Climbing back from the precipice

Any positive could signal an upside market surprise

Given the speed at which interest rates are moving, we all had to know something was going to break. And by the end of September, it seemed like a lot of things were on the verge of breaking.

The fact that we are living in a world where the U.S. 20-year government bond yields moved from 0.25% to 4.25% in one year indicates there will be massive amounts of stress on other asset classes. One stress that emerged last month was in the foreign exchange (FX) market. The strength of the U.S. dollar has become a global issue that is straining the system. In September, we saw central banks from Japan and the United Kingdom react to defend their currency, both of which are trading at multi-decade or all-time lows vs the U.S. dollar.

Memories of 2008 and the Global Financial Crisis are still alive and well for many investors. Everyone seems on edge, expecting another Lehman moment to emerge. The glimmer of hope for investors would be if the Fed pivot, which markets have been waiting for over the last few months, were to emerge.

By now, everyone knows the Federal Reserve’s Open Market Committee made a mistake by allowing stimulus programs to run longer than they should have last summer. This has allowed for runaway inflation in many areas and was exacerbated by the commodity sanctions on Russia. But now as they are playing catch-up to try to fix their error, they risk making a second error of hiking too fast.

The end result is that investors have lost confidence in the system and in the central banks’ ability to act as a stabilizing factor.

In a month of many historic events, one that stands out is investor sentiment. The US AAII Bear index hit an all-time high in the second last week of the month. But what is more remarkable is that for an index that commonly shows large swings both up and down, the following week it remained elevated and even ticked higher. This may be close to a sign of capitulation amongst investors.

In September, equity markets saw another down month, and another down quarter with the S&P 500 off 9.6% and the S&P/TSX off 4.5%. This marks the third down quarter in a row for the S&P 500, which is the first time this has happened since 2009. In a time where bond and FX markets are crashing, equities will be collateral damage until things stabilize.

The setup heading into October isn’t great. However, this should not be a real surprise for anyone, and leaves markets open to creating a low. More bear markets have bottomed in October than any other month. We all know earnings will be awful when reported over the coming weeks, but it will also offer a signal on positioning if stocks can move higher on bad news.

If everyone is expecting the worst, getting anything better could be setting us up for a positive surprise.

What we really need to see for an actual low is confidence that we have seen the peak in both the U.S. dollar and bond yields, as both assets have been a runaway train higher over the last year. If there are any signs of either a peak in inflation or the Fed turning more dovish, both of these moves could come to a quick end.

Reversing the moves of the U.S dollar and bond yields would allow for an opportunity to put in a bottom in equities and attempt a bounce into year-end.

This would also help end the worst ever year for bond investors. After a few years where investors needed to stay short duration as yields increased, it is getting very close to the time to reversing this trade and going long duration. That will be the trade to watch in October and may be the most important call for investors over the next year.

Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.

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