`Hijacked' by Rates, Bull Market Loses Footing on Shaky Ground

(Bloomberg) -- A chill wind is ruffling markets. Treasuries are balanced precariously near a putative three-decade support level. The resurgent dollar is blowing a multitude of trades off course. And bumper earnings have failed to excite stock bulls en masse.

It’s all creating havoc for some of the most popular investments on Wall Street -- from momentum stocks to emerging markets -- amid fears over the longevity of the business cycle.

“The sharp sell-off in rates has hijacked market sentiment,” strategists at Toronto-Dominion Bank including Richard Kelly wrote in a recent note. “The 3 percent level on the U.S. 10-year does not have any magical properties, but market participants are trying to navigate a global markets regime shift with a toolkit of mostly unstable correlations.”

Here are some questions investors are wrestling with right now.

Is the business cycle peaking, presaging recession and defaults?

Warning signs continue to flash in dollar interest-rate markets. Even though the Treasury cash curve steepened this past week, the swaps market is already signaling an end to the Federal Reserve’s rate hike cycle in 2020, or early 2021.

“The market is barely pushing up the level that it prices for peak rate but is now contemplating that peak coming sooner,” Kit Juckes, a global currency strategist at Societe Generale SA, wrote in a recent note to clients.

The first half of 2020 will usher in the start of the next “major” default cycle, according to strategists at Deutsche Bank AG. They cite pressure on the Treasury curve to invert as a signal the U.S. economy risks overheating amid elevated corporate leverage.

Their bearish missive echoes warnings from a slew of Wall Street counterparts of late that the end of business cycle is nigh with higher volatility and lower returns ahead.

Why have earnings beats failed to lift stocks?

After strong results from a variety of sector bellwethers, Corporate America is on track for its best quarterly earnings season since 2011. Yet over the past five trading sessions, the S&P 500 has dropped about one percent. Thursday offered some respite as the gauge ended the session in the green. But the choppy trading is a frightening prospect for bulls, who have relied on the 80 percent of index gains that traditionally come during reporting seasons.

“Limited price upside to strong earnings and revenue could be function of investor concerns on profitability moving forward,” said UBS AG strategists including Keith Parker in a note.

Beneath the surface, however, investors are rewarding positive earnings -- quantitative stock baskets that hinge on earnings metrics have performed the best over the past week, data from Bank of America Merrill Lynch show.

While that suggests a sustained rebound could be in the offing, it’s also possible -- with the asset class already priced so richly -- that steady earnings won’t be enough to lift the broader market in earnings seasons to come.

Is the traditional stock-bond portfolio doomed?

Easy diversification may be a thing of the past. Tumbling Treasuries in tandem with sliding stocks underscore bonds’ diminished value as a portfolio hedge. Correlations between and within asset classes are in a state of flux -- in equities, traditionally defensive stocks are moving akin to the broader market in recent sessions.

As such, simple allocation strategies are struggling. The DFA Global Allocation 60/40 portfolio is trading in the red this year while realized price swings are elevated, further eroding returns adjusted for risk.

Global bond yields would need to decline by more than 1 percentage point to offset losses in a given 60/40 portfolio, which is unlikely to happen, said analysts at Morgan Stanley.

“Given where global bond yields stand currently, the ability of bonds to offset an equity market sell-off is diminishing now,” wrote the bank’s strategists including Wanting Low in a note.

Can emerging markets advance versus a stronger dollar?

As the greenback rebounds, market participants may have exhausted easy returns on effective short-dollar strategies like carry trades in emerging-market currencies. One index that tracks the latter fell into the red this week as higher short-term dollar borrowing costs bite.

For now, the consensus on Wall Street remains bullish as commodity prices and output in developing economics increase -- but higher U.S. real interest rates threatens to tighten financial conditions around the world in the coming months while challenging valuations.

Is the reign of the equity-market leaders over?

In recent sessions, investors have been pulling the ripcord on the bull market’s pacemakers -- technology stocks. While robust results from Amazon.com and Intel Corp. spurred a surge in the after-market Thursday, investors are more cautious on the sector as a whole.

The proportion of global funds overweight tech stocks is at the lowest this decade, according to data from Barclays Plc. Momentum stocks finally got too expensive for investors to stomach amid growth that isn’t quite living up to lofty expectations, according to Pankaj Patel, director of quantitative research at Cirrus Research LLC.

“Whenever momentum gets stretched beyond historical norms, we see in the next two to three months the performance breaks down,” Patel said. “We’re seeing that now.”

While there are some signs value stocks are picking up the slack from their pricier stablemates, it’s not clear a true rotation is underway. And if the latter kicks off, investors will have to ask a fresh question: Will emerging trends have the muster to revive a flagging bull market?

©2018 Bloomberg L.P.

Bloomberg
Stay Updated With Stock Market News on BloombergQuint