There is an “insatiable” risk appetie” in markets, a Jefferies report notes, as the “front loading of positions in some futures markets” is causation for a price drop in certain asset markets. There are first, second and third level concerns that center around a risk appetite that “has produced a windfall risk backdrop for equities,” the report notes, pointing to such issues in a variety of global stock, currency and bond markets.
Risk Appetite – The global economic temperature might be starting to turn
When Jefferies Chief Global Equity Strategist Sean Darby looks at the investing world, he sees a complex global web of nuance.
In a May 19 Global Asset Allocation report written with Quantitative Strategist Kenneth Chan and Equity Associate Irene Zhou, the trio looks at layers of performance drivers that overlay market risk. In a report titled “The First, Second And Third Derivative,” they attempt to set the table for a world where low-interest rates have motivated investors to take risks they normally would eschew.
While bullish investors might think the world is operating at Goldilocks temperature, the Jefferies report starts to note a cooling trend that might leave a bad aftertaste.
“With producer prices peaking and commodity markets subdued investors are questioning whether the first derivative of growth is rolling over,” the trio observed. “While China has begun to tighten credit, investor positioning is just as much to blame for the ‘apparent dampening’ in demand,” they write.
But it is not just the first level where concern exists. “There are also tentative green shoots of second and third derivatives of growth.”
Risk Appetite – The many forces that create market distortions
Taken in sum total, low interest rates around the world have created a distorted environment where investors will do anything to obtain yield – and in part, this is impacting the delicate global market balance.
“On almost all measures, risk appetite is insatiable,” the report said. “A weak dollar, negative real rates on virtually every G7 10-year bond alongside tight credit spreads has produced a windfall risk backdrop for equities.”
While this market action has, in some cases, created the desired economic outcome, that result is not consistent across markets, as it “has not necessarily produced symmetrical inflows.” As inflows into fixed income continue “unabated,” Jefferies notes “equity buying have failed in most cases to have matched the outflows seen in 2015 and 2016.”
From their perspective, the multi-level layers of performance drivers are being combined with speculative input into derivatives markets that is only adding to distortions:
‘Phantom’ or apparent demand created by speculative positioning in the futures has been as much as force for commodity price rises as well as falls over the past year. Excess liquidity (money that is not demanded by the economy) has been so large due to central bank operations that it has been able to distort pricing. For example both the British pound and US treasury speculative futures positioning at the end of this year was the most extreme ever.
It is with the British pound that Jefferies points out a particular “front loading of positions in some futures markets” that has gotten ahead of itself. This is one of the reasons for the drop in asset markets despite improving economic conditions,” as sentiment towards the British currency was “very bearish.”
Looking at global markets and their underlying drivers, there are three levels of issues that could come into play:
Why are investors worried about derivatives? We have argued that services have held up well through most of the world but alongside the collapse in commodity prices, the manufacturing sector experienced an inventory overhang or ‘Kitchin’ cycle. The first derivative has been a sharp inventory destocking phase which ended in 2016 and has produced a rebound in Global manufacturing PMI. In turn, global trade has turned around. There are green shoots of second and third derivatives. There are genuine concerns that the global economy will relapse as the destocking phase finishes. Second derivative or wage and Capex growth is appearing in Japan, Germany and the US respectively. The third derivative or loan growth has also emerged in France, Japan and the UK. The bottom line is that investors ought to have an open mind towards how Capex and loan growth evolve. Wages are already growing in the G4 while there are green shoots in loan data. We have made some changes to our outstanding trades in exhibit.
Today’s markets in a yield-starved environment are much more nuanced than the unabated upward stock market grind that is putting global investors to sleep.