Bond market warning sends shiver down spine of risky assets

Equity markets are falling on Wednesday and the currency market is experiencing a flight towards safe havens as weak economic signals, the escalating US-China trade war and a clash between France and Germany over who should take over the top jobs at the European Commission and the ECB all unnerve investors. 

China not willing to support economy… yet 

Surprisingly, not even a cash injection from China’s central bank managed to calm nerves. Although Chinese shares edged higher, Japanese and South Korean shares took the brunt of the losses in Asia. The cash injection of $36bn was in response to the government seizure of Baoshang Bank, which had sparked a jump in Chinese inter-bank borrowing costs. The PBOC does not want the collapse of one bank to trigger a wave of panic in its banking sector, hence the cash injection. For the rest of the market this cash injection offers no solace from the recent market panic as it not directed to boost economic growth. This is worrying, as expectations are rising that the Chinese economy experienced a broad weakening in May. The May PMI reports for China are released on 31stMay, and these are expected to fall below the 50 mark, indicating contraction. If fears about China’s growth are confirmed at the end of this month, then equity markets may fall even further. 

Watch out for a surprise move from Beijing 

There is a risk that weak PMI surveys could trigger another round of stimulus measures to support the Chinese economy. Since global financial markets are extremely sensitive to the global growth, we may see a sharp reversal in equity market performance, with stocks and other risky assets rallying on the back of an economic stimulus package from Beijing. Commodities including copper and oil, the Aussie and Kiwi dollars and broader Asian and German stocks could also be impacted. 

Fundamentals in focus

The chief driver of the move away from risk is the bond market. This is a market often overlooked by retail traders as it can be difficult to trade, however, it is always worth noting the performance of bonds, particularly US Treasury yields, as they can explain movements in other markets. We mentioned a few months’ ago about the inversion of the US yield curve; this is when short term yields rise above longer-term yields. In bond traders’ parlance this is called the ‘inversion of the yield curve’, and it’s important because it can be a signal that a recession is looming. The gap between 3-month Treasury yields and 10-year yields is at its widest level since 2007, at 12 basis points. The yield on 10-year US Treasury debt slipped 4 basis points on Tuesday, to 2.23%, the lowest level for 20 months. 

Recent movements in the US yield curve indicate a few things. Firstly, it’s an indicator of growing uncertainty, which is negative for risky assets, second, it’s a sign that the global economy has passed its cyclical peak, and economic performance could be weaker from here. Hence, corporate earnings could be on the decline and credit spreads may start to widen, with corporations left facing a higher cost of capital eroding profits further in the future. All of this is bad news for stock markets. 

Geopolitics still weighing on risk 

Financial markets are also concerned that the trade tariffs implemented by both the US and China have yet to impact growth, hence economic performance could be further impaired in the future. 

The trade war is still a major theme for financial markets because there is no resolution in sight. The next time both sides are likely to get together and potentially hash out a trade deal is not until the 28-29thJune at the G20 meeting in Japan. That is a long period of uncertainty for financial markets to cope with, thus, we believe that traders could be in a limbo until then, with a bias to the downside for risky assets like stocks and currencies. 

Small stocks start domino effect 

There have already been sharp declines for small cap stocks, and at the start of this week key European investment banks cut their outlook for European small cap stocks. This typically happens then the going gets rough for markets. Thus, we believe that large cap markets will outperform small caps in the coming weeks, and we may see a flight towards defensive stocks such as consumer staples – supermarkets, general goods producers, healthcare etc – and away from banks, some tech stocks and consumer discretionary in the short to medium term. 

China takes a bite out of Apple 

Fears that the next move in the China-US trade war will be Chinese tariffs on rare earth metals, a key component of smart phones, have rocked the Apple share price, which is at its lowest level in 2 weeks. Apple, the world’s most valuable company, is a consumer company, thus It is exposed to slowing global growth and a dip in consumer demand, and also to a trade spat that impacts its supply chain. If China does slap hefty tariffs on rare earth metals then Apple could experience a steep decline, with $155 a key medium-term support level. 

More woe for EUR and GBP 

The FX market is also experiencing a typical risk off pattern. The JPY and CHF are rising, while the euro and the pound are coming under pressure. EUR/USD remains depressed as German economic signals remain weak, bets are now rising that EUR/USD may falls back to its 2019 lows at 1.11, as technical signals continue to suggest that there may be further downside for the single currency. 

GBP is also struggling, it has weakened below the mid 1.26 zone, and the path of least resistance appears to be a move back towards multi-month lows below 1.25.We continue to think that the prospects for the pound remain bleak and it could be a perfect storm for sterling, with political risks, Brexit and a global factors all weighing on the British currency, Technical factors are also indicating that the pound remains a strong sell, which could further weigh on the pound in the coming weeks.