Trending
On Wednesday, the Fed raised interest rates by 25 basis points and announced plans to begin unwinding its balance sheet later this year. The Fed also indicated another rate hike is likely this year and possibly three more in 2018.
The Fed’s message was hawkish, more so than the market expected. Economic and inflation data have been weaker than expected but the Fed still subscribes to the Philips Curve view of the world, in which low unemployment will lead to inflation, thus the need to raise interest rates now. The problem seems to be that unemployment, at least measured by traditional metrics is already at unusually low levels and inflation remains stubbornly low.
An interesting thing happened on Wednesday morning before the Fed announcement. Retail sales in May were weaker than expected and consumer inflation fell, taking year-over-year CPI down to 1.9%. The bond market’s reaction was telling, long-term bond yields fell sharply, presumably because it meant the Fed might not raise interest rates after all.
I have different interpretation. The bond market, through the flattening yield curve has been signaling rising economic risk and the market perceives the Fed is at risk of a significant policy error if they continue down the path they are on. The Fed raised interest rates, articulated a more hawkish position than expected and the long end of the yield curve still rallied (lower yields)!
This defies the conventional wisdom that the economy is fine and leads me to this interesting chart.
iShares 20+ Year Treasury Bond ETF (TLT) – Weekly Chart
The TLT is on the cusp of a “golden cross”. A golden cross is defined by the 50-day moving average crossing above the 200-day moving average. TLT looks technically strong, implying additional appreciation (lower yields) is likely.
If bonds rally from here, I believe it signals a weaker global economy than is currently priced into the equity market and puts equities at risk of a correction.
Equity Market Valuations
By most common valuation metrics, the market is somewhere between fairly valued to expensive. I thought the graphic below was interesting, which shows the direct relationship between the stock market and global central bank balance sheets since 2009.
What makes this interesting to me, is this week’s announcement from the Fed to not only raise interest rates but to also begin shrinking its balance sheet. This action from the Fed, combined with existing tightening policies in China (PBOC) and expectations that the European Central Bank (ECB) is nearing an end to their quantitative easing program, potentially put global equity market valuations at risk.
China Concerns
One emerging risk story that seems to be getting little attention is China’s tightening monetary conditions, as the government tries to deleverage the economy.
One interesting consequence of this tightening policy is the impact it has had on the yield curve in China.
The Chinese yield curve has now inverted.
If this were to occur in the U.S. or most developed markets it would signal a recession is likely around the corner. When these types of things occur, there are always explanations from market pundits or government officials on “unusual circumstances” or other “factors” at work, causing a distortion in the market. In my experience, these explanations usually give way to economic reality.
This is the first major crack to form in the global synchronized recovery story and is a shot across the bow for equity investors.
This is a developing situation that needs to be closely monitored. If China’s GDP slows to even 4-5%, this would “feel” like a recession. China is the world’s second largest economy and the negative reverberations would be felt around the world.
Additional Equity Market Risk from Risk Parity Allocators
Risk parity is an asset allocation concept that involves allotting to various asset classes that are not highly correlated with each other, such as equities, bonds, commodities, currencies, etc., so that they have the same level of “risk” in the portfolio. Risk is usually defined by volatility and as equity volatility has been persistently low, more dollars are allocated to equities, relative to other asset classes. The most well know advocate of this strategy is Bridgewater Associates, run by Ray Dalio. For those unaware, Bridgewater is known as the world’s largest macro hedge fund.
The graphic below shows the allocation to equities in risk parity portfolios is at a record high. This is one more risk factor the market faces when these trades unwind. The abrupt allocation changes are easy to see in the chart. The last peak in this indicator was in early 2011, preceding the last 20% market correction by a few months.
Source: @WSJ; Read Full WSJ Article
Conclusion
The easy money policies from the global central banks that have propelled the equity markets higher since the global financial crisis are reversing.
China appears to be further along in this tightening process than widely recognized and the Fed appears determined to “normalize” monetary policy even in the face of weakening economic and inflation data.
The buy-the-dip strategy that has worked so well for years has caused complacency to set in among many investors. While the market remains in a clear uptrend, the risks are rising.