Policy-Put Hopes Prevent Markets From Selling Off

By Michael Msika, Bloomberg Markets Live reporter and strategist

Faith that policymakers will step in with a lifeline for markets in an emergency is keeping increasingly cautious investors from turning fully risk-off.

Equity markets have retreated moderately since the Iran war started, with the S&P 500 down over 3%. The Stoxx 600 has been hit a little harder, but seems to have stabilized. The absence of heavy selling is striking. Less than 20% of developed market stocks are technically oversold, a sign that profit taking has been narrow so far. There was even some limited dip buying last week.

“Positioning still more bullish than bearish because consensus is war won’t be long, private credit not systemic, and policymakers always ride to Wall Street rescue,” say Bank of America strategists led by Michael Hartnett. They note that risk-off outflows are mostly focused on high-yield bonds, emerging-market debt and financial stocks. “Big picture positioning yet to show a bear panic for contrarian investors to buy.”

According to the BofA team, corrections end when “oversold” assets trough, “overbought” assets are sold, and “safe havens” are no longer bid. “This sequence is playing out, which means liquidation pressures should soon ease if policymakers respond,” they say.

And for policymakers — and investors — this looks like a crunch week. The roster of central bank meetings includes the Federal Reserve, the ECB, the Bank of Japan and the Bank of England. Their commentary around inflation risks and the outlook for interest rates will be scrutinized as oil prices trade around $100. Swap markets are already fully pricing in rate hikes in Europe, have now priced out cuts in the UK, and are starting to price them out in the US too.

“Investors still believe in the Trump put, hence global equities are not down as much as in past oil shocks,” say Barclays strategists. “But nervousness is growing by the day and the longer the Strait of Hormuz stays closed, the more stagflationary markets will turn.”

The strategists note that while the increase in volatility for equity markets has been moderate, bond markets have repriced more negatively, particularly at the front end as inflation expectations adjust higher. In the event of deeper shocks on inflation and growth, with economies staring at a recession, equities should be vulnerable to declines, the Barclays team says. By contrast, a sharp but brief surge in oil prices would mean inflation pressures are regarded as transitory with any impact on growth likely staying benign. “Central banks may prefer to look through price rises in such a scenario, which would ultimately be supportive of risk assets,” they add.

The conflict and its impact on markets have become so clearly binary that investors have responded with targeted profit taking or increased hedging, rather than turning completely risk off. But the longer oil prices stay elevated, the higher the risks for the economy. The consequences of the war on inflation and the cost of living may put pressure on the US administration to find ways to end the conflict, especially ahead of midterms. Meanwhile, central banks may soon feel the need to step in.

There are some signs that fear might be peaking. VIX skew is near all-time highs relative to at-the-money volatility, implying that the market is paying up hard for tail protection. That’s a classic “hallmark of maximum pessimism,” according to Liquidnet Alpha cross asset sales specialist Anthony Benichou. Still, forced deleveraging and systematic flows can create sharp moves in both directions, he warns.

“We are now in the phase where investors are looking into possible policy responses,” says Benoit Peloille CIO at Natixis Wealth Management. “If the conflict lasts much longer, there will also be some kind of response from central banks, even if we’re not there yet.”