Talk From The Trenches: Correction or Bear Market?

By Ian Stannard

     LONDON (MNI) - Talk From The Trenches: Correction or Bear Market?

     Talk from the Trenches has been on the road, visiting European customers.

We thank our European customers for the great reception and feedback. We very

much enjoyed the insightful discussions.

     Indeed, we are glad to say the reception was far warmer than that received

by other UK delegations to Europe recently. While risk factors were the top

discussion theme, surprisingly little emphasis was placed on Brexit, with

broader global risks the focus.

     One customer framed the debate over the risk environment very succinctly in

our view, with the question "correction or bear market?"

     Cyclical Disconnect

     While last week's sharp SPX decline, generating increased asset market

volatility, has sharpened the focus on global asset market risks, the overall

performance of broad equity indices has masked warning signals that have been

flashing for some time.

     Diverging performance between Consumer Discretionary and Consumer Staples

probably provides one of the clearest examples, with this cyclical equity

performance ratio also decoupling from US Treasuries since October 8th (See MNI

US TSYS: ###POV: CYCLICAL DISCONNECT).

     Risk-Off or Repositioning?

     An outright scaling back of risk or repositioning of portfolios to cope

with a more challenging risk environment was a major theme of discussion on how

to best respond. A shift away from the traditional high beta positions was of

course seen as the first step, but where to invest now was the next question

being posed.

     In a traditional risk-off scenario the USD would be the obvious answer to

the portfolio allocation questions currently being asked. But, given many of the

warning signals being generated are US centric, is the USD the answer?

     One of the key risk factors cited by customers was higher US yields,

particularly at the longer end of the US curve. This together with the

simultaneous sell off in the US equity market could give the impression of US

assets generally losing their appeal. Not such a great scenario for the USD.

     One customer was focusing on specific levels of curve steepness as a

potential tipping point, interesting when viewed in the context of the Fed's

obsession with flattening and the potential of curve inversion signaling a

recession. Could curve steepening be the trigger for a recession via higher

yields?

     The impact of higher long-end yields on the mortgage market is a theme that

has been explored by the team, with convexity hedging by mortgages service

providers seen as having the potential to exacerbate yield moves (TFTT, Oct 12,

2018).

     Global Risk Factors

     However, if risk factors are more global, the USD's traditional role of

attracting support during risk-off bouts is likely to remain intact. In this

regard, the markets attention on China is important.

     China growth concerns given recent data disappointments were a point of

discussion with customers. This is consistent with the historically bearish

outlook for the Chinese economy expressed by participants in the MNI China

Liquidity Survey (See MNI LIQUIDITY SURVEY: PBOC Taps Still Open On Econ

Worries). One customers also cited China NPLs as an ongoing risk factor.

     Interestingly, European yield spread widening, more specifically the BTP-

Bund widening was not cited as much as expected as a global risk factor. While

significant from a local European market perspective, customers did not see this

as challenging to global risk environment.

     Recent MNI analysis from the markets team has highlighted that European

spread widening has tended to reduce European investor outflows (See MNI

ANALYSIS: European Foreign Debt Buying Dries Up When BTP-Bund Spread Widens).

--MNI London Bureau; +44-203-865-3820; email: Ian.Stannard@marketnews.com