After the disastrous equity market performance in Q418, as the world desperately hung onto any sort of support in the markets, the media is now hailing Q119 as the best quarter since 2009! Happy days, all is well. Who would have thought Q119 would see the S&P 500 ( (SPY) ), Eurostoxx 50 (SX5E), and Chinese markets ( (FXI) ) close up 13%! For most funds that is one year's of performance done and they can easily switch their screens off and head early to the beach for the summer. The key word being "if" they managed to be long going into Q119. Most funds had been agnostic of any recovery and perhaps only got caught chasing their tails in March following the dovish FOMC meeting which just reinforced what the Fed suggested earlier in February. The U.S. and Chinese trade officials threw in one liner teasers every time the market dipped more than 1% which added fuel to the fire as no one wanted to be caught short in case a trade deal was finalized.
The end of Q1 also saw massive portfolio rebalancing flows as funds had to make sure their equity and bond allocations were matched correctly. No one wanted to enter Q2 with an underweight equity allocation as they would be at pains to justify the underperformance to their investors. This week the U.S. enters a new round of negotiations with China and the market awaits any result that could be four to six weeks away at the earliest as key issues remain unresolved. China will not cave in to U..S pressure, and the U.S. needs any deal to save face and see markets higher. Behind the scenes, the macro economic data seems to be deteriorating and ignored by most at their own peril. By the end of this week about 40% of U.S. companies will be in their "blackout" period so they'll be unable to buy back their own stock.
After China reported recessionary data for January and February, the March PMI report showed that manufacturing had bottomed, coming in at 50.5 vs. expectations of 49.6. Even China's non-manufacturing data showed an improvement to 54.8 vs. expectations of 54.4. The Chinese Shenzhen index cheered this data and moved up another 2%. What is missed by most investors is that this "improvement" is a result of the gargantuan liquidity injection by Chinese central banks in January aimed at jump starting the economy after stalling in Q418. The more pertinent question is, how much of this has already been priced in by the market and what is the marginal trade here? The longer the delay in reaching a trade deal, the more the risk of a market selloff as most of the good news is priced in. There is also a chance of the tariffs still being in place till a deal is reached, which will curb global growth and trade. EU automobile makers are still suffering with regards to U.S. sanctions.
The move that astonished most investors in Q119 was the price action of the bond market vs. the equity market towards the end of March. After the Fed March FOMC meeting, bond markets went into an ultra bull market mode as yields collapsed across the global markets. Currently about $10 trillion of the global bond market is in negative yield territory. According to JP Morgan, the U.S. equity market is pricing in about a 15% chance of a U.S. recession vs. the bond market pricing in about an 80% chance. Who is right? No one seems to know yet, but there is a huge disconnect. Both of them cannot be right. It seems the bond market has taken a very pessimistic stance on any recovery happening. In fact, it is pricing in a rate cut this year.
If the equity market is rejoicing on signs of some sort of stabilization in Q119 and a potentially positive trade deal, then the U.S. bond market is massively overpriced. If the former happens, the Fed will have to start thinking of a rate rise, not a cut this year. Are investors and the dollar priced for that potential outcome?
It seems the risk reward is massively skewed to being short the U.S. bond market (TLT) as yields have gotten too unsustainable levels. If not, then U.S. equity markets (SPY) are a short as the lower growth and deflationary world needs to be priced in.
Unfortunately, both asset classes cannot be right, something has got to give.