In a note aptly titled “October Requiem“, Goldman strategist Charles Himmelberg recaps the recent action in the market, noting that since Oct. 1, the S&P 500 is down roughly 9%, while the Nasdaq and Russell 2000 are down roughly 11% in what has been one of the worst months for the market since the financial crisis.
And while global equities have suffered similarly, fixed income and commodities have been relatively subdued. US Treasuries, in particular, have been remarkably quiet Himmelberg notes, with 2y and 10y yields having fallen by just a single basis point over the past four weeks. Additionally, with the exception of oil prices, which have fallen roughly 9%, commodities have been fairly quiet, with copper falling 1% and gold rallying 3.5%. Meanwhile, even as the USD rose 1.4%, the JPM EM FX index, which fell over 15% between February and September, was flat for the month.
To Goldman, this sharp drawdown – which has mostly hit stocks – likely reflects three “uncomfortable” macro themes.
- First, the downside risks to growth have risen: Market concerns over global growth first emerged last spring, when the macro data flow began to show EM growth underperforming the US. EM markets clearly reflected this growth deterioration, but US markets showed few signs of concern. Around the same time, Goldman’s “market-implied” growth factors show a strengthening of US growth expectations, just as the impact of US tax bill began to show up in growth and earnings data.
- Second, markets continue to price in Goldman’s forecast that the Fed will hike rates five more times through the end of 2019, gradually “boiling the frog” on risk appetite. The temperature rise went mostly unnoticed last year and early this year because the market narrative on global growth was “strong and synchronized”. But the view of non-US growth was shaken over the spring and summer, while recently the US outlook has been weighed down by the expectation that the 2018 tailwind from fiscal stimulus will likely become a headwind in 2019.
- Third, markets appear increasingly uncertain over the Fed’s reaction function. Himmelberg notes that “for some time now”, markets had taken comfort from the knowledge that the Fed’s policy path would be “data dependent” – that the FOMC would adjust the pace of rate hikes to match the strength of the data flow. Moreover, markets have expected the FOMC would make such adjustments using a relatively dovish Taylor Rule, one reflecting well-anchored inflation expectations and thus tilted toward growth concerns. However, October suggests that markets are second-guessing this assumption. Most telling is the extent to which the sell-off in equities was not accompanied by a rally in Treasuries. Indeed, until last week, yields on 2y and 10y bonds had actually risen on the month by roughly 10 bps. As Goldman wrote recently, “it is this relative repricing of bonds and equities that drive the “US monetary factor” in our new macro factor model and which shows a material tightening of monetary policy this month.“
Most importantly, it is “this complete lack of correlation between 2-year bond yields and our model’s market-implied US growth view that we interpret as the market’s reassessment of the Fed data dependency”, Himmelberg writes. While this is not an assessment based on the sensitivity of 2-year yields to actual data – as the actual data flow in October was uneventful – and thus not inconsistent with the lack of movement in bond yields, when the bank measures implied macro themes from the cross-sectional repricing of macro assets in October, it identified a large decline in expected future growth rates.
In short, “were markets expecting a data-dependent policy response, they should have repriced 2-year yields accordingly.”
But they didn’t: to shows that, the Goldman chart below presents another way to see this by plotting the “beta” coefficient from a 3-month rolling regression of daily changes in the 2-year Treasury yield on daily changes in Goldman’s market-implied US growth factor.
The time-series of this sensitivity parameter suggests that during 2016 and 2017, the pricing of the Fed’s forward path (as reflected in the 2-year) was responsive to the market’s view of the US growth outlook, moving roughly 2bps per each daily standard deviation move in the US growth factor. However, since the autumn of 2017, this sensitivity has fallen to just over 1bps, and over the past few months it has fallen even further to just ½bps.
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So what changed, and when?
Responding to this question, the Goldman strategist notes that while it is hard to precisely date the decline in the sensitivity of bonds to the market’s growth views, the period of decline overlaps numerous speeches and interviews by Fed Chair Jay Powell and other FOMC members in which they strengthened their endorsement of the FOMC’s projections for both the economy and the path of rates. Perhaps most surprisingly, considering a series of soft inflation reports in August, not a single FOMC participant at the September meeting that previously was projecting 3 or more hikes fell into the 2-hike camp
In other words, and as Deutsche Bank explained yesterday, it’s “the Fed’s fault” why equities have not only decoupled from other growth signals, but why they have been punished substantially in recent months.
What happens next?
Looking ahead, “risk appetite will likely remain on fairly shaky foundations,” according to Himmelberg because two of the uncomfortable themes at the core of the market’s concerns – expectations of slower growth and rising rates – will likely prove persistent.
Responding to bullish concerns, Goldman writes that the best scenario for risk appetite would be one in which the Fed signals its willingness to pause in response to continued macro or market pressures. But, as the bank concedes, the bar for this seems high, and even though its economics team is forecasting a deceleration of growth in 2019 (to 2.0% Q4/Q4 from 3.2% in 2018), they do not expect this will be large enough or fast enough to deter the Fed from our expectation of five hikes before the end of 2019.
Another possible, but unlikely, re-risking scenario would be a “catching-up” of ex-US growth. And while this is Goldman’s baseline expectation, Himmelberg admits that “the downside risks have risen considerably”:
China weighs on EM, Italy weighs on Europe, and rising US rates weigh on the global rate environment, raising the temperature on other economies that would rather be cutting rates to boost growth than raising rates to defend their currencies. It also appears that global growth is currently benefitting less from US growth than it typically does.
This leads to the following ominous conclusion from the cross-asset strategist:
Increasingly, it seems to us, the tailwinds for global growth are harder to see than the headwinds.
If it is indeed the case that the world is slipping ever closer to a global recession, Goldman suggests that the best, and perhaps only, hope for a bounce in risk assets “may simply be the likelihood that markets are over-reacting, equity markets in particular.”
The bank offers two reasons why that may be the case:
For one, while the macro decomposition of asset returns reported in Goldman’s macro factor model (shown in Exhibit 3 below) reveals that most of the cross-section of asset returns can be “explained” by one or more macro factors, there is nonetheless a “residual” for each asset that cannot be explained. To explain this, Goldman believes that technical explanations like crowded trade unwinds, market illiquidity, etc. – factors that have been cited by some market observers as contributors to the recent drawdown.
In any case, whatever the explanation for this over-reaction vs the prediction from Goldman’s macro factors, the bank’s view is that a reversal is more likely than not.
Finally, Goldman provides one last loophole for hurt bulls, suggesting that if it’s true that markets have been worried about the Fed’s reaction function – as many have suggested – then there’s a reasonable chance these concerns will turn out to have been over-reaction, too, for the reason that while it may be the case that the Fed needs to maintain its focus on the risks of overheating, this doesn’t mean that the risks are not still “balanced”, or that the “put” implied by the Taylor Rule’s dependency on growth expectations has expired.
Indeed, in the Q&A session following his Oct. 25 speech, FOMC Vice Chair Richard Clarida indicated that “…changes in financial conditions are something that’s relevant for the economic outlook.” He further commented on the importance of looking at a wide range of real and financial data to get a sense of where the economy is heading, and that “financial conditions are part of that, but on a sustained basis.”
There is a very simple way to test that “Fed put” thesis: push the market low enough and observe if and when the Fed will react. If it doesn’t, well then the Fed’s “reaction function” no longer responds to market declines.
In parting, Himmelberg puts everything together, and writes that when he looks at the unusual magnitude of the performance gap between US bonds and equities, he believes that something’s got to give: “either equities rally back, bonds rally further, or some combination of both.”
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