(This article was written before the US elections)
(With deepest apologies to Shakespeare)
US equity markets have taken on a definite sickly hue of late, with the major indices now off more than 4% from the cycle highs seen in late August/early September, a weakness that is also putting global equity markets firmly on the defensive. What makes this recent equity underperformance all the more interesting is that it has occurred at a time when government bond yields have been rising, not just in the US but globally (albeit with one noteworthy exception – more on that later). In other words, what is occurring is definitely not your common-or-garden-variety “risk-off” episode.
Short-Term Anomaly Or Bubble?
Using insights derived from crowd-sourced sentiment data one examines whether this is the first stage of the long-anticipated bursting of the global bond market bubble as many worry, or whether it is a short-term market anomaly linked to next week’s US Presidential election whose outcome is now in doubt (Brexit déjà vu anyone?).
As noted in a recent Market Insight, the recent underperformance of US equities is hardly surprising in light of the elevated levels of crowd-sourced Fear towards the S&P500 that has been observed over recent weeks and given the proximity of the US presidential election whose outcome has become notably less certain. Indeed, even before last week’s surprise announcement by the FBI that it was taking a fresh look at the Clinton email investigation, the race looked to be tightening following a significant rebound in our crowd-sourced measure of US government anger.
This sentiment measure has served as a reliable lead indicator of opinion polls for the simple reason that Clinton is about as “establishment” as a presidential candidate can be – former First Lady, Senator, Secretary of State – whereas Trump, having never held political office, is firmly viewed as an “anti-establishment” outsider.
More Anger, More Trump
Hence, when US government anger is falling (as occurred mid-September), the shift in public attitudes benefits Clinton over Trump. Conversely, when US government anger is rising (as occurred in July and, more recently, in late September), the shift benefits Trump to the detriment of Clinton. This was a relationship illustrated in a tweet posted earlier this week – see chart below.
As the above chart clearly shows, last month’s rebound in the crowd-sourced measure of US government anger (recalling it is shown with a one-month lead and is on the inverted right-hand scale) constituted a prescient warning that the “Clinton comeback” would not only fade, but was set to reverse. And, as the polls have subsequently confirmed, her lead over Trump has slumped to a percentage point or so – well within the margin of error.
Political Risk Vs The Markets
Heightened uncertainty as to who will inhabit the Oval Office come January 2017 can readily account for the recent stock market stumble, but what about the weakness in global bond markets?
True, the increase in US political risk (government anger is one of the five components in our sentiment-based Political Risk Indicator – see chart below), may have encouraged investors to demand a higher risk premium on all US financial assets, including Treasuries. But, the move higher in government bond yields has not been restricted to the US, other developed bond markets have also suffered.
The most cited reason for the reversal in government bond yields is a growing sense amongst market participants that inflation pressures are finally starting to emerge, implying less accommodative monetary policy settings are required globally, i.e. Fed interest rate hike, asset purchase tapering by the ECB and BOJ and reduced prospects of additional BoE easing.
Indeed, with almost all fundamental models of government bonds having been flashing overvalued for many, many, months (if not years), there is considerable speculation that the imminent reduction in monetary policy accommodation means one is on the cusp of the long-talked-about bursting of the global bond market bubble and the start of a major uptrend in global interest rates.
Public Sentiment On Key Indicators
Using the same methodology that was outlined in a previous article, combining future inflation and economic growth sentiments via the complex mathematical operation of addition, one can derive a sentiment-based proxy for nominal GDP growth individual countries. Minimally, one would expect crowd sentiment towards economic growth and future inflation to have become significantly more positive (i.e., reflationary), or at least less negative, if the recent back-up in long-term interest rates is to continue as the bond bears anticipate.
In the UK, the country that has witnessed the most pronounced yield back-up (ten-year Gilt yields having risen by an impressive – painfully so for those who were long – 48bp last month), one sees clear evidence of reflation in the sentiment indicators.
As the chart below confirms, our crowd-sourced UK nominal GDP growth proxy began its significant uptrend in early August, before the rise in government bond yields. Unsurprisingly given the magnitude of GBP’s post-Brexit devaluation, this uptrend is almost solely due to higher inflation expectations as opposed to improving economic growth sentiment. Hence, it is clear that the rise in UK interest rates and a higher term premium is entirely consistent with a marked shift in public perceptions about the trajectory of UK nominal GDP growth.
In the case of Japan, with the BoJ having adopted an explicit yield target for ten-year JGB’s – a profound shift in the operation of monetary policy – Japanese government bonds have barely participated in the global sell-off with yields up only 3bp (to -4bp). Nevertheless, there is clear evidence of a more reflationary bias in the crowd-sourced sentiment with our Japanese nominal GDP growth proxy having risen markedly since the yield target was adopted on September 21st – see chart below. Drilling down into the two components of the nominal GDP growth proxy, one finds that, just like the UK, rising sentiment towards future inflation has been the main driver of rising nominal GDP growth expectations.
So, even though the BOJ this week pushed out the timing as to when they expect to achieve their 2% plus inflation goal, and despite all the doomsters predicting that the BOJ will once again fall short of achieving its reflationary ambitions, crowd-sourced sentiment data provides early validation that the new monetary framework is having the desired effect of turning around a deflationary mindset that has plagued Japan over recent decades.
What About The US?
On the face of it, one would think that there would be considerable evidence of a reflationary bias in US growth and inflation sentiment, supportive of the rise in Treasury yields. After all, the Fed has been consistently messaging a follow-up rate hike to last December’s Liftoff including this week’s FOMC statement, which described the economy as having “picked up from the modest pace seen in the first half of the year.”
Similarly, US break-even inflation has risen over recent weeks to 1.75% – its highest level since last December’s Lift-off (see chart below). As a result, investors are firmly braced for a Fed funds rate rise next month. Such perceptions would, however, be wrong.
Historically, ten-year US break-even inflation rates and crowd-sourced sentiment towards future US inflation are strongly, and positively, correlated as one would expect. Since October one has been witnessing a rare period of divergence. Contrary to the rise in US break-even inflation, the future inflation sentiment indicator has fallen further into negative territory, and to levels not often seen over the past decade for which there is data available.
US Negative Sentiment
Moreover, it is not only inflation where public perceptions are extremely low in the US; economic growth sentiment is also firmly into negative territory. As a result, the sentiment-based US nominal GDP growth proxy has fallen to levels reminiscent of January’s severe “risk-off” episode, when global investors were worried another Great Recession was unfolding, and Treasury yields fell sharply.
So, unlike the other the other major economies, where crowd-sourced sentiment measures are confirming the reflationary environment signalled by the bond market, this is not the case in the US. If anything, they are firmly pointing in the opposite direction.
One interpretation of the weak sentiment data is that the US economy is much softer cyclically – and hence less reflationary – than the backward-looking “hard” macroeconomic data are suggesting. Under this scenario, it is extremely difficult to envisage the recent rise in Treasury yields being sustained. It certainly suggests that the Fed tightening cycle does not have much longevity and depending upon how quickly this weakness is realised could even see the Fed passing up on the December rate hike.
That said, as mentioned previously, the sentiment-based nominal GDP growth proxy is not designed to predict how the economy evolves, rather it measures how the crowd judges the economy as likely to evolve. Such expectations could prove to be wrong, especially when profound – yet binary – risk events such as next week’s presidential election are on the near-horizon.
The Trump Influence
So, while the above scenario is entirely plausible, it is more likely that the sharp drop in the sentiment-based US nominal GDP proxy reflects public fears over a Trump victory, which do not forget, is not just a political risk but also a significant negative macroeconomic risk. Indeed, many commentators argued that it was the biggest risk event of 2016, surpassing even the Brexit vote.
US Elections Vs Brexit
However, as regular readers will recall UK sentiment slumped in the days preceding the June 23rd referendum vote, correctly anticipating the “surprise” Brexit result. Hence, one doubts being alone in having a distinct feeling of déjà vu when considering the above chart. By this one means that, as occurred with Brexit, the divergence between markets and crowd-sourced sentiment is a signal that financial markets are significantly underpricing the risk of a change to the status quo (i.e. a Trump victory).
After all, it is worth remembering that while investors are the ones whose collective decisions determine equity and government bond prices it is the broader public that determines the outcomes of referenda and elect presidents, and as the crowd-sourced sentiment indicator are strongly signalling, they are clearly very worried about the US right now.