Markets Moving into Overshoot Mode
According to Citi’s Credit/Equity Clock framework, financial markets are moving into phase 3, a period where reasonable equity returns come with higher volatility.
All the great equity market bubbles of the last 30 years had occurred in Phase 3 of the Credit/Equity Clock. As equity markets move into overshoot mode, risks are rising. While investors can stay invested to enjoy the ride, they may not want to be complacent. Investors can consider taking profits from concentrated positions and continue to keep portfolios diversified.
In the US, the S&P 500 stayed flat while the Nasdaq Composite gained 1.14%. Currency strength weighed on the European and Japanese equity markets. The European Stoxx 600 fell 1.08% while the Nikkei 225 and the Topix declined 1.47% and 0.55% respectively.
The MSCI Emerging Markets outperformed, up 2.09% in August. Emerging Europe outperformed, up 7.2% as the Russian market gained 8.51%. Latin America rose 4.71% as Brazil rallied 8.13%. MSCI Asia ex Japan rose 0.53%, led by the Thai stock market which rose 2.7%.
- Citi's Credit/Equity Clock is a framework that looks at the relationship between credit and equity markets.
- This framework is premised on the belief that bond markets are leading indicators for equity markets. In the last 3 market cycles since 1988, high yield bond spreads started falling before the equity markets began to rise while rising bond spreads warned of the imminent end of the equity rallies.
"As equity markets move into overshoot mode, risks are rising."
Take your next step with Citigold
- There were two episodes in recent history where widening credit spreads did not lead to equity market corrections. In 2011-2012 and 2015-2016, global central banks, notably the European Central Bank stepped in to stop the widening of credit spreads through its asset purchase program.
- With the Federal Reserve and the ECB poised to taper its balance sheet in the coming months, Citi analysts believe that financial markets are entering into Phase 3. In this phase, despite widening credit spreads, equities can still generate reasonable returns. However, those returns are likely to be accompanied by higher volatility and market dips may get bigger and more frequent. Phase 3s have lasted as short as 4 months in 2007 and as long as 32 months in the 1980s.
- What could be the potential signposts to warn investors that Phase 4 is approaching? According to Citi analysts, investors may want to become more watchful when spreads on US high yield credit and US Investment Grade bonds reach 600 basis points and 400 basis points respectively. At current levels, 400 basis points for US high yields and 110 basis points for US Investment Grades, it is still too early to call the move into Phase 4.
Any advice is general advice only. It was prepared without taking into account your objectives, financial situation, or needs. You should consider if this advice is appropriate for your situation. We recommend you read the Product Disclosure Statement (PDS) or Terms and Conditions, available online or via a Citibank branch, in addition to seeking independent legal, financial and taxation advice on your personal circumstances before acting on the information contained in this material.
This material is for general information only. All opinions are subject to change without notice. This material is taken from sources which are believed to be accurate, however Citibank accepts no liability of any kind to any person who relies on the information in it.
Investments are not deposits or other obligations of, guaranteed, or insured by Citibank N.A., Citigroup Inc., or any of their affiliates or subsidiaries, or by any local government or insurance agency, and are subject to investment risks, including the possible loss of the principal amount invested. Investments are subject to risk, including loss of income and principal. Past performance is not an indicator of future performance. Due to exchange rate fluctuations, you risk losing capital if you invest in foreign currency. Some products are not available to US persons and may not be available in all jurisdictions.
© 2019 Citigroup Pty Limited. All rights reserved. ABN 88 004 325 080, AFSL No. 238098, Australian credit licence 238098. Citi, Citi and Arc Design and other marks used herein are service marks of Citigroup Inc. or its affiliates, used and registered throughout the world