Some investors are already breathing a sigh of relief as stocks bounce back from the biggest selloff of the year on Monday. But they shouldn’t get too comfortable. Nomura strategist Masanari Takada recently warned investors to brace for a potential “Lehman-like” aftershock, suggesting this week’s market rout may just be the initial tremor of a much larger financial earthquake. The spike in volatility, triggered by fears over escalating trade tensions between the U.S. and China, is only the first wave.
“We would add here that the second wave may well hit harder than the first, like an aftershock that eclipses the initial earthquake,” Takada wrote in a note to clients, according to a recent detailed story in the Financial Times. “At this point, we think it would be a mistake to dismiss the possibility of a Lehman-like shock as a mere tail risk.”
What it Means for Investors
Citing past historical selloffs in August, Takada said another plunge in the market could take place as early as the end of the month. Hedge funds are selling and trend-following algorithmic traders are still in the process of unwinding bullish trades. “We would expect any near-term rally to be no more than a head fake, and think that any such rally would be best treated as an opportunity to sell in preparation for the second wave of volatility that we expect will arrive in late August or early September,” he said.
Current sentiment trends suggest the supply-demand picture for equities is deteriorating and fundamentals are breaking down. Tuesday’s rebound could be short lived. “Above all, the pattern in U.S. stock market sentiment has come to even more closely resemble the picture of sentiment on the eve of the 2008 Lehman Brothers collapse that marked the onset of the global financial crisis,” Takada added.
Unfortunately, illiquidity maybe even more of a problem in a downturn this time around compared to a decade ago. The regulations imposed following the financial crisis have limited traditional market makers from the amount of two-way deal making they might otherwise be willing to do. Their asset inventories just aren’t what they used to be. U.S. investment grade credit, for instance, grew by 43% between 2007 and 2018, but dealer inventories are only 6% of what they were in 2007, according to JPMorgan Asset Management, per the Financial Times.
With dealers limited in their capacities to take the other side of a trade, buyers and sellers of financial assets today are much more dependent on a double coincidence of wants or interests. Such a double coincidence of wants can be sporadic, and in a bear market when everyone is selling, there’s nobody willing to take the other side of the trade.
Governor of the Bank of England Mark Carney claimed earlier in the year that there was $30 trillion tied up in difficult-to-trade (i.e. illiquid) investments. The Federal Reserve noted similar concerns about bond and loan mutual funds. A recent report by Moody’s indicates that even supposed liquid assets, such as exchange-traded funds (ETFs), are not immune to sudden extended spikes in volatility.
Already investors have been flocking to safer assets as gold rises and bond funds post record inflows. Spreads between high-yield junk bonds and risk-free bonds are now at the widest they’ve been in three years as investors ditch risky debt in favour of safer debt. “High yield is often the canary in the coal mine when it comes to recessions,” said Max Gokham, head of asset allocation at Pacific Life Fund Advisors, adding that, “if concerns about a recession build you will see a lot of selling.”
Interestingly, the recent selloff and spike in volatility came only days after one of the largest suppliers of liquidity—the Fed—cut interest rates for the first time since the crisis. The markets didn’t react well, interpreting Fed Chair Jerome Powell’s labelling of the cut a “mid-cycle adjustment” as a “one-and-done” cut. That slip didn’t instill the kind of confidence investors were looking for amid escalating trade tensions and signs of a slowing global economy, wrote respected financial executive Mohammad El-Erian.
Liquidity and confidence are highly correlated, and the largest suppliers of both over the past decade have been central banks. Whether or not they have enough fire power in the tank to fight off the next downturn in a world of record-low (even negative) interest rates is still a big question mark at this point. Quantitative easing (QE) might soon become conventional monetary policy.