Global markets got spooked this week, but here's why Citi is still 'buying the dips'

(Donat Sorokin via Getty Images)
  • Citi says global markets are in Phase 3 of a 4-stage investment cycle.
  • The bank said volatility will rise, but a solid growth backdrop means it will still provide opportunities to “buy the dip” in select markets.
  • Only four of the 18 items on the bank’s bear market checklist are flashing sell, compared to 13 items prior to the 2008 financial crisis.
  • Citi’s equity analysts are overweight US and UK stocks, and underweight Japan and Australia.

“Late cycle, not end cycle.”

That’s how Citi’s global equity strategists view the current investment landscape.

It’s worth noting within the context of this week’s surge in bond yields, which has sparked fears the US Fed may have to raise rates quicker than expected.

Stock prices can continue to climb as interest rates rise, but when bond yields spike unexpectedly it’s often the catalyst for a sharp correction on equity markets.

Citi says markets are now in Phase 3 of what the bank considers to be a 4-stage investment cycle.

Phase 3 is defined by rising volatility and higher credit spreads, but robust economic growth continues to provide support for risk assets.

According to Citi’s equity analysts, global markets entered Phase 3 in February, which makes it around seven months old.

“Phase 3 lasted 16 months in the late 1980s, 32 months in the late 1990s, but only 4 months in 2007-08,” Citi said.

So getting the timing right is an inexact science, but Citi said the evidence suggests market are still some way off from entering the dreaded stage 4 — the bear market phase.

For starters, the bank’s “bear market checklist” shows only 4 of the 18 warning signals are flashing the sell sign:

Source: Citi

The warnings signs have nudged higher compared to January, when 3.5 signals were indicating sell.

“The checklist told us to hold our nerve in 2011-12. It told us to do the same during sharp corrections in August 2015 and early 2016,” Citi said.

The model isn’t a predictor of events, but rather a guide of what to do if stocks fall. And “right now, it is telling us to keep buying the dips”.

Citi said to keep an eye on two factors in the checklist: the spread between US 2-year and 10-year government bonds (know as the yield curve) and credit spreads on high-grade US corporate bonds.

A flat yield curve has often been a good predictor of recessions, although this week’s spike in yields has seen the 2-10 spread widen out to 30 basis points as 10-year yields rose more sharply.

But if the yield curve does flatten and the spread between high-grade corporate bonds and US treasuries climbs above 175 basis points (from the current level of 109 basis points), “we would be much more worried about the future direction of global equities”, Citi said.

So factoring those risks into account, are markets late-cycle or end-cycle?

“Current opinion is deeply divided,” Citi said. “The guidance from prior bear markets is inconclusive. Many metrics already look stretched, but there is no ‘magic level’ at which markets consistently roll over.”

Ultimately, Citi said profit growth remains strong and interest rates in major developed economies are still low. As a result, the bank said there’s “still room to run” for equities.

The bank’s analysts are overweight US and UK stocks, and underweight Japan and Australia.

“We are not bearish but think that Australian equities will lag,” Citi said.

Here are the levels Citi’s equity analysts predict major global stock markets will reach by the end of next year:

Source: Citi

NOW WATCH: Money & Markets videos

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.