The Orient Express Sell Off

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The Orient Express Sell Off

“Someone always knows. Be that someone.” If traders had a guild crest, that would be written in Latin on it, perhaps in green letters on a ribbon, surrounding an image of a 9-screen trading station…

Today’s mid-day selloff in US stocks is a frustrating reminder of how hard it is to live up to that motto. News accounts of slow Chinese iPhone sales doesn’t fit the bill. I can almost hear cries of “Titanic sinks!” and “Man lands on the moon!” from trading desks everywhere, the customary retort when someone calls out old news.

The closest we can get to solving the mystery of Thursday’s sudden reversal is to collect an assembly of possible contributors. To our thinking the action today was an “Orient Express” sort of crime; many suspects played a role.

Let’s begin with two topics we covered yesterday:

  • US Growth has had an epic run versus Value this year. As Cliff Asness noted in his blog post yesterday, we’re in 0th – 1st percentile territory, with Growth moving too much relative to value in YTD 2020.
  • Market uncertainty, as measured by Implied Volatility, has been giving Tech and other large groups a pass on coronavirus fears and only punishing deep cyclical sectors like Energy, Materials and Industrials.

Now, take those imbalances and add the following:

  • The difference between 3 month and 10-Year Treasuries closed today at negative 6 basis points, the deepest inversion of 2020. This is the data the NY Fed uses in its recession probabilities indicator.
  • 30-Year yields dropped to 1.96%, the lowest of the year and close to last September’s all-time lows of 1.94% (when recession chatter was everywhere).
  • While we understand his point, Fed Vice Chair Clarida made the rookie mistake of saying “markets have it wrong” when he cited his preference for human economists’ rate forecasts over Fed Funds Futures. Those responded today by putting heavier odds on 2 rate cuts by December.
  • The investment narrative around the coronavirus has shifted from a China-predominant outbreak to include Japan and South Korea. Both the yen and won have weakened in the last 5 days, a sign that financial markets take the threat of a slowdown in these important economies seriously.
  • Also worth noting: the euro is in slow-motion free fall, at $1.08/$ and lower than last September ($1.09/$) when German bund yields were -0.70% rather than -0.44% today. The only conclusion: China’s slowdown is going to cause a European recession.

The big question now is “does today’s market action portend further volatility, and what do I do about it?” Our take:

  • We do not have the necessary preconditions to see a rotation into Value such as that occurred in early Q4 2019. That was driven by higher long-term rates, lifted by confidence in a global synchronized economic rebound. Today’s bond market action looks nothing like that. This limits hedging opportunities by reweighting major sectors.
  • The offsetting positive to all this from a US equity holder perspective: American corporate earnings remain reasonably strong, the domestic economy is decent, and low interest rates mean high valuations as long as profitability continues to hold in.

The bottom line here: today was the day US equities peaked over the fence and saw several troubling signs in fixed income and currency markets. We don’t expect that to magically reverse in the next few days, if only because so many red flags have popped up. Our basic recommendation of overweighting US equities over rest-of-world remains. But we’re prepared for some bumpy times to come.