MARKET EXPOSURE: COMMODITIES & CENTRAL BANK POLICY SHIFT

Citi's Jeremy Hale notes,

forward expectations of earnings for current year and next year in the US are holding up reasonably well compared to previous years (Figure 4, top LHS), however the real question is what happens in Q3/Q4?

 BofA's Michael Hartnett said earlier this week 

"the most dangerous moment for markets will be when rising rates combine in three or four months’ time with an inflection point in corporate profits. In anticipation of this, we would use the next couple of months to buy volatility, and within fixed income slowly reduce exposure to IG, HY, and EM bonds."

EARNINGS EXPOSURE TO COMMODITIES

Another concern has emerged. As Citi adds, looking at the driver of these earnings expectations, the commodity rally over the past 12 months has caused analysts to revise higher expectations of forward earnings to relevant sectors, so one would expect oil & gas and basic materials to have large increases in EPS projections. However, given that crude oil continues to make lower highs and lower lows since the start of the year, with increasing non-OPEC production and concerns about the ability of OPEC cuts to sustainably increase the oil price, it’s possible that we begin to see downgrades in these expectations if oil continues to trend lower.

But even if one assumes that somehow future earnings are not dinged as a result of recent oil price weakness, Citi points to something else entirely: the collapse in correlations between earnings and price return since the financial crisis...

CENTRAL BANK'S QUANTITATIVE TIGHTENING POLICY DIRECTION

... and warns that there are "bigger forces at play" when it comes to future asset prices. Or rather one force: central banks, and specifically "the advent of QE and the ‘easy money’ that has dominated asset markets in this cycle."

The gradual reduction of these purchases and movement to less easy policy from developed market Central Banks potentially leaves asset markets in somewhat of quandary. Our credit colleague Matt King presents a chart which particularly resonates with us, showing asset purchases on a 12 month rolling window vs. risk asset momentum (Figure 5, bottom RHS).

The fit, as Hale admits, "is rather incredible, and ultimately what these charts clearly illustrate is just how important unconventional monetary policies have been for markets in recent years. As such we agree that the removal of CB liquidity, especially if occurring at the same time across the main Central Banks, cannot be ignored."

For risk assets, we are cognizant of recent market experience. In 2015, UST real 10y yields jumped 80bp running into the first Fed hike in December. With a significant lag, equities ended up correcting about 14-15%. In contrast, when real yields rose a similar 80bp in the second half of last year, equities barely noticed (Figure 6 LHS).

One difference is in the data which was weakening sharply in the first episode even before real yields rose (a Fed policy error?). But in the 2016 event, data was strengthening, the global recovery broadening and EPS recovering.