Put the Santa rally on hold

Equity markets enjoyed the benefits of the potential thawing in trade wars between China and the US, on Monday. On Tuesday they hit a dose of reality once again as concerns surfaced on the strength of the trade truce along with fears the global economy continues to slow. The S&P 500 giving up half of the past weeks gains in a few trading hours.

The Vix index rose despite the gains on Monday in US equities, suggesting investors are not wholly convinced we are about to start the Santa rally. There has been some focus on the US yield curve as the yield on the five-year maturing debt fell below that of the three years. The inverting yield curve is supposed to be a forecaster of an impending recession. A Bloomberg article, highlighting this event did also point out that it can be quite a long lead indicator as the yield curve inverted two and a half years before the recession took hold in 2007. If we are a similar distance away from the next recession most equity investors would take that timeline. Another sign of caution as the Japanese yen, considered a harbour of safety, has been rallying against the US dollar.

The three topics that had focussed investor sentiment, trade, US interest rates and Italy have now calmed. Capital markets will focus once again on a global economy that is slowing and as a result, analysts have been cutting earnings estimates. Analysts, earnings estimates for the companies in the S&P 500 dropped by 2.6%, for the fourth quarter, according to FactSet.

The other topic that has been in focus has been credit markets as the spread between high yield and investment grade has been widening. The current spread is around 4%, roughly where it was early 2007. It has been as high as 8% twice since 2008. Once in 2012 during the euro crisis and again in early 2016 when the market speculated the US economy was heading into recession. At the height of the 2008 recession, the spread hit over 20%.  In the past week, high yield has outperformed investment grade, that should send a positive signal if the trend continues.

Credit markets always go before equity markets, for this reason, equity investors get nervous as credit widens. Jerome Powell speaks again this week, having been accused by some of raising rates too fast. This would include the President of the United States. If the Chairman continues to set a more dovish tone, that could possibly reassure equity investors into the year-end.

Posted on December 4, 2018 .