Risk appetite takes a backward step to end the month
Global risk appetite retreated on Thursday as China delivered a couple of blows. A combination of disappointing economic data and doubts over a long-term trade deal with Washington tempered market sentiment that was aiming to end October with a flourish. Then again, it’s a day for a trick or a treat.
The news from China — led by its manufacturing sector shrinking for a sixth straight month and service activity at its lowest since February 2016 — were hardly surprising given Beijing's stimulus this year has been piecemeal as it focuses on deleveraging efforts. As for trade, a temporary truce is pretty much the best and most likely outcome, as Donald Trump searches for a venue to shake hands with Xi Jinping next month.
The upshot for Thursday's markets were lower sovereign bond yields, equity benchmarks in retreat, and a US dollar extending its post-Federal Reserve meeting weakness. The dollar index edged further below its 200-day moving average, lining up the reserve currency's biggest slide below this measure of momentum since June.
The edgy tone also comes ahead of a double dose of key US data within the next 24 hours: the October employment report and ISM manufacturing activity. Sluggish tidings are expected on both counts, with payrolls forecast to rise 85,000 after 136,000 jobs were added in September, although the report will be affected by the recent General Motors strike. Meanwhile, manufacturing activity is expected to remain in contraction territory, below a reading of 50, reinforcing Thursday's Chicago Purchasing Managers index, which arrived at 43.2 for October, its lowest reading since December 2015.
So there is scope for plenty of market noise to kick off the start of November as investors assess the Fed's recent policy statement and actions.
A further drop in market expectations of inflation on Thursday suggested Jay Powell's comments during Wednesday's press conference, in which he said it would take a “significant rise in inflation” for the Fed to consider raising interest rates, were leaving a mark (the 10-year Treasury slid as much as 10 basis points on Thursday to 1.69 per cent, well below 1.75 per cent, the ceiling for fed funds). Lower Treasury yields also effectively price in weak US data on Friday.
Mr Powell's admission implied the direction of interest rates and Treasury yields were capped, while the risk of further rate easing (driven by the tone of economic data in the coming months) remained on the table. Indeed, the latest US inflation data revealed a core rate at 1.7 per cent in September, marking the 12th consecutive month that this measure of the Personal Consumption Expenditures index had arrived below 2 per cent.
At a time of low unemployment, many in the market note how US core PCE inflation has only rarely exceeded the Fed's 2 per cent target in the past decade.
And as Nick Colas at DataTrek duly reminds us:
“Unlike the 1990s or even mid-2000s, inflation is not doing its usual late-cycle lift above 2 per cent.”
The private wages and salaries component within the US Employment Cost index for the third quarter arrived at an annual figure of 3 per cent and has been stuck at that pace all year, down from a decade high of 3.1 per cent recorded during the final quarter of 2018.
Oxford Economics says:
“The tame momentum in compensation growth, along with the moderation in other wage metrics in recent months, suggests that wage growth has likely reached a cycle peak.”
For risk appetite, restrained long-dated Treasury yields should represent good news, given how they have played an important role in pushing up equity valuations for much of this year as earnings growth has gone into reverse. The only quibble is how much of that trade has already passed. Equities also prosper when credit conditions remain tranquil and that's certainly the story at present, apart from the speculative areas of high-yield debt and loans.
Here's how things look among the lower rated tiers of US credit. Red flags are fluttering over the highly risky areas of the market such as triple C debt and the $1.15bn leveraged loan market. The need for yield has simply encouraged a rotation up one rung to single B away from triple C-rated paper.
The chart below shows the wider relationship between these two sectors of high yield. Meanwhile, the relationship between the bulge of triple B-rated investment-grade credit and the highest quality high-yield paper, double B, has narrowed to 2007 levels.
It is notable that a weaker tone in the more leveraged sectors of the credit universe pervades during a time of strong performance for other risk assets in general. Some argue this sets up a big buying opportunity should the Fed's view of moderate growth and an absence of further easing ensue during 2020.
Krishna Memani at Invesco writes:
“Lower-rated credits are significantly wider than higher-rated credits even after adjusting for their interest rate sensitivity. That typically happens at the troughing of the economy and the markets.”
He concludes:
“Therefore, if growth is indeed bottoming out, as I think it is, the tell-tale sign will come in the form of tightening spreads at the bottom rungs of the credit markets. I believe we will see that happen by the end of the year, and likely a quarter before an actual acceleration in global growth.”
The current policy mix has the power to nurture risk appetite into year end, particularly if money moves off the sidelines and investors become less defensive. But there are pitfalls: any data that shows cracks in the consumer will in turn spur additional easing from the Fed, although that may not arrive until next year.
Paul Shea at Miller Tabak & Co notes:
“Unless the economic situation fundamentally changes, we think the Fed is done until at least mid-2020. The Fed’s credibility has been damaged, however, by its recent underestimation of rate cuts and it isn’t surprising that markets are still pricing in about a 20 per cent chance of a December rate cut and a 45 per cent chance of one by June 2020 while entirely ruling out rate hikes.”
But don't expect market sentiment to wait that long before acting while the Fed assesses the situation.
In the case of further Fed easing, official US borrowing rates could head towards zero. That should worry credit investors, as it implies much weaker growth and, above all, little inflation pressure. The need for higher inflation that can help erode debt piles is rather pressing given that many companies have pumped up their borrowings over the past decade.
Even the best-case scenario, in which 2019 merely represents a mid-cycle slowdown, simply delays the inevitable pain of deleveraging for companies.
Happy Halloween and on that note this year marks the first time, Junior, aka iMac, has carved the pumpkins (he requested two) bought sweets with his pocket money to hand out to trick and treaters in our neighbourhood and, most importantly, pulled together a costume. They do grow up far too quickly.