Investors face challenge of their convictions


A collection of U.S. one dollar bills sit in this arranged photograph in London, U.K., on Friday, Jan. 29, 2016. The International Monetary Fund extolled the potential benefits of virtual currencies and said they warrant a more nuanced regulatory approach, at a time when the future of bitcoin, the most well-known example, is in doubt's. Bitcoin traded at about $379 on Jan. 20, about a third of its peak in 2013. Photographer: Chris Ratcliffe/Bloomberg©Bloomberg
The US dollar has weakened
 
 
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.
 
Soon, things are going to get very interesting, as investors face the challenge of their convictions.

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.
 
Such a view is reinforced by examining the nature of the recent recovery in asset prices. EM, mining and energy companies, whose shares and bonds were hammered during the first six weeks of the year, not surprisingly have led the recovery. We have also seen spectacular surges in the prices for EM currencies, metals and resource companies at various times in recent weeks.

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.
 
Now there are signs that what began as technical bounce in market sentiment is attracting support from investors as more money follows rising prices. The betting from here in terms of sticking with risk assets largely boils down to the direction of the dollar.

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.
 
When the Fed is in your corner, who can blame some investors for pouring more money back into credit, equities and commodities. Why not buy when policymakers remain fully engaged in pumping up prices?

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.

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