Investors face challenge of their convictions
All hail the great rebound.
A weaker US dollar and firmer commodity prices — most importantly that of oil — have underpinned an impressive recovery in asset prices from their nadir in mid-February.
Clearly we have moved on from the panic of early in the year when fear of a US recession and a large currency devaluation by China dominated investor sentiment.
As the end of the first quarter approaches, we have US equities in positive territory for 2016, oil prices above $40 a barrel, while investors are embracing credit exposure. Sure enough, funds investing in US stocks, emerging markets and high-yield bonds are attracting inflows as the investor herd chases recovery in risky areas of the market.
If you are bearish on the global economy, think commodity prices still face a reckoning in the face of numerous supply gluts and see a huge bill due from the global credit binge — with China and the likes of Valeant in the vanguard — selling the current rebound surely makes sense.
This trading pattern reflects a classic short squeeze, whereby bearish bets are hastily unwound via the purchase of stocks and commodities, fuelling a further rise in asset prices.
Squeezes of this sort are notoriously violent and can drive markets for some time. As JPMorgan analysts noted last week: “The short covering phase that started a month ago is very advanced but it is not yet fully completed.”
That’s not to short-change the propitious timing of those traders who waded into the market at the height of new year pessimism, and benefited from the squeeze on the bears. Some savvy fund managers in the US credit sphere started buying when risk premia for corporate debt in mid-February reflected rising odds of a recession for the world’s largest economy, a very pessimistic outlook.
EM, commodity prices and S&P 500 companies reliant on foreign revenues all like a sliding dollar. And they have a powerful ally. The US Federal Reserve, with last week’s shift to a more dovish stance on monetary policy, has indicated that dollar strength is problematic.
And according to the folks at JPMorgan, plenty of money that was pulled out of markets last year could well return and push equities significantly higher from here.
No matter that firmer US employment and rising inflation should merit a higher cost of borrowing. The Fed’s striking dovishness could well maintain the current positive momentum in emerging markets, commodities, junk bonds and equities for some time.
Even the recent retreat of the dollar which has reduced financial headwinds for the US economy was downplayed by a US central bank that has hitched domestic interest rate policy to the global outlook.
The shift by US policy officials reinforces how worried we should be about China as it grapples with massive debts and slowing growth. A much weaker renminbi remains the likely escape valve for alleviating China’s economic and financial stress before year-end.
So stand by for another test of the financial system and its weakest links. The great rebound has simply provided markets with some breathing room and investors only need recall how the upswing in global equities last year that peaked in November eventually turned over.