Since the end of September, markets have rebounded sharply. Equities, real estate, spread products and commodities all rallied. The price of Brent oil has increased by more than 12% since 2 October and the unloved emerging market (EM) assets also staged a rally.
Turnaround in our global cycle indicator
Remarkable rally in risky assets
Remarkably, the turnaround came on the back of disappointing US economic data. The ISM Manufacturing index, one of the key leading indicators for the US economy, declined in September to just above 50, the dividing line between growth and contraction of activity. The next day a weak payroll number came in. Payrolls rose by only 142,000 in September and the August number was revised lower. Also wage growth failed to pick up.
It seems therefore that we have moved back into the market ecology where bad news is good news. After all, the weak US payroll data mean that the probability of a US rate hike in the near term has declined. Uncertainty with regard to global monetary policy has receded and markets can benefit longer from the global lower-for-longer regime, with the Federal Reserve on hold and the ECB and Bank of Japan willing to maintain the expected difference in policy stance by easing more and keeping their currencies competitive.
Market sentiment had turned very negative
Another reason for the rally in risky assets is market dynamics. Most if not all indicators pointed towards extreme pessimism. Flows were weak, positioning was low, especially in the commodity-linked universe, and traditional fear gauges like the VIX were at high levels. On top of this, some company-specific risk in the car and mining industry completed the dire picture in investors' minds.
So, the market looked ready for a bounce and this is exactly what we got. The rebound was most pronounced in the commodity-related pockets of the market, such as the energy and basic materials sectors, emerging market assets and high yield credits.
Relief for emerging markets
Interesting is the rebound of emerging markets, as in September the market reaction after the Fed’s rate hike postponement was very negative. Concerns about an EM crisis intensified, resulting in more EM currency depreciation, rising EM bond yields and declining stock markets. Due to the weak US labour report, expectations of the first Fed rate hike moved out again. An important change is however that investors now see the justification for the delay in monetary tightening in US labour market softness and US inflation expectations, and not primarily in EM risks for future US growth or liquidity.
Emerging markets, especially those most dependent on foreign capital, now have a bit more time to fix their problems. The global search for yield might get a new boost and capital outflows from EM might slow. It is still early days, but we might see some easing of EM financial conditions after the sharp tightening in the past few months. These new hopes about flows and financial conditions, in combination with the recent improvement in EM growth momentum, are creating an environment in which the pressure on EM assets should abate.
We have therefore moved EM equities from underweight to neutral, while we also closed our underweight position in EM currencies.
Improvement in global cyclical momentum
We believe that it was not only expectations of prolonged easy global monetary policy conditions that drove markets higher. If that were the case, it would have made more sense to see a rally in government bonds and commodities lagging behind. Since the opposite happened (bonds down, commodities up), it looks likely that other factors were also at play.
Next to the very pessimistic mood that we described earlier, we think that the improvement in the global cyclical outlook also played a role. For the cyclical outlook, it is important that developed market (DM) resilience was recently confirmed – despite the weak payrolls and PMI numbers in the US – by domestic service sector activity, household income and spending data and survey based evidence from the corporate and household sectors. In the Eurozone, economic sentiment kept improving further in September.
Our survey-based Global Cycle Indicator rebounded in September after signs of cooling in the previous months. On top of that, signs of bottoming are also tentatively emerging in cyclical indicators in emerging markets. This was reflected in the latest Chinese PMIs, but also in a broader set of indicators and countries in EM space. Unlike DM, EM growth indicators are still pointing towards a weakening growth backdrop, but the pace of weakening seems to be moderating. The latter might actually be just enough to have defensively positioned investors reconsider the risk-return trade-offs in their portfolios.
We reduce our defensive allocation stance
All in all, it seems to us that more is at play than just the expectations of more easy money that is driving markets higher. It is not yet enough to be fully convinced that a robust year-end rally is in the offing, as EM weakness/contagion and Fed tightening risks have far from faded completely. It is however enough to reduce our defensive stance and move to a more neutral overall tone in our top-down tactical asset allocation. The short squeeze in defensive trades might well persist a bit longer and the balance of risks surrounding the cyclical outlook or the upcoming earnings season seems no longer negative enough to stay defensive.
As a result, we have upgraded both equities and fixed income spread products from underweight back to a neutral stance. We moved real estate from neutral to an overweight to somewhat counterbalance the ongoing underweight in commodity space.