Investors should watch two key forces in global markets – the health of the US economy and pressure on oil-based sovereign wealth funds to liquidate assets – to gauge the risk of a further sell-off.
The bear is not a homogenous beast. For example, the American black bear is a relatively timid animal compared with the more bellicose brown bear. Confrontation with either comes with risk, but the probability of injury depends on which species you encounter.
Bear markets are similarly anomalous. They can take different forms, and the level of scarring investors may endure depends on their shape. Broadly, there are two types of bear markets. The first is a ‘black bear’ scenario, which presents an injurious but relatively mild experience for investors.
This bear market tends to be shallower in nature. Markets may retrench 20-25%, but the downturn will be relatively short-lived. Examples of this market have been in the late 50s, the late 70s, and more recently over the summer of 2011.
The second – a ‘brown bear’ market scenario – is a deeper, scarier prospect. Typically a 40-45% market fall is accompanied by a gruelling, long road to recovery. Examples of this market have been the late 60s, early 70s, the bursting of the tech bubble, and of course the global financial crisis of 2008-09.
Currently, I believe we are facing the milder black bear scenario. However, the form of the market may change: should the dynamics accelerate in the following two key areas, I believe we could face the more savage brown bear market.
Are we facing a full-blown US recession?
Market fears have been largely focused on China and deteriorating oil prices. But while these are certainly factors driving negative sentiment, there are other dangers shadowing the global economy.
Despite the rise of Asian powerhouses, the US remains the dominant force in the global economy. Increasingly, data points are indicating the US economy is in decline – and worse still, it may face a full-blown recession.
There is a raft of data to show the manufacturing sector – an area which accounts for 25% of the economy – is already in recession. But perhaps more troubling is recent research by Bank of America and Deutsche Bank that looks at the slope of the two-to-ten-year issues along the yield curve. Traditionally, when that slope flattens, it does so immediately prior to a deep recession.
The slope is already down below 1%, so the raw numbers alone indicate that it is beginning to flatten. Yet the situation might be worse than at first glance. For structural reasons the now still positive slope may be false because we are so close to zero interest rates.
The overnight indexed swap rate, which rebases the slope, suggests that it is very close to being flat already – should that be the case, the likelihood of a severe US recession increases to 50%.
The threat of forced sellers
Along with a declining US economy, global markets face a wave of forced sellers that could plunge the world into a more protracted bear market.
There may always be forced sellers existing along the asset class spectrum, but in the current environment, there is a trident of market-moving investors that are increasingly becoming forced sellers.
First, there is China. It is weakening its currency and at the same time striving to defend the spread between the offshore renminbi and its onshore equivalent. As a result, it has become a forced seller of assets, particularly US treasuries and US corporate bonds.
Second, there is a growing mass of investment strategies that are targeting volatility control, such as risk parity in all its different flavours, and momentum-type strategies. By their very nature, should we see sharp crevices in the markets, we could see a major equity sell-off.
Oil-backed sovereign wealth funds complete the trident. Last year, they were forced sellers of equities to the tune of about $220bn. This year, if the oil price stays in the $30-40 range, they will likely be forced sellers of assets worth $400-500bn.
Event risk could brew a perfect storm
Given the presence of such potentially major sellers of assets, there is contagion risk. One only needs to consider the sheer volume of assets at stake.
The threat of an accelerating equity market sell-off, combined with a full-blown US recession, is deeply troubling. However, if we factor in a key event risk or asymmetric shock, we could see a spiralling effect that poses contagion risk across asset classes.
In the event of an economic shock, a lot will depend on the fragility of markets – and to what extent they are undermined by forced sellers. But if this perfect storm brews, we could face a savage bear market.
The views and opinions contained herein are those of Eoin Murray from Hermes Investment Management, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.
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