The FINANCIAL -- The potential disruptions – including Brexit, a tech slump and trade wars causing a weakening RMB – are framed as alternative scenarios for investors to consider as hedges to market consensus, according to Dominic Konstam, Head of Global Market Strategy, and William Marshall, Strategist. The authors add that the potential shock scenarios can offer hedges to Deutsche Bank’s House View [link], which supports the Fed raising rates twice more this year and another four times in 2019.
Seven potential market shocks:
A Brexit shock resulting from the possibility of UK and EU negotiators not reaching a deal before the March 2019 deadline. “A disorderly departure from the EU where negotiators go over the proverbial cliff without a deal would bring immediate uncertainty, likely necessitating a reaction from the Bank of England (BoE) and markets globally reacting to negative growth shock fears,” the report says. “Bigger picture, it would likely bring a more definitive marking down of markets’ outlook for future BoE policy.”
The report also suggests core euro area government bonds should rally on the risk of a negative growth shock, with equities selling off. “We suspect financials would be particularly vulnerable given the immediate restrictions to business that would likely become a reality.
The chance of a single sector – the tech sector – generating a larger economic shock. The tech sector is of particular interest given building regulatory scrutiny, as well as its large weight to overall market cap and its outperformance. Tech stocks account for about 25 percent of the overall market cap of US equities, and the tech component of the S&P 500 has returned 62 percent since the end of 2016.
In terms of valuation, Deutsche Bank’s equity risk premium framework shows the tech sector is about 8 percent rich to fair value, trailing only consumer discretionary and financial stocks. According the report, a drop in tech-related investment would be consistent with slower productivity growth, and estimate the effect of a decline in tech stocks on GDP growth.
Rapid Renminbi (RMB) weakening from ongoing trade tensions in order for China to maintain market share. Less global growth is likely and might encourage competitive devaluations, with EM weakness implicit.
Bank of Japan (BoJ) adjusts on the view that Japanese Government Bond (JGB) purchases are unsustainable and rates are too low for bank profitability, with the risk from JGB curve bear steepening, particularly at the front-end.
State and local demand for fixed income is strongly linked to equity market performance. Higher stocks implies faster fixed income buying. This in turn should put flattening pressure on the yield curve, potentially inverting it far sooner than priced into the forward rate.
An Italy “fix” that allows for a more positive view on ECB normalization given debt sustainability challenges, persistent Target (centralized payment system for euro area central banks) imbalances, and the importance of QE to containing credit risk. A solution such as an Italian Twist (buying more and longer duration Italian debt) would possibly allow a more risk-positive ECB normalization to take place. This would potentially allow the market to re-price ECB policy rate expectations and normalization of German term premium to fair value, with ECB becoming less behind the curve.
The US Federal Reserve adjusts its approach to monetary policy, explicitly recognizing that it can influence potential growth and triangulating policy on its projections for real growth, inflation, and potential growth. This critically does not need to mean that the Fed pauses, just that the real funds rate lags r star (the real short term interest rate that would pertain when the economy is at equilibrium).