Capitulation in recovery trades
Technicals point to bounce in risk assets in very short term - but risk of another leg down later
Development from here depends on (1) positioning, (2) central bank response, (3) Ebola risk and (4) length and depth of global slowdown
Capitulation in risk assets has been the theme of the week. While European stocks have traded weakly for a while, the risk-off sentiment escalated markedly this week as US stocks took a big hit and more dominoes fell on Thursday as both credit spreads and peripheral bond spreads widened significantly. The canary in the coal mine seemed to be the oil price where the decline escalated in early October and has since led to a cumulative drop of more than USD30 from the peak in June to close to USD80 per barrel.
The sharp decline in oil was perhaps the first capitulation of a ‘recovery position’ taken this year. Since then other recovery trades have been shut down. The consensus trades going into the year were traditional recovery trades: long stocks, short bonds, long credit. Another consensus trade as much based on search for yield was long peripheral bonds in the euro area.
However, as growth in the euro area and Japan disappointed sharply over the summer, stress has been building and, with the US being the last man standing, markets got vulnerable. As have we written in recent weeks, it was increasingly likely that US data would enter a period of disappointments, see Strategy: Shaky environment to continue in the short term, 3 October 2014. In addition to a more fragile growth picture, new risks have come to the surface, not least with the Ebola crisis getting worse, see Strategy: Global growth momentum losing momentum amid new risks, 10 October 2014.
This week the straw that broke the camel’s back was a weak US retail sales report that confirmed that the US is likely to go through a soft patch in coming quarters, see Flash Comment US: Weak retail sales point to slowdown in US economy. That the US was bound to slow down should not come as a surprise. Most forecasters predict slower growth. Nevertheless, markets tend to trade on the direction of growth and when the economy loses speed, concerns rise. And more so when the world outside the US is looking weak. That the euro economy is struggling was confirmed again this week as the German ZEW index for October fell further to -3.6 from 6.9 in September. It was the 10th straight month of decline and added to fears that the eurozone is heading for recession.
That we see a bigger correction in risk assets currently is not unusual at this phase of the business cycle. We are currently in what we call the ‘red phase’ in which growth as measured by OECD’s leading indicator is slowing and the output gap is negative. This is normally the most fragile phase for risk assets. Our models suggest we will stay in this phase for the rest of the year and hence should expect continued high volatility. Whether we see more downside from here will depend on several issues:
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