Mounting evidence that global markets are in the last stage of their rallies before a downturn in the business cycle is seen by HSBC Holdings Plc, Citigroup Inc. and Morgan Stanley.
In addition to investors ignoring valuation fundamentals and data, the breakdown of long-standing relationships between stocks, bonds and commodities were cited as signals by analysts at the Wall Street behemoths. This essentially means that standing at risk of a painful drop are the stock and credit markets.
“Equities have become less correlated with FX, FX has become less correlated with rates, and everything has become less sensitive to oil,” Andrew Sheets, Morgan Stanley’s chief cross-asset strategist, wrote in a note published Tuesday.
Even after U.S. stocks joined high-yield credit in a selloff triggered this month by President Donald Trump’s political standoff with North Korea and racial violence in Virginia, his bank’s model shows assets across the world are the least correlated in almost a decade.
The model shows that investors are shrugging off broader drivers, such as the latest release of manufacturing data and are pricing assets based on the risks specific to an individual security and industry, just like they did in the run-up to the 2007 crisis. Traditional relationships within and between asset classes tend to break down as traders look for excuses to stay bullish.
“These low macro and micro correlations confirm the idea that we’re in a late-cycle environment, and it’s no accident that the last time we saw readings this low was 2005-07,” Sheets wrote. While reducing holdings of corporate debt, where consumer consumption and energy is more heavily represented, he recommends boosting allocations to U.S. stocks.
According to Morgan Stanley, feeding risk appetite globally, that dynamic is also helping to keep volatility in stocks, bonds and currencies at bay. The CBOE Volatility Index remains on track to post a third year of declines despite the turbulent past two weeks.
Signals that investors aren’t paying much attention to earnings is another sign that the global rally may soon run out of steam for Savita Subramanian, Bank of America Merrill Lynch’s head of U.S. equity and quantitative strategy. According to her research, no reward from investors was received by companies that outperformed analysts’ profit and sales estimates across 11 sectors, and this had happened for the first time since the mid-2000s.
“This lack of a reaction could be another late-cycle signal, suggesting expectations and positioning already more than reflect good results/guidance,” Subramanian wrote in a note earlier this month.
Another red flag for U.S. equity bulls is pointed out by Oxford Economics Ltd. macro strategist Gaurav Saroliya. On a year-on-year basis, pursuing a negative value now is a measure of the value of goods after adjusting for the costs of production – the gross value-added of non-financial companies after inflation.
“The cycle of real corporate profits has turned enough to be a potential source of concern in the next four quarters,” he said in an interview. “That, along with the most expensive equity valuations among major markets, should worry investors in U.S. stocks.”
According to Societe Generale SA, based on margin patterns going back to the 1950s, the U.S. is in the mature stage of the cycle — 80 percent of completion since the last trough.
Before a recession that pushes stocks and bonds into a bear market, markets are on the cusp of entering a late-cycle peak, Citigroup analysts also say.
They write that as investors fret over elevated corporate leverage and thanks to declining central-bank stimulus, spreads may widen in the coming months.
“Bubbles are common in these aging equity bull markets,” Citigroup analysts led by Robert Buckland said in a note Friday.
(Adapted from Bloomberg)