It’s been an eventful period for financial markets so far in 2016. The first six weeks were tumultuous to say the least. Risk assets were pummeled, dragged down by fears for the global economy, led primarily by China.
However, like a switch was flicked, sentiment turned around dramatically from mid-February. Risk assets soared, the global economy — only weeks after it was about to implode — was looking good once again.
Chalk and cheese. A game of two halves. Jekyll and Hyde. No matter your description, it’s been a wild ride for investors.
To Ajay Rajadhyaksha and Michael Gavin, researchers at Barclays, it was an eventful quarter in which not much of fundamental significance changed.
“It would be intellectually satisfying to attribute this round-trip to some threatening macroeconomic factor that loomed much larger at the start of the year, and then faded in the remainder of the quarter,” said the pair in a research note released earlier this week.
“But we find it hard to rationalise the market’s intense oscillations on the basis of actual news flow.”
“The world looks to us broadly as it did at the end of last year, and not radically different than in mid-February.”
Instead of fundamental factors, Rajadhyaksha and Gavin suggest that wild swings in sentiment are a consequence of a tug-of-war between expensive market valuations and central banks aggressive attempts to support asset prices.
“In such an environment, it is no surprise that investors hit the ‘sell’ button hard when the markets seem on the verge of a stumble, given that they are not convinced of valuations on the basis of fundamentals,” say the pair.
“It is equally unsurprising that market downdrafts have been short-lived; when markets stumble, interest rates are pushed into negative territory, asset purchases are stepped up, and investors find it too painful to stay in safe assets.”
The so-called central bank “put”, the notion that policymakers will do everything in their power to support the markets, has seen risk assets become so expensive that investors are questioning whether they still represent fundamental value, leading to sharp declines on next to no information.
With these twin factors likely to remain in place for some time yet, Rajadhyaksha and Gavin expect this tug of war will continue in the quarters ahead.
Investors will be confronted with a conflict between the longer-term implications of expensive asset prices in a low-growth environment and the tactical imperative to fade market downdrafts while central banks remain supportive. In that sense, Q2 is likely to be similar to Q1,” say Barclays.
“Asset prices are unlikely to move up in a sustained fashion, but any sharp downturns should be bought, in our view. However, the outlook for medium-term returns remains mediocre, and the passage of time does not help, because it brings asymmetric, mainly downside, risks (that are not now imminent) closer to markets.”
Rajadhyaksha and Gavin suggest that the risk of an imminent sharp downturn in the US or Europe, a sharp selloff in the Chinese renminbi or a near-term hard landing in China as low, although they suggest that the recent recovery in commodity prices in unlikely to persist.
Barclays recommend “fading the global risk rally of the past several weeks”, suggesting that investors maintain a modest underweight exposure to equities and concentrate risk in investment-grade credit. They also suggest that the rally in emerging market (EM) stocks is unlikely to mark the beginning of sustained outperformance, recommending that investors take a selective approach to EM assets.
Here’s the bank’s asset class forecasts, along with a selection of recommended trades.