Fra Zerohedge:
Having been one of the most bearish voices on Wall Street for a good part of 2018, with downgrades of small caps and tech stocks earlier this summer and one month ago going so far as to call the peak of both Treasurys (in September) and Stocks (this December)…
… in his latest Sunday Start note, Morgan Stanley’s chief US equity strategist Michael Wilson, takes what may end up being yet another premature victory lap following the latest equity selloff inspired initially by surging rates and the continued chaos over the Italian budget process and – overnight – the Chinese market crash, and writes that “the break higher in interest rates last week appears to be the tipping point, enabling the rolling bear market to complete its unfinished business in these last bastions of safety.”
Wilson also reminds us that based on the bank’s Equity Risk Premium framework, the S&P 500, as a whole, had become overvalued for the first time since January, and that “this overvaluation was apparent as yields on the 10-year broke through the 3% barrier. Small caps had already been underperforming for several months, but as rates moved above 3%, their underperformance accelerated. With last week’s surge toward 3.20%, weakness finally came to the high-flying growth stocks where valuation is the most stretched.”
In short: for Wilson, it’s all downhill from here, even though the stock peak appears to have come some 2 months earlier than he had predicted earlier.
We present his full note is below:
The Tipping Point
September bucked the normal seasonal pattern, proving to be a fairly calm month for financial markets. Global equities even started to broaden out a bit with international stocks doing better, led by Japan. Credit markets also displayed resilience with one of their better months this year, despite the fact that the rates market was suffering one of its worst. The presumption was that global growth was improving and could be more sustainable than markets had feared.
As we entered October, the move in rates continued, with the 10-year Treasury yield making new highs last week in dramatic fashion. We’ve often found that it’s not the magnitude of the rate move that matters most for financial markets, but its speed. Last week’s surge checks both boxes—it was big and fast!
Perhaps Japan’s newfound leadership in September was an early warning that this rate move was coming. After all, Japanese equities would stand to be the biggest beneficiary of rising global inflation and interest rates, accompanied by a stronger US dollar. Emerging Markets, on the other hand, don’t fare as well under this scenario and have been a laggard in September and so far in October.
Since July, we have been recommending that investors fade the areas of relative strength in global equity markets—US small caps, Tech, and Consumer Discretionary shares—in favor of some of the laggards like Japan, Europe, Energy, Industrials, and Financials. In short, we’ve been recommending value over growth on a global basis.
Over the past 10 years, growth stocks have absolutely trounced value stocks worldwide. In the era of below-trend GDP growth and negative real interest rates, it was logical for investors to favor a barbell of steady income and growth stocks. Therefore, early in the recovery from the financial crisis, this led to extraordinary performance in bonds and income, producing stocks known as the “dividend aristocrats.” Growth stocks also enjoyed most-favored-nation status.
However, as interest rates began to rise from their secular lows in summer 2016, bonds and the dividend aristocrats started losing their luster, while growth stocks continued to attract capital and re-rate even higher. I think this disconnect made sense when rates were still very low. Bonds and bond proxies are sensitive to moves higher in interest rates from any level, while growth stocks remain immune until rates cross a certain threshold.
Was that level breached last week? We think the answer is yes, because growth stocks now are less attractive while many discarded value stocks, like financials, become more appealing. It’s notable that last Thursday the MSCI World Value Index had its greatest one-day outperformance relative to MSCI World Growth since May 2009.
In our US Equity Strategy research, we highlighted in September that the S&P 500, as a whole, had become overvalued
Premium framework. This overvaluation was apparent as yields on the 10-year broke through the 3% barrier (see Exhibit). Small caps had already been underperforming for several months, but as rates moved above 3%, their underperformance accelerated. With last week’s surge toward 3.20%, weakness finally came to the high-flying growth stocks where valuation is the most stretched.
Given their lack of dividends and high valuations, high-flying growth stocks are arguably the longest-duration assets in the world. Therefore, it’s perfectly reasonable that they would eventually succumb to rising rates. We just didn’t know at what level it would happen.
Much as in January, when a sudden move higher in the 10-year yield led to a rapid and broad 12% correction in US equity valuations, we see a similar risk for the smaller cadre of stocks and assets that have maintained their valuations since the January highs or moved higher.
This was precisely our call back in July when we downgraded US small caps and Tech stocks. At the time, we thought the valuation gap would close as the sustainability of growth was called into question. However, the break higher in interest rates last week appears to be the tipping point, enabling the rolling bear market to complete its unfinished business in these last bastions of safety.
With the recent 10-year Treasury move, the S&P is now overvalued for the first time since January.
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fra Zerohedge:
Having enjoyed a largely one-directional ascent since the end of March, when it was trading around 105, and rising above 114 in early October helping push the Nikkei225 to 27 year highs…
… the weakness in Japanese yen, traditionally a safe haven during risk-off times, has finally cracked and starting around the time of Thursday’s selloff has jumped with the USDJPY sliding over 100 pips today as traders demand haven protection amid fears about China’s depreciating currency and the U.S.-China trade dispute, dropping below 113 to 112.85 – the lowest level since late September.
As Bloomberg notes, the yen is stronger against all its G-10 peers Monday as traders demand haven protection amid fears about China’s depreciating currency and the U.S.-China trade dispute. The yen strengthened after U.S. Secretary of State Michael Pompeo cited “fundamental disagreement” with China’s foreign minister during a testy exchange in Beijing that highlighted rising tensions between the world’s two largest economies.
And now that the upward momentum appears broken, USDJPY may have much more to drop.
In a prescient note published last Thursday, Deutsche Bank’s FX strategist George Saravelos wrote that it is time to sell the USDJPY, for three specifics reasons:
(1) The correlation between US yields and equities will likely turn negative. USD/JPY has benefitted from the “perfect mix” of rising US rates and equities. But the DB fixed income colleagues make a compelling argument that at a level of US yields around 3.50% it becomes far tougher for equities to rise in tandem with yields.
In turn, this should be negative for USD/JPY because it is equity outflows that have dominated Japanese investment over the last twelve months. Weaker equities via slowing outflows and repatriation will matter more for the yen than rising rates. In this world, yields higher, USDJPY lower hybrid trades offer substantial correlation cheapening.
(2) Japan to sell USD/JPY above 115. According to DB, it has received strong feedback from pension fund and lifer investors that they see little value in holding unhedged dollar investments above 115. This sentiment can be seen in the record levels of USD/JPY selling already taking place by local margin speculators, i.e. Mrs Watanabe’s momentum chasing is at a record.
Historically such extreme levels of USDJPY positioning from Mrs Watanabe have either coincided with a top (October 2017) or a stop-out move higher (May 2015) which then reverses as the longer-term investors step in. Either way, this extreme level of local yen bullishness is reflective of the local view of the yen and fits in with Deutsche’s assessment that the yen is the world’s cheapest currency.
(3) BoJ stealth tapering is alive and well. The BoJ signaled a clear desire for greater volatility in the JGB market in its July monetary policy meeting reflected in the continued subdued buying of JGBs even as yields rise.
While the new 20bps ceiling to 10-yr JGBs is unlikely to be breached the same cannot be said of longer-dated yields which are now making new cycle highs as the Japanese curve steepens. BoJ tolerance for steeper and higher yields limits policy divergence with the US and the return of fixed income outflows. It is also coinciding with renewed upside surprises in Japanese inflation amid Japan’s exceptionally tight labor market.
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In making its reco, DB concedes that it may be a little early on the trade “given the stop-out risks of extended local margin positioning, positive equity seasonals around US midterms and the fact that we are only just starting to cross the threshold where rates matter for equities.” However, in light of the extreme level of yen valuations, the bank “prefers being early rather than late in buying the yen – the upside is far greater than the downside.”
So far, its trade has been spot on, and once the CTAs get on board and start pushing momentum lower in the pair, the yen may soon be revisiting the 2018 highs, especially if the BOJ gets cold feet about “renormalization” after a few more days of sharp selling in stocks.
