Reuters / Tobias Schwarz
Asset classes around the world are trading in close
lockstep right now, which poses a big risk because one minor
dislocation could cause a painful chain reaction, says Deutsche
Bank.
The firm is one of many that have recently sounded the
alarm on stretched sentiment across a wide range of
assets.
Markets around the world are unified in the
worst possible way.
A wide range of assets — from stocks to oil — are trading at extremely
stretched levels, which can quickly turn into be a disastrous
situation if their current equilibrium is disrupted at all.
It certainly has Deutsche Bank's attention. In a
recent client note, Binky Chadha, the firm's chief global
strategist, warned of possible asset contagion — a term
frequently used to describe when shock to one market causes a
negative chain reaction in others.
The chart below goes a long way towards explaining why this risk
is so pronounced at the moment. It shows the degree to which a
handful of assets trade in lockstep — and as you can see, their
interconnectedness is at a multi-year high.
Deutsche
Bank
"The tight correlation in the moves across the
major asset classes (oil up, dollar down, equities and bond
yields up) suggests a pullback in one for idiosyncratic reasons
would likely spill over to the others," Chadha wrote in a recent
client note.
So which assets are the most overextended, and by how much?
Deutsche Bank has ranked them according to how many standard
deviations (sd) above average they are. Here's what they found:
- Oil (+2.8sd) — "Oil prices look reasonably
valued given the depreciation of the dollar and pickup in
global growth, but the rise has been closely tied to increased
positioning, in our view leaving them vulnerable to an unwind."
- Euro (+1.7sd) — "Futures positioning in the
euro is very long."
- US stocks (+1.5sd) — "Mutual fund positioning
has risen in tandem with the rebound in growth to a 6-year high
... From a fundamental perspective, we see equities as having
priced in the rebound in US and global growth, the corporate
tax reform and as having gotten a little ahead."
- EM stocks (+1.5sd) — "Positioning in equity
futures is very elevated while shorts in equity ETFs have
fallen to a new low for the cycle."
- Rates — "Overall short positioning in rates is
back to all-time extremes reached post the 2016 Presidential
election."
With that order established, Deutsche Bank has gone a step
further and identified potential catalysts for an unwinding that
could rock markets:
- Oil (most vulnerable) — "While it has been
supported by a series of positive factors, a turn in any,
especially a lagged increase in supply as is typical after
periods of rising oil prices, risks a sharp positioning
unwind."
- Dollar — "A rise in the dollar has potentially
the widest fundamental impact across asset classes."
- Stocks — "Equities, while vulnerable to a
positioning unwind, have seen very little in terms of inflows."
- Rates — "Short positioning in rates is at an
extreme and vulnerable to a pullback, but bond valuations
remain in our view completely out of line with growth,
reflecting weak inflation, which we expect to turn up."
Creeping pessimism
While Deutsche Bank is a recent example of a Wall Street firm expressing concern
over extended markets, it's far from alone.
On Friday, the global investment strategy team at Bank of America
Merrill Lynch announced its proprietary Bull & Bear indicator
had issued a sell signal after a
long flirtation with overbought levels. It marked the culmination
of months of warnings, which saw the firm repeatedly express
concern over the so-called "Icarus trade" — defined as a reversal
of the "melt up" seen in stocks since early 2016
Meanwhile, strategists at Macquarie have been crying foul over
volatility they say is way too low across various asset classes.
In a recent client note, the firm lamented "grotesquely swollen financial
markets," and highlighted the possibility of a "very strong
dislocation."
Even Goldman Sachs has gotten in on the action. Peter
Oppenheimer, the firm's chief global equity strategist, recently
said there's a "high probability" of a 10%-20%
correction in stocks over the next few months.
And that's just from the past week.
With all of these warning signs flashing, investors would be
well-served to
seek protection on their holdings. Because when market
contagion does come, it will be a swift and ugly comeuppance —
one that could be tough to handle for even the most nimble
traders.
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