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The writer is senior macro investment strategist at BlackRock
Much has been made of the speculative fervour that underpinned the gains in equity markets at the start of the year. After a challenging 2022, there was sharp rebound in riskier assets with investors seemingly taking a more bullish view of the world, particularly on the path of interest rates.
But beneath the shift, there were signs that the foundations of the “fear of missing out” rally might have been shakier than it initially appeared. They help explain the recent retracement of gains and why there are reasons for caution now.
Rather than being driven by stickier investments in traditional equities or funds, much of the rally was underpinned by factors such as the covering of short positions and a frenzy in US options activity.
In January, there was surge in the buying of call options, effectively bets that pay off when a stock or an index reaches a certain level and an investor can buy the underlying security. Such purchases constituted much more than the average daily number of trades in US equities in January.
This derivative trading amplified the upswing in underlying assets as dealers bought and sold positions to ensure a market-neutral stance. Yet as markets rallied, more of the contracts started “moving into the money” by surpassing their strike price and the opposite effect played out. Dealers were forced to unwind positions in underlying assets as options were exercised, sparking volatility and adding to the broad equity sell-off.
The lack of conviction in a renewed bull market for stocks was also evident in the broader flow of investor funds. Global equity buying meaningfully slowed at the start of the year.
Using flows into exchange traded funds as a proxy for shifts in positioning, it is clear that any money that has been deployed this year has largely gone into under-owned exposures.
Investors have reduced allocations to US equity ETFs so far this year to fund increases elsewhere. European equity ETFs attracted their largest inflows in a year in January and a further $4.8bn was added in February, though Europe remains under-owned after last year’s outflows compounded selling in previous years.
But such a flow from US-based investors into Europe doesn’t tend to be sticky or euro hedged; it can reverse at the first sign of relative underperformance.
Upside surprises in economic data could be seen as justification for the shifting style preference away from the quality-tilted US stock market towards value-orientated Europe equities, which benefit from a more positive growth environment.
Yet that data means market pricing for rate cuts by the Federal Reserve, the European Central Bank and the Bank of England that accompanied the start-of-the-year stock market rally was misplaced. The surprising resilience of economies, particularly in Europe, tilts inflation risks to the upside, raising the odds of higher-for-longer policy rates.
Despite ongoing hawkish guidance by central banks on monetary policy, expectations of an easing of rates next year have not changed that much, setting up another reckoning for riskier assets. Especially outside Europe, money has chased parts of the market that are most vulnerable to rate rises yet did not participate in the February sell-off, including consumer discretionary and technology stocks.
Of course, animal spirits are a hard force to fight when mixed with ample liquidity. Investors have stockpiled cash, with nearly $5tn held in US money market funds globally, while the growing balance sheets of the People’s Bank of China and Bank of Japan are further offsetting monetary policy tightening by their peers.
However, signs of sustained price pressures in Japan suggest the BoJ may have to shift tack on monetary policy while the unleashing of cash reserves is probably contingent on the economic backdrop remaining supportive — an increasingly unlikely outcome as past and future rate rises take effect.
This still-precarious position for equities makes a case for staying invested in value parts of the market. Investors are also rightly eyeing rising opportunities in fixed income. Global bond and credit ETF flows have outpaced equity buying year-to-date as a result.
All in all, inflation risks remain, monetary policy paths are uncertain and recessions may be needed to bring inflation back to 2 per cent targets. While equity price action looked as though the bulls were in the driving seat to start the year, an abundance of uncertainty and potential economic pain is starting to feed through to market pricing with more to go.
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