James Bevan: Markets, worries and risks

From early February to mid-August, the S&P500 traded in a narrow 110-point range. Following the devaluation of the yuan and the increase in market nervousness, the range for the S&P500 is now much wider, spanning 263 points between the record high of 2130 on May 21^st and the August 25^th low of 1861. And there are now wild daily swings.

The flash-crash correction and all the volatility have depressed the Investors Intelligence Bull/Bear Ratio, which fell to 0.92 this week, and that’s the lowest since October 2011. It’s so bearish that it’s bullish, at least from a contrarian perspective. Readings below 1.00 have provided strong buy signals in the past.

From a fundamental perspective, investors are fretting over lots of known unknowns. China’s economy is slowing, but there is no clear view as to whether it’s a bumpy, soft, or hard landing, and if hard, whether it’d be hard enough to cause a global recession.

With commodities, the plunge in prices might be good for consumers, but bonds issued by commodity producers are at risk of default, as evidenced by the rising yield spread between corporate high-yield debt and 10-year Treasury bonds.

Currencies of emerging markets (EMs) have plummeted this year as a result of capital flight, risking crisis conditions, and there’s a risk that if the Fed does start raising rates, this could lead to an unravelling of global carry trades.

We all know what the issues are. We just don’t know how they will actually play out. And that’s the challenge for investors.

Nevertheless, stocks may be set up for yet another relief rally if all the worst-case possibilities of the known unknowns don’t unfold.

Just as important for the bull case is that no matter what happens, the US economy remains resilient and strong. So far, that seems to be a known known. We see plenty of evidence of that in the latest survey of small businesses and the JOLTS report.

Small businesses are important because collectively they have a big impact on the US jobs market, with small and medium-sized companies currently accounting for 42% and 36% of private payrolls, according to ADP.

Large companies account for just 22% of total private sector jobs – and overall, total private payrolls troughed during February 2010, and since then, have risen by 12.8 million through August. Over that same period, small, medium, and large company payrolls rose 5.1 million, 4.9 million, and 2.8 million, respectively.

As to the current outlook, the NFIB’s Index of Small Business Optimism was unchanged in August, with most of the survey’s components remaining historically strong.

Then yesterday we had this week’s JOLTS report, and it was revealed that nationally, job openings jumped to a record-high 5.8 million during July, and there are now just 1.4 unemployed workers for every job opening. That’s the lowest since March 2007. The series peaked at a record high of 6.8 jobless workers per available job during July 2009. Lifting the lid on the details, job-opening rates are at cyclical or record highs for most of the major industries.

Needless to say, there are already naysayers who say that all this good news is bad news because it will lead to higher wage inflation, which will be passed through into price inflation, which will force the Fed to tighten monetary policy more rapidly than currently anticipated.

Certainly in the past, there has been a good correlation between job openings and wage inflation, but the divergence between rising job openings and subdued wage inflation during the current economic expansion is significant and may remain different to prior cycles, with employers facing skills mismatches not addressed by hiking wages.

The likely route forward is that employers accelerate plans to automate if possible, and competitive pressures are also likely to keep employers from hiking their employment costs. As a point of detail, it may also be that job openings are being filled rapidly, but new ones are getting posted even faster.

Our conclusion is that markets are focused on significant real world issues – but for now assume the worst. If a better outcome is confirmed in due course, and optimism returns, there’s scope for a significant rally in the pricing of risk assets.