Buying on ‘bad news is good news’
Indeed, this month we have seen the return of the “paranormal” to the markets — a phenomenon that,…
Indeed, this month we have seen the return of the “paranormal” to the markets — a phenomenon that, in the wake of the financial crisis, we have seen before. In “paranormal” markets, bad news is good news for stocks as it implies a more accommodative stance of monetary policy.
As accommodation by global central banks serves to inflate asset prices, the Pavlovian (or “paranormal”) response of financial markets in a post-crisis world to bad news was to buy stocks.
The market declines in September saw that behavioral construct come under question after the Sept. 17 Federal Open Market Committee meeting. In the immediate market reaction to the “bad” news, which was that the Federal Reserve delayed raising rates, stocks moved higher. But by the end of the day they ended lower and continued lower until the end of September. Why?
MARKET UNCERTAINTY
Because in having raised the significance of “recent global economic and financial developments” to the level of the U.S. economic data, the Fed inadvertently raised market uncertainty. At the core of that uncertainty lays an unanswered question: What if those international developments were to restrain U.S. economic activity? What policy tools could the Fed deploy to offset issues of an international order? The answers are not clear and so much of the September decline in global risk assets can be attributed to the realization of those international issues and their financial linkages to the U.S.
Such factors suggest a potential end of the paranormal market and would represent a significant inflection point for global markets. The factors undermining the paranormal fundamentally relate to the collapse in commodity prices and the financial consequences of unsustainable debt.
Yet the beginning of October saw a return of the paranormal. Though an unambiguously disappointing payroll report on Oct. 2 was initially greeted with “bad news is bad news” and an immediate decline in stocks, by the end of the day, stocks reversed course and ended up.
Perhaps global policy accommodation will still be able to reflate financial assets. Weakening data in Europe, coupled with the Fed’s delay — forcing up of the value of the euro — is leading to a rally in European bond markets. October brings renewed focus on whether the Bank of Japan will add more to its historic levels of policy accommodation. And the market focus on China, so apparent in the aftermath of its stock market declines and currency volatility, awaits signs of whether policy stimulus can stabilize economic growth and along with it the outflow of capital.
Lower bond yields in the U.S. follow all of these developments, and though stocks appear to have recouped their ground from September, bond yields remain closer to 2%. That reflects the impact of all these global and international developments on U.S. interest rate expectations. Our own have similarly shifted downward. And replacing the fear of rising rates is the fear that the Fed won’t be able to cut rates or expand policy accommodation when those international developments require them to do so.
LONGER HORIZON
Those longer-run considerations weigh on our longer-horizon investment thesis. Yet at the same time, over a shorter-term perspective, yields have reacted to those considerations by repricing significantly higher. And that creates some notable relative value potential. Consider that, partly as a result of the focus of concern in the high-yield energy space, yields outside of that sector have increased since May by around 2%. And though the outlook in many emerging-markets countries continues to be weighed down by the uncertainty in commodity prices, others show resilience and even benefit from the impact on domestic inflation from falling imported commodity prices. Hence the outlook for bond investing in Brazil looks very different from that in India.
Those examples highlight the fact that while our longer-term viewpoints have shifted toward a more defensive outlook, the near-term market reaction suggests some tactical opportunities.
Jeffrey Rosenberg is chief investment strategist for fixed income at BlackRock Inc.
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