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2019-05-05 10:44:11

Market Actions: What’s Next?

The recent market actions are consistent with improving global growth. Chart 8 shows that the recent bond market weakness has been led by a resurgence in real bond yields, while inflation expectations have stayed largely stable, at around 2.1%.

In the meantime, the dollar tried to break out to new highs back in August but failed. Since then, the DXY has slid by about 3%. If the weakening trend in the dollar is sustained, it could signal that the growth profile for the rest of the world is improving.

Obviously, uncertainty abounds when making a forecast for market actions because there are a variety of possible outcomes, each with different market implications over the next 6 to 10 months.

For example, should the economic boom in theU.S.persist whileChina’s economy starts to turn around and begins accelerating, global bond yields would rise, the dollar may be stuck in a narrow range, but emerging markets should recover, and commodities should continue to advance.

It is hard to know whether or not EM would outperformU.S.stocks in this scenario, but the former may have the edge over the latter from a valuation viewpoint.

However, if the U.S. economic boom crests and growth softens to around 2%-2.5%, but the Chinese economy turns around and begins to accelerate on fresh policy stimulus, Treasury bond yields should stay more or less flat, probably at around 3%, while the dollar should weaken.

In this case, both EM stocks and commodities will likely outshine the S&P 500, but the bull market inU.S.equities would be preserved by a weaker dollar and steady interest rates. Historically, a "soft landing" for the economy has been bullish for stock prices.

Finally, if theU.S.economic boom turns into a bust or a recession, bonds would soar, stocks would tank, and the dollar would be strong. No equity market would do well, but the worst performers would be markets with high beta. In this case, commodity prices would retest their old lows and even fall to new lows.

There are many recession indicators, and some are more reliable than others. Most of these indicators suggest low odds of a recession happening in the next 12 months, except one that is based on the Treasury yield curve and unemployment rate (Chart 9). This recession gauge is rising, due primarily to the flattening yield curve and very low unemployment rate.

Nevertheless, this indicator may ignore the impact of some structural changes. For example, a secular drop in the term premium and/or a structural fall in NAIRU would lead to a major downward revision for this recession gauge.

Regardless, we view the risk of recession in the next 12 months as a tail risk, so the odds are overwhelmingly in favor of the first two possible outcomes. Moreover, with the stimulative impact of tax cuts fully spent and the restrictive effect of higher rates kicking in, theU.S.economy should soften a notch. If so:


•  The dollar could start to weaken on the prospect of improving economic growth in the rest of the world.

•  Emerging markets should soon reach a bottom, followed by a rebound relative to theU.S.equity index.

•  U.S. bond yields have limited upside. The market is already crowded with short positions and sentiment is negative (Chart 10).

•  The trend for commodity prices would be bullish, particularly for oil.

In short, investors need to add rather than liquidate EM stocks, buy commodities and slightly underweight duration for bonds.

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