HSBC believes there are many similarities between the developed world’s fiscal crisis and that of the deflationary period that occurred in Japan in the early 90’s. This is an argument I have been quick to point out in the past. But like HSBC, I also understand that markets can and will have incredible rallies during this secular bear market. After an incredible run HSBC believes the rally is beginning to run into resistance due to 3 primary reasons:
There are, we think, three worrying tactical signs and we’re chopping five points from our US and European equity holdings. Activity-surprise indices compiled by our currency strategists have turned down lately, government-bond yields have been falling and commodity prices have been weak. Yet world equity prices have climbed more than 50% from their low and have scarcely paused for breath of late. Developed equities are now up by 15.5% this year and emerging equities by 47%. Equity investors might be right to be sanguine: perhaps none of the three is important or, even if they are, all three could turn up again. But given the gains that we have seen in all risky asset markets and the amount of risk that we are still carrying in credit, it seems prudent to take at least some risk out of the portfolio. Credit, we think, is still cheaper than equity and we can’t see spreads widening much unless and until equities take a real bath.
Consider our activity-surprise indices. These have been turning down everywhere. Charts 2 and 3
show the indices for the US and Asia. Clearly, these have been rolling over. And given how much equity markets have gone up and how much hope is built into equity prices, that’s a bit worrying.
They could, of course, turn up again, but there are two other reasons to think that equity markets might struggle for a while: bond yields and commodity prices.
Bond yields are excellent leading indicators of secular trends in a deflationary environment. The long end of the curve is clearly forecasting low inflation, while the short end of the curve is clearly pointing to a very slow recovery.
Bond yields have been a really good lead indicator of activity and equity markets over the past few years. Chart 4 shows the US 10-year bond yield and the US activity-surprise index. Rising bond yields have generally been followed by rising activity and equity markets and falling bond yields the opposite. That falling bond yields are bad for equities may surprise older hands, weaned as they were on the notion that lower yields were good for equities. But this really hasn’t been true since the autumn of 1998, after the Russian and LTCM crisis. Ever since then, shorter-dated government-bond yields and equity markets have been positively correlated. In English, this means falling yields have generally meant falling equity prices and rising yields have meant rising equity markets.
In Japan in the 1990s, equities went up and equities went down, but government yields fell and fell and eventually so did the equity market. So the bond market was worth keeping an eye on because it was telling you something worrying about growth rates, and ultimately it was right.
In addition, HSBC is increasingly concerned with the weakness in the commodity space:
Now, commodity prices are still extraordinarily strong given the financial earthquake that has reverberated around the world, but there are unmistakeable signs of weakness. Brent crude prices are now 11% off their recent high in early June. But prices for December delivery of heating oil have fallen 8% since early August. US wholesale petrol prices for December are down by about 15% from early June. Having fallen by twothirds, the price of coal seems to have peaked (for now, at least) in mid-July. True, natural gas prices have been climbing of late, but then these had been – and despite their recent rise still are – at multi-year lows.
While I agree with much of what HSBC says I would be more inclined to put my money where their mouth is if I didn’t believe that the market is primed for another quarter of earnings that are going to be better than expected. Being short over the next month could be a dangerous position as earnings unfold….
* Thanks to reader MS for contributing to this piece.