China, Oil & Fed: Policy relief can break the circuit
Three risks hit the market at once: China, Oil and Fed tightening
It is becoming increasingly clear that apparent CNY stability will again give way to bouts
of volatility in the future. In addition, the developments that could ultimately lead to a
correction in excess supply for oil are unlikely to be risk positive (e.g. potentially defaults
in the US oil sector). Finally, the Fed’s tightening amid declining inflation expectations
and tightening financial conditions is among the least appreciated drivers of the sell-off
in risky assets.
The interaction among the three drivers is amplifying market uncertainty
The link among the three risks is not well understood by markets and policy makers
alike. Lower oil prices have been viewed as a positive for DM activity but the short-term
ripple effects to lower US capex and tighter US credit/non-bank liquidity have been
underappreciated. Dollar strength has helped oil producing nations to withstand the
impact of lower crude prices. Against a backdrop of weak EM/China growth, the
impact of dollar strength on the US economy has likely been larger than originally
anticipated. The decline in oil prices has weighed on long-term inflation expectations at
a time of Fed tightening.
The Fed can break the circuit
It is hard to contemplate durable circuit breakers to this negative loop of shocks coming
from China and Oil. But, with the inflation base effects dampened significantly for
2016, global disinflationary forces weighing on inflation expectations and financial
conditions tightening, there is room for the Fed to reassure markets by managing
expectations on the medium-term path for rates normalization. The more intense the
pressure on markets and financial conditions, the higher the odds for Fed-driven relief.
Just like in Q3 2015, the ECB moved first into striking a dovish tone earlier today and
markets are already benefiting from that, but markets will mainly be looking to the Fed
for stabilization and sustainable relief.
What to do?
In that sense, we would not chase risky assets lower here as we do not view the riskreward
to be appealing. Instead, investors can remain reasonably defensive while
anticipating Fed-driven relief via long US bond positions in intermediate tenors (3-5yr
yields). When policy relief does arrive, we would expect long-term yields (5y rates 5y
forward) in the US to recover from highly suppressed levels and would also position for
higher yields in the Euro-area where data remains resilient. In FX, we would buy $/JPY
upside as the risk-reward profile there is asymmetric at current levels, and would sell
EUR/$ downside. Finally, we would hedge tail risks from deteriorating US credit
dynamics and EM weakness by being short US small caps (vs long caps) and EM
financials (vs DM), although arguably, Fed relief may offer a better entry level. From an
equity market standpoint, European equities continue to offer a better risk-reward.
All of these trade recommendations are part of our year-ahead arsenal of a risk neutral
set of positions, consistent with bouts of elevated levels of volatility. Along those lines,
we have been recommending varying degree of exposure in each component of the
portfolio as market pressures intensified. What has not changed is the asset classes that
we have chosen to assume more or less defensive market exposure over time.