Winter arrives in markets

{"text":[[{"start":null,"text":""}],[{"start":5.6,"text":"Good morning. The headlines in both the FT and The Wall Street Journal pinned the blame for the market’s bad day yesterday on Mark Zuckerberg: Meta’s “blockbuster spending plans” set off “another massive rotation trade on Thursday, with investors dumping stocks connected to the AI boom”. It’s a fair enough assessment, but it is important to distinguish between the fundamental forces bearing on investors (roughly quantifiable, most of the time) and the catalysts that set off big market moves (always more or less speculative). As scapegoats go, Zuck and Meta are better than most. But there are bigger forces at work. Email us: unhedged@ft.com."}],[{"start":6.1,"text":"Brr"}],[{"start":48.82,"text":"Yesterday’s epic Treasury rally, and the accompanying rout in tech stocks, had the feeling of a turning point — the sudden arrival of winter after a long summer. The yield on the 10-year fell a whopping 19 basis points, to 4.96 per cent, and the Nasdaq lost 2.6 per cent."}],[{"start":61.46,"text":"But stepping back, Thursday was the culmination of a cooling process, not a sudden freeze."}],[{"start":67.06,"text":"Treasury yields peaked in the first week of this month. The decline since then does not reflect an anticipated reduction in inflation. The whole move was driven by falling real yields. Break-even inflation expectations have been extremely stable. Nor does the move in real yields reflect changing expectations for Federal Reserve rate policy; those have been steady all month. Only yesterday, in the face of the ugly market action, did they begin to ebb."}],[{"start":92.62,"text":"So what has happened in the past few weeks? In an email, Bob Michele of JPMorgan Asset Management gave a pithy three-part summary of the move in bonds:"}],[{"start":101.46,"text":"1. Pessimism on the bond market was extreme . . . most participants were worried about surging growth and inflation"}],[{"start":108.34,"text":"2. Valuations were compelling, indicating an oversold bond market . . . a 3% real yield on the 10 yr UST was last seen in 2002, and nominal yields of 5.3% were last seen pre-GFC"}],[{"start":122.66,"text":"3. The market was waiting for a spark . . . the drawdown in tech stocks as earning expectations have moderated were that spark . . . concerns over French debt and possible wider Euro sovereign contagion are also a spark . . . lastly, short covering is driving a lot of the momentum today"}],[{"start":139.58,"text":"The first two points feel right to me, especially the second. Real yields had begun to look very tempting as compared to what was on offer in equities (even if Unhedged is not a big fan of the Tips market). But it’s Michele’s third point, about the “spark” that sent investors running for bonds, that is most important. A drop in real yields that is not about central bank positioning is usually about slowing growth expectations, or the perception of rising risks elsewhere in the markets. This looks like the latter — a classic risk-off bond rally, driven by fear. The pieces for this fear trade have been falling in pace for some time now."}],[{"start":176,"text":"Starting in May, the industrial stocks that had hitched a ride on the data centre boom, many of which had doubled since the start of the year, began to fade:"}],[{"start":null,"text":""}],[{"start":183.9,"text":"At the end of August, the market began to narrow to the point where only the AI trade was keeping it from falling. And then, more recently, tech companies at the periphery of the AI trade started getting picked off:"}],[{"start":null,"text":""}],[{"start":195.06,"text":"Meanwhile, since bond yields peaked, the best-performing sectors (other than energy, which continues to collect war dividends) have been the classic defensives, health care and consumer staples:"}],[{"start":null,"text":""}],[{"start":206.48,"text":"This turnaround is particularly striking in the case of consumer staples, a sector that has been hated for what feels like forever. Consider the turnaround in the very most defensive companies in the group — makers of booze and paper towels, discounters, grocers and packaged foods producers:"}],[{"start":null,"text":""}],[{"start":223.74,"text":"We have written a lot recently about how to hedge a concentrated market. Well, there is part of the answer: beaten-up defensive names are a good place to start."}],[{"start":232.46,"text":"The stocks that have fallen most since yields peaked, on the other hand, are remarkably concentrated among hyperscalers, semiconductors and industrial stocks associated with data centre construction. Everyone else is doing OK; almost three-quarters of the stocks in the S&P 500 are up since October 5."}],[{"start":249.7,"text":"Yin Luo of Wolfe Research has built an AI risk factor model quantifying US stocks’ exposure to the technology (the factor construction is, naturally, handled by AI agents that score companies’ AI exposure by scraping earnings call transcripts, regulatory filings, news reports and the like). That factor has suffered, in the past week or so, the longest string of bad days in three months:"}],[{"start":null,"text":""}],[{"start":272.42,"text":"Was yesterday the start of a big correction in equities — or, if you prefer, a proper rally in Treasuries? Well, stocks still have two related things going for them, even with the AI trade out of commission for now. The first is a strong economy, underpinned more by resilient consumer spending than by data centre investments. Real consumer spending grew 2.5 per cent in the second quarter. The second is corporate earnings that are increasing very quickly. According to FactSet, S&P 500 earnings are set to rise 33 (!) per cent this year and another 16 per cent in 2027. It’s hard to imagine a proper sell-off taking hold while both of those things remain true. If one of these two supports falls away, though, the picture starts to look awfully bleak. As earnings season unfolds, downward revisions to earnings expectations will, in particular, be a good indication that we have a nasty winter ahead."}],[{"start":272.92,"text":"One good read"}],[{"start":273.42,"text":"Index vigilantes."}],[{"start":null,"text":""}],[{"start":null,"text":""}],[{"start":null,"text":""}],[{"start":329.1,"text":""}]],"url":"https://audio.ftcn.net.cn/album/a_1792771951_2342.mp3"}