Risk Of Equity Correction Rising‏

Last week we wrote that tail risk was falling fast for the global economy and hence also for stock markets. It was based on a) the more dovish stance by the Fed and b) the fact the Emerging Markets risk had come down significantly. At the same though, we highlighted that the market was in overbought territory. In the short term, this seems to be the dominant factor driving the market – together with the fact that a new tail risk is emerging as US budget and debt talks are intensifying.

This week, we generally had more decent data with strong Chinese PMI, a further rise in euro PMI and a further decline in US jobless claims (see below). Nevertheless, stock markets failed to gain. Instead, we have seen moderate declines.

We now see a rising probability that we are in for a bull market correction where stocks could decline around 5% lower. For very tactical investors, we recommend to turn risk levels down a notch – especially as the US budget and debt issues will take up more headlines in coming weeks. With the way things are going it cannot be ruled out that we are heading for a short government shut-down. While this should have very little effect for US growth prospects in the medium term, it will likely lead to a temporary decline in risk appetite.

Our medium-term positive view is unchanged as the global recovery should soon translate into stronger earnings growth. A low rate and yield environment will also continue to drive investors to a search for asset returns. Hence, we recommend to use a correction in the market to scale up on risk again once we get over the US fiscal challenges and short-term technical indicators (such as RSI) support an increase in risk exposure again.

Focus increasingly turns to US budget and debt ceiling talks.

The risk of a government shut-down in the US starting on 1 October is currently going up. As democrat senator Mark Warner warned this week: “I think we’ve got a false sense of security... This time, the wolf really could be at the door”. The Republicans’ attempt to include a delay of President Barack Obama’s healthcare law by a year is damaging for the negotiations and Democrats have been very clear that they will not allow that. The Senate, where democrats have a majority, is expected to pass a bill on Saturday that then has to go to the Republican-led House. As they are likely to demand amendments, it leaves very little time to get the bill through both chambers. It is not the first time US negotiations have continued to the very last hour. But the apparent willingness to allow a government shut-down among some Republicans is a bit unnerving.

Alongside the budget negotiations US politicians negotiate on raising the debt ceiling. The deadline for this is mid-October. Hence, the fiscal uncertainty will not end even if we get a budget deal in place. And if the 2014 budget law fails to be approved and we get a government shutdown, it could prove even more damaging for the ability to reach agreement on the debt ceiling.

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