Back in late October, I published a note entitled “It’s Time to be Neutral or Short Risk”
I now think that current market levels and conditions warrant getting long. My reasoning is as follows:
Oil prices have been a major driver for other assets, primarily via second round effects. So let’s start there.
First, speculative positions in Oil are now very low, back to 2009 levels:
Second, the ~26 level on oil is a very long term support resistance level that stretches back several decades:
Third, $20 or so is the current cash cost of producing shale oil, which means that even if prices get there, they are unlikely to be at that level for long. As such, this means downside is capped.
Finally, Oil has had a seasonal tendency to bottom around now:
In addition, investment grade credit, which lead the way lower, has been broadly stable on an outright yield basis, though spreads have widened as risk free yields have fallen.
In high yield space, the spread (Barclay’s HY OAS below) has hit levels not far from the very worst levels of 2011:
The fundamentals for the economy also remain decent, though not robust. Earnings ex-energy are still growing. Employment is still growing, though likely to slow a bit in the months ahead. Retail sales still strong. Credit conditions easy. Even in China, the policy easing we’ve seen over the past 4 months will start to bear fruit soon – allowing for at least some stabilization in the data. The Philly Fed has bounced, which suggests that ISM manufacturing could do the same:
It is also worth noting that while the negative effects of lower oil prices are front loaded, the positive effects play out over a longer period of time. Per FTA, current oil expenditures as a percentage of world GDP has dropped at a pace not seen since the mid 1980’s:
Back then, world GDP in USD terms subsequently rose strongly over the next 5 years:
Here is a related chart from Deustche Bank:
Fear, as proxied by cash levels from the BAML survey, are already as high as highs from 2011 / 2012:
And the price action has been bad enough to have triggered technical selling on the breach below the ~1880 area. But note that a break below, followed by a rally above the close would bring a lot of chart driven short covering. The break has probably been bad enough to flush out most of the remaining ‘weak hands.’
Supporting that hypothesis is the fact that futures volume yesterday was about ~4mm contracts, a level that has historically coincided with near term lows:
The bottom will take some time to form. Volatility will need to fall to bring buyers back in. But I do believe that we are at the beginning of the end rather than the end of the beginning.
In interest rates space, investor expectations are now very gloomy indeed. Citi distributed a survey yesterday to its rates clients, and reported that 3/4th of respondents expect a terminal Fed Funds rate at or below 1% this cycle. (!) A stabilization (and possible bounce) in oil and associate risk assets, in conjunction with improving data, will allow inflation breakevens to reprice substantially. In the inflation swap market, 5y5y forward inflation is through the 2008 lows: (caveats apply given the market, but the point applies regardless. 30 TIPS breakevens are ate 1.5%)