Nerves make for thin market
Jul 21 2010 by Andrew Miller, The Journal
RISK assets are not out of the woods yet. Investor behaviour remains fickle and as a result there is a lower than usual number of buyers and sellers, resulting in what we would call a “thin” market. Moreover, there is no shortage of potential flash points in the weeks ahead.
For example, the US second quarter earnings season has started well, but the good news still seems likely to fade if only because the bar was set so high in the last two results seasons. Against this background, there is plenty of room for individual disappointments to be extrapolated – in a downward fashion – across the broader market.
Meanwhile, successful auctions of government debt in Portugal and Spain still leave eurozone bond yields at levels that testify to deep-seated nervousness.
We think that the stress tests for 91 European banks to be unveiled this week should help to increase confidence in the sector. We also think that the European banking system is not now as fragile as many commentators fear.
But there is considerable scepticism regarding the stringency of the tests, and, as with earnings, individual results could have a disproportionately large short-term impact.
Looking at the macro-economic picture, some of the forward-looking economic data continue to fall back from their recent inventory-flattered highs, and we know from questions crossing our desk that many investors and colleagues alike remain sceptical of the US consumer’s ability to grow at all given balance sheets as large as they are.
In reality, the level of nominal and real consumer spending in total has already surpassed its previous peak, even as credit availability has been shrinking. But our economists note that income growth, in particular, is falling short of that seen in previous recoveries. This may keep investors’ nerves on edge.
Elsewhere, Chinese GDP growth of “only” 10% in the second quarter is being viewed as a significant slowdown. Further slowing is likely as we go into the second half of the year and will doubtless be extrapolated by some – however unreasonably – into the feared “hard landing”.
Against this backdrop, we think that during the months ahead, investors’ expectations will remain polarised, risk appetite will stay fragile, and market volatility is unlikely to fall much further.
We stay overweight equities and high-yield credit, but as we have discussed in previous columns we are also overweight high-quality long-dated government bonds. We see the resultant “barbell” tactic – funded by an underweight in cash and investment-grade credit – as the best way of being positioned for these unconventional expectations.
By the standards of the last decade, our tactic itself is unconventional. For most of that period, stocks and bonds have been negatively correlated – ie, when stocks performed, bonds tended to struggle and vice versa. But if we look back to the 1980-98 period – or indeed even to the last year – we can find plenty of precedent for a positive correlation, and for such a “bimodal” approach outperforming, albeit for different reasons.
Bond yields are, of course, much lower now than they were back in the 1980s and 1990s, but so too are returns on cash. Of course, investors should remember that bonds and equities can fall in value, which means that their capital is at risk.
:: Andrew Miller is regional office head of Barclays Wealth in Newcastle
