European and US equities suffered a bad week as geopolitical concerns mixed with more hawkish Fed rumblings took their toll. Having fallen by on average 3% last week, developed markets are showing distinct signs of damage. The very simple question for investors is whether the current selling is a minor tremor or whether it is the start of something more serious.
All the major UK benchmarks are now down this year as are the French and German markets. Spain and Italy are still solidly higher for the year which leaves Europe pretty much unchanged. The chart below shows the EuroStoxx 50 Index which is currently experiencing its largest correction since last Summer. Furthermore, the index is trading at its lowest level since late March, well before Mario Draghi promised in May that the ECB was ready to “act” (meaning negative interest rates and more liquidity).
This chart is beginning to have the look of a market that is developing some downside momentum, although we would note that there is decent support between 2,900 and 3,000 points. If support holds, we expect some sort of rally to develop, however, the bigger picture is beginning to look more vulnerable and so we are cautious in making a short term bullish prediction here.
The next chart shows the EuroStoxx 50 Index on a weekly basis together with the 55 week moving average (in red). Whenever the index is above its own 55 week moving average, and the moving average is also rising, the European market is generally considered to be in a bull market. Conversely, when the moving average starts falling and the index is below the moving average, the European market is considered to be in a bear market. As can be seen, the index is trading right back down to the 55 week moving average. Much more weakness in the next couple of months, and the bull market that was launched by Mario Draghi back in August 2012 (when he declared he would do whatever it takes) will be under a lot of pressure.
There is no doubt that geopolitical tensions are having a greater impact on European equities than elsewhere although the lack of economic and corporate earnings growth is likely dragging on performance as well. We also note that global investors have poured hundreds of billions of Dollars into European assets in the last two years so it could be that, without outright QE from the ECB, European equities are more vulnerable than elsewhere.
Technically, the major US indices seem to be in better shape than those in Europe with the exception of the Russell 200 Small Cap Index which is now down 4.2% year to date. Until this week US investors have shown an amazing capacity to ignore both geopolitical concerns and a more balanced Fed. The rise in volatility and sell-off in Junk Bonds are signs of increasing vulnerability for US equities. As with European equities, unless prices begin to stabilise soon, the risk of an accelerating move lower becomes a real possibility.
The extent of the sell-off in Junk and High Yield is now a real worry as too many investors have been chasing yield and there will simply not be enough liquidity in the market when these guys want to sell. The chart below (which we showed a couple of weeks ago) shows the spread between Junk and US Bonds (in red) and the S&P 500 (in green). The current Junk Bond spread widening is the largest since the taper tantrum of last year, and is happening with US 10 year bond yields near the low end of the range, as opposed to the high bond yield movement during the taper tantrum. This is a classic risk off move in the bond markets, and could well drag the equity market lower.
However, it appears to us that equity markets are fast approaching an important juncture. For two years or more, investors have gorged at the Central Bank punch bowl and bought every dip regardless of any risks. As noted above, volatility has risen, and in the chart below, we show the S&P 500 (in green) and in the lower panel the relationship of 3 month implied volatility versus spot Vix. In recent months, when the relationship between 3 month implied and spot Vix has been below 1, the S&P 500 has been at or near a buying opportunity. With the relationship again below 1, we suspect that the bulls will be looking to buy the current dip.
Overall, global equities seem to be losing a lot of momentum, with Europe faring worse than the US. We continue to believe that the ingredients for a major top are in place, yet we also see the potential for a short term rally to begin quite shortly. We believe that the next few weeks could be extremely important in terms of setting the tone for the next few quarters and if nearby support is broken, then the downside could open up quite quickly.