Crunch time for yields direction Challenging Growth - Rates tradeoff caps stocks; Fade Cyclicals either way
* Looking at the last time we had a bond selloff, in April-June '15 when German 10 year yields were up by 90bp, market was lower, Cyclicals were lower, with only the Banks moving higher. We believe a pair trade of long Banks vs short Cyclicals remains a good relative value trade in the current environment.
* We think that the upcoming BoJ meeting could be more relevant than Fed one for near-term bond yields direction. Out of numerous potential scenarios, the BoJ decision on the maturity of bond purchases might end up being the key one. Ahead of the Sept ECB meeting only a minority of investors expected any additional action, but still there was a
“disappointment”, with German bond yields moving up 10-15bp in the aftermath. The hurdle rate appears much higher for BoJ, where most investors expect a range of additional policy measures to be unveiled. The potential for another “disappointment” is therefore probably greater, which could give second wind to the “bonds are on the cusp of a regime
change" narrative.
* Looking at the last time we had a bond selloff, in April-June '15 when German 10 year yields were up by 90bp, market was lower, Cyclicals were lower, with only the Banks moving higher. We believe a pair trade of long Banks vs short Cyclicals remains a good relative value trade in the current environment.
* Given that the increased uncertainty over the future path of bond yields comes just as we had US CESI moving negative, ISM manufacturing moving below 50, and services ISM falling the most since ‘08, our view remains that the Growth - Policy tradeoff has likely deteriorated for equities. Because of this, we believe that equities will continue to unwind July/August bounce.
* At the sector level, we believe the good hedge against increased bond volatility remain the Banks, but would not overstay our welcome in Cyclicals. Cyclicals might be the losers in either scenario. If yields do not move higher, the rotation into Cyclicals is likely to peter out. If yields do move higher, overall market might suffer given the elevated bond-equity correlation currently, which could pressure Cyclicals given their high beta to the market direction. In addition, the mixed activity backdrop suggests that any bond selloff might not be happening for the right reasons. In contrast to popular view, Defensives are not all expensive. Pharma is trading outright cheap on P/E relative, with political risk potentially over discounted.