Last friday when Ukraine/Russia news came and market took dive of more than 1 % later markets were off lows which may force us to think how sensitive or nervous markets are with geopolitical news or it is something else what worries market.
When something has been so good for so long, the idea that it may be coming to an end can cause a lot of angst. The main reason for that is that change is imbued with uncertainty.
That realization appears to be setting in for the market, which is sniffing a change in the monetary policy dynamic. That is the sense we get anyway when reading between some of the performance lines.
An Understated Problem
Since the start of the third quarter, the S&P 500 has declined 2.6%. That's a drop in the bucket when taking into account how far it has come since March 2009.
The thought worth focusing on is that the pullback has occurred in the face of incoming economic and earnings news that has been mostly better than expected.
- According to S&P Capital IQ, second quarter EPS is up 10.1% year-over-year versus a 6.6% growth rate projected on July 1.
- The advance estimate for second quarter GDP showed output increasing at an annual rate of 4.0% versus expectations for 3.0% growth ahead of the report.
- Upward revisions contained in the Factory Orders report for June and a narrower than expected trade deficit in June will support an even higher growth rate when the second estimate is released.
Most of the commentary gravitates around the unsettling geopolitical scene. There is some validity to that viewpoint, yet we think it is providing headline cover for the real source of angst, which is the thought that the Federal Reserve will soon be done with its asset purchases and that the first hike in the fed funds rate is apt to occur sometime in the next 6-12 months.
The Federal Reserve has acknowledged that its latest asset purchase program is on track to come to an end in October. Meanwhile, the timing of the first rate hike remains a key point of debate.
The fed funds futures market is currently pricing in a 66% probability of the first hike occurring in July 2015, according to data compiled by the CME Group.
Fed officials continue to warn, however, that rate hikes could come sooner than expected if incoming data are stronger than expected.
Angst
With the six-month time horizon starting to enter what is a viable window for a change in the fed funds rate, it makes sense that the capital markets are starting to feel some added angst about higher interest rates.
It isn't major angst, but it is angst nonetheless that has started to manifest itself in a telling way.
To get to the heart of the issue, we can first turn to those areas that have done extraordinarily well with interest rates remaining near the zero bound. Four areas stand out in that respect -- high-yield bonds, the utilities sector, small-cap stocks, and dividend-paying issues -- and all four have underperformed the S&P 500 since the start of the third quarter.
The dive in the utilities sector and widening high-yield bond spreads have really stood out in the downtrodden mix.
The utilities sector was overplayed and overvalued when the quarter began. It has declined nearly 9.0% since then, which is remarkable considering its defensive-oriented disposition has not resonated in the midst of all of the geopolitical concerns.
High-yield bonds, meanwhile, fell under the same umbrella of being overplayed and overvalued as a desperate search for yield led to a pretty crowded trade in that asset class. Accordingly, with the specter of higher rates on the map, marginal buyers (aka "the greater fools") seem to have faded from the scene, leading to a big jump in spreads over investment grade corporate debt.
Some will argue that the weakness in high-yield bonds is a sign of bad economic things to come. The steady state of investment grade debt, however, doesn't really support such an argument.
To us, the notable weakness in high-yield bonds isn't much at all about default concerns. Rather, we think it reflects more of a rebalancing effort driven by the recognition that high-yield bonds are overvalued and that there is budding interest rate risk for the holders of those bonds.
Moving Out
Looking further at the stock market, it is striking how little has done well since the end of the second quarter. Some areas have done better than the S&P 500, yet the information technology sector is the only sector that hasn't lost ground-- and that has a lot to do with the outperformance of one stock, Apple (AAPL), which is up 1.7% since the end of June.
In prior retreats, there was an inclination to rotate money between sectors. The inclination of late, however, has been to rotate money out of the stock market altogether; hence, the declines in all but one sector.
| Sector | Quarter to Date |
|---|---|
| Basic Materials | -2.0% |
| Consumer Discretionary | -2.2% |
| Consumer Staples | -2.7% |
| Energy | -4.9% |
| Financials | -2.8% |
| Health Care | -1.8% |
| Industrials | -4.8% |
| Information Technology | unch |
| Telecommunication Services | -1.0% |
| Utilities | -8.4% |
| S&P 500 | -2.6% |
There is a case to be made that everything was due for a pullback anyway with valuations being stretched and the S&P 500 not having seen a 10%+ correction since August 2011. We suggested as much in our Market View update in mid-June.
Even so, the stark underperformance of the utilities sector and other sectors generally known for offering nice dividend yields (consumer staples, energy, and industrials) implies rate hike concerns are in the mix as a causal factor behind the selling interest.
Maybe, Just Maybe
Admittedly, the Treasury market is one area at first blush that doesn't look nearly as bothered by the thought of the Fed raising interest rates in the foreseeable future as other areas are.
The yield on the 2-yr note has come down two basis points since the end of the second quarter to 0.44%, yet it would be remiss not to add that it has risen five basis points since the end of 2013. It had been up 15 basis points to 0.54% as recently as July 29, but a July employment report that showed no growth in average hourly earnings and a lot of geopolitical headline noise has tempered some of the rate hike expectations that were pushing up the front of the yield curve.
The benchmark 10-yr note for its part has been a picture of unexpected strength all year. There are various reasons for why that is. We won't rehash them here, but it is interesting to us that the 2yr-10yr spread has flattened since the start of the quarter (and year) with yields at the long end falling and yields at the front end rising. The yield on the 10-yr note settled on Thursday at its lowest level since June 2013.
Other forces, such as the Fed itself, have helped drive yields lower for the 10-yr note, but with the curve flattening even before the most recent bout of geopolitical angst, we can't fully dismiss the idea that maybe, just maybe, the market was accounting for the possibility that the Fed will raise rates too soon and choke off the recovery effort.
It is in that vein that the Treasury market's behavior factors into concerns about potential rate hikes on the horizon.
What It All Means
It is undeniable that the geopolitical headlines have been a pressure point for the capital markets. If nothing else, they have highlighted the overextended nature of certain asset prices and have provided a very good excuse to lower risk exposure.
Should the diplomatic dealings with Russia evolve in a favorable way, such that Russia acquiesces and de-escalates its involvement in the Ukraine conflict in good faith, there could be a nice-sized counter-trend trade.
We don't know what the future holds, but the recent past in our estimation isn't simply, or entirely, about the capital markets having geopolitical angst.
While just about everything was due for a pullback, the underperformance of some of the market's biggest beneficiaries of interest rates at the zero bound suggests there is some budding angst about a changing monetary policy dynamic.
If nothing else, that underperformance has provided a taste of the likely performance trends when interest rates do indeed head higher.
It doesn't have to be all bad for rate-sensitive areas when that happens, but it certainly won't be all easy like it has been with the Fed continuously buying trillions of dollars of government securities and holding rates at the zero bound.
That thought is causing some understandable, if not widely acknowledged, angst in the midst of the overwhelming geopolitical noise.
Sources : --Patrick J. O'Hare, Briefing.com
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