Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Equity rally continues but be aware of rising Japanese yields and crowded VIX trade
Peter Garnry
Chief Investment Strategist
Summary: Equities are higher again today with South Korean equities leading the way. However, the most interesting market to watch right now is Japanese government bonds where the 10-year yield made its biggest move in six years last week and rose again today closing in on zero for the first time since March. This could be the beginning of higher rates and the end of negative rates as central banks recognise that negative deposit rate breaks the credit transmission from banks. In addition the short VIX trades are becoming crowded which is always a bad sign for equity investors of a potential violent move down.
While equities continue their ascent, new signals are brewing beneath the surface ready to change the trading environment. The Japanese 10-year government bond yield is up 28 basis points from the lows in August and is close to break above zero not observed since March. Last week’s move in the key Japanese benchmark yield was the biggest move in six years. Financial markets are generally very noisy so when you observe significant moves like in the Japanese bonds it is a signal to watch. One of our key contrarian views for 2020 is that the negative rates could come to an end as central banks recognise that it makes the banking system impotent and thus breaks the credit transmission mechanism. Higher yields mean that value and banking stocks could be the essential exposure in the portfolio over the next year.
As we talk about in today’s Market Call podcast there is an inflection point where higher rates are bad for equities. If we assume no change in inflation expectations, then the rising yields are signs of higher expected growth (real rates go up) and real term premia go up as well. This means that the initial move in yields are not bad for equities as the growth component is larger than the negative effect from the discount rate (nominal rate) as it comes from very low levels. However, as we have seen when the US 10-year yield goes into the 2.5-3% area then growth expectations come down due to high debt levels in the economy but also because the higher discount rate compresses growth stocks valuations which dominate the key equity indices in terms of index weights.
But for now, the higher rates are not negative equities and today’s price action in the leading South Korea equity index, KOSPI 200, was encouraging as the index shrugged off the negative sentiment from yesterday. There are clear signs that things are turning in South Korea with the official leading indicators at the highest levels this year. If South Korea is turning, then the global economy is turning so we recommend everyone to closely watch South Korea and the KOSPI 200 Index.
Outside the current positive narrative on global equities there are potentially dark clouds gathering. The short VIX futures trade is becoming crowded again with record speculative positions short VIX futures. One of the drivers is of course the potential roll yield of shorting the front months VIX futures. The chart below shows the current expected roll yield shorting the second front month VIX futures contract assuming unchanged spot (VIX Index). What is clear is that the current VIX slope is attracting many speculators, but these trades always come with a tail-risk of a violent upward move in the VIX Index as we saw in February 2018. So, keep an eye on the VIX curvature as indications of accelerating risk-off dynamics.
Saudi Aramco is starting its IPO on November 17 allowing investors to begin bidding for its shares. The recent prospectus has left investors in the dark in terms of the size but also pricing range which means that the IPO could get cancelled if investors are setting the price high enough for the Saudi government likings. There are indications that the government prefers a substantial retail investor base in the company allowing an allocation around 0.5% and the rumours are that the final IPO size could reach around 1%. With an estimated total market value around $1.6trn this translate into a free float market value of $15bn which will not meaningfully impact the MSCI Emerging Markets Index or change its composition. The real impact from the Aramco IPO is that it gives a new dynamic and link in the oil market, and a rare quarterly insight into production and return on capital.
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