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What are the markets telling us?

Januar 21, 2016 09:34

Torrid start to 2016

It's been a torrid start to 2016 and there has been plenty of hyperbole in the media about the markets. Some of that may have been justified. But it never hurts to take a step back and look behind the headlines and sound bites at what's really happening. Perhaps the best way to do that is to look at what the data is telling us and if you like let the facts speak for themselves.

A picture can speak a thousand words

As we can see from the chart below we are in "Risk off" mode. The VIX index which is often thought of as measure of "Fear & Greed" has performed strongly year to date. The higher this volatility index rises the more fear there is in the market. Note though that even after this sharp rise the VIX is still less than half way to its 52 week intraday high, seen in the turmoil that characterized the later part of August last year.

The chart shows the performance Year to date (19-01-16) of selected US futures contracts (Source

We can also see that safe-haven assets have made gains since the turn of the year. Gold, the US 30 year bond and the Japanese Yen (JPY) have added at least +3.2% as of the close 19-01-2016 (for more detail about JPY as safe haven see my recent article the perpetual learning curve )

Equities have been hit hard

The biggest casualties Year To Date, apart from Oil and Gas, have been global equities. The Japanese Nikkei has been particularly hard hit. The index has many large exporters within its ranks and as a consequence it has been hit by a weaker Chinese Yuan and a strengthening Yen. Both of which combine to make Japanese exports more expensive relative to their Asian peers.

Remember that a weak Yen was one of Shinzo Abe's Three Arrows policies, which were intended to reflate the Japanese economy. It remains to be seen at what point the BOJ will try to weaken the Yen if at all. But presumably they won't wish to see what little success they have had in rebooting the economy swept away.

Oil & Inflation

Oil prices continue to fall and the focus may now move from the absolute price of Oil (which is surely not too far from making the move to capitulations lows. Whether that be at $10, $15 or $20 per barrel) to the effect that low Oil prices are having on levels of inflation. That effect is to depress levels of inflation and to keep them rooted very closely to and in some cases below zero, particularly in developed economies.

More over prolonged low levels of inflation are having a pronounced negative effect on market expectations about future inflation growth.

The chart below shows the implied levels of future Inflation in both Eurozone and USA

(USA in yellow, EZ in white: Rates are derived from the respective Futures and Swaps markets) source Blonde Money.

As we can see from the chart above the inflation outlooks on both sides of the Atlantic are heading lower once more .

This chart takes on added significance when you realise that these implied rates of inflation are forecasts for inflation five years hence.

An unpleasant surprise

Inflation is often seen as a proxy for or companion to economic growth. I looked at the prospects for global growth in the article Growing Pains on the 13th Of January and I have seen nothing to dispel my concerns, since then. Indeed the IMF has trimmed its global growth forecast by -0.2% since I wrote the article.

In assessing the macroeconomic background and the implications for markets and prices I like to look at the trends in the underlying data. One tool I find very effective in aiding this is the Citi Economic Surprise Index (see below). Which measures the deviation of economic data releases from the consensus of analyst's forecasts, on a geographic & regional basis. The higher the index score above zero the bigger the cumulative beat, the lower the score below zero the bigger the disappointment.

Chart shows the deviation of economic data from the consensus of analyst's forecasts

I have highlighted, in the red ellipses above, the current situation for both the USA (dark blue line) and China (bright blue line) both of which have seen their readings dip and trend lower in recent weeks. The scores are cumulative and could of course reverse direction on any substantial positive surprises. However the charts suggests to me that this is not what we will see in the medium term.

Worse before it gets better

As I write the Nikkei has officially moved into a bear market, having fallen by more than 21% from its recent high, to its closing level as of the 20-01-16. Dollar Yen (JPY USD) has tested down to 115.97 before bouncing and European equity indices are sharply lower. Many by as much as 3%.

I said on television a week ago that the current downturn was a correction rather than a crash. That view still stands as we haven't had another " Lehman Brothers moment" which completely derails the situation.

There are pinch points in the system however, such as high levels of Dollar denominated debt in China and the Emerging Markets and of course the ongoing commodity price plunge and deflationary spiral mentioned above. Which means we can't rule that sort of inflection point out of the picture entirely, I am afraid.

Note several other leading equity indices have now moved into technical bear markets and whilst it's probably best to judge these things on a weekly or even monthly basis, this will inevitably weigh further on investor sentiment.

The "smart money" is cautious but not panicking

Let's leave the last word to the Fund Managers that control more than US$500 billion in assets, as questioned by Bank of America Merrill Lynch in their influential and informative monthly survey.

As we can see from the graphic below the respondents are increasingly bearish on the global growth outlook, but only 12% of them believe we will see a recession in the next 12 months.

Chart shows expectations for global growth amongst the Fund Managers participating in the BOA ML Survey

Finally I should remind readers that in periods of heightened volatility and uncertainty markets may be less liquid and price action more exaggerated.

In these situations it's sensible to review your exposure and risk, your trade sizes and placement of stop losses.

Follow me on Twitter to discuss the latest markets events @Fatdaz


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