan and South Korea's economies are heavily reliant on the semiconductor market - Taiwan and Korea are ranked 2nd and 3rd in global production value for semiconductors, with the US in first place. Yet, the Taiex managed to close the week higher, while the Kospi managed to close the week almost unchanged. In the chart below, heavyweight Taiwan Semiconductor Manufacturing (TSM) interestingly managed to eke out a small gain for the week.


Could semiconductors continue to be punished further? Sure. But get this - markets are now pricing in 37% probability of 2 rate cuts by the end of the year. Very aggressive, considering the central bank has only 5 more meetings for the rest of 2019, and undoing half of last year's work might end up scaring, rather than stabilizing, the markets. The bears may have overstretched on this one. Key equity markets (EEM, Taiex, Kospi) which are firmly in the epicenter of the global trade war are also starting to see early shoots of demand. These are markets that are currently deemed untouchable by investors, and which consensus has turned outright bearish. On balance of probability, I would say a risk-on relief rally could be due in the near term, and I would suggest starting to take up small positions in EEM, EWT and EWY.

Disclosure: I am/we are long EWT. 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.