For some time now, global markets seem fixated on events unfolding in Europe. Greece and Italy have been hogging the headlines as investors worry about defaults and the governments’ ability to access markets for funds. For now, politics appears to be driving markets with rumours that the two prime ministers may step down or form new coalition governments. In the short term, the bear market rally still has legs; however its run may be ending because risks continue to rise and the market approaches numbers which cannot be justified without corresponding economic growth.
As observers of recent political events, it becomes plain that no one in Europe wants to be associated with the downfall of a country. That is why George A. Papandreou, prime minister of Greece, pushed for a referendum in an attempt to get parliament (both allies and the opposition) to stand behind the bailout and the tough austerity measures. On the other hand, rumours that Silvio Berlusconi, prime minister of Italy, would step down sent Italy’s stock market soaring - only to reverse when the news was officially denied. This proves that politics is contributing significantly to current market volatility.
Therefore, we are better off looking at market signals to see where global markets are headed. European equities were just 5% from the 200-day moving average before events took a turn for the worse (Figure 1). It is the same for emerging market equities (Figure 2).
Figure 1: European equities close to its 200-day moving average.
Figure 2: Emerging market equities.
European financials continue to perform in the face of rising uncertainty (Figure 3). Despite the high risk of failure of the Greek government and the European Financial Stability Facility withdrawing a bond issuance, it is holding up well. The Euro also did well against safe haven currencies like the Japanese yen (Figure 4). These positive indicators suggest that the rally could be sustained for longer.
Figure 3: European financials holding up despite the bad news from Greece.
Figure 4: Euro strengthening against the Japanese yen.
On the other hand, some signs of risks have emerged. On a relative basis, European financials have begun to underperform the market (Figure 5). After holding steady for the past few weeks, the relative performance has turned down. This is not a good sign as investors have changed their preference for financial stocks.
Figure 5: European financials underperforming the market recently.
In the US, despite a spate of positive economic numbers from PMI reports and the news of reduced odds of a recession by Wall Street economists, we find troubling signs in the fixed income markets. Investors’ preference for safety has emerged in the high yield market. Yields on CCC-rated bonds, relative to BB-rated bonds, has turned up (Figure 6) meaning that investors are dumping lower-rated bonds and seeking safety. Furthermore, TED spreads continue to rise from 0.415 to 0.441 (a rising TED spread often presages a downturn in the US stock market, as it indicates that liquidity is being withdrawn). The market that is usually more concerned with the return of capital is signaling rising risk to the economy and risk assets in general.
Figure 6: Difference between CCC-rated bonds and BB-rated bonds continue to rise.
We see the risk of another down turn in cyclical assets as high. Investors riding the bear market rally should practice risk management prudently and be mindful of a change in trend despite positive economic reports from the US and China1.
For the cash portfolios, we will use our core fund (United G Strategic) to quickly pare down our equity exposure when we see a trend reversal. For the CPF portfolios as we have recently rebalanced to below neutral position, we should be able to ride out future volatility. Please talk to your adviser if you need more information on your portfolios.
1. World Dodges Slump With China-U.S. Buoy. Bloomberg News Nov 8, 2011
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