CIO Flash: Digesting the Christmas market dislocation

After having caused a drop of the S&P 500 Index below 2400 around Christmas, the Fed has meanwhile managed to calm financial markets. Investors should brace for more such smallish dislocations.

The Federal Reserve (Fed) made a policy mistake on 19 December, disclosing Quantitative Tightening (QT) was on ‘auto-pilot’. The subsequent drop of the S&P 500 Index below 2400 around Christmas time has led the Fed to blink pretty fast. Meanwhile, China is increasing monetary and fiscal stimulus to support growth.

Trade talks between Washington and Beijing are ongoing. US corporations have started to feel the lagged effect of the trade tensions. In light of the recent softening of economic data and market volatility, both sides have a much stronger vested interest to find an agreement.

The US bond market is pricing in an interest-rate cut in the next 12 months for the first time in 11 years. The discrepancy between the US central bank and the market is record-wide.

Europe finds itself in a precarious situation with the European Central Bank (ECB) hoping to normalise negative interest-rates against a slowing economy, uninterrupted Yellow Vest protests in France, an uncertain Brexit outcome, and upcoming elections.

The ‘flash crash’ of the Japanese yen, and the S&P 500 pre-Christmas mini crash highlight the changing market structure, where systematic flows dominate short-term trading activity. Investors should brace for more such smallish dislocations caused by ‘algorithms’, i.e. programme traders, ignore or trade them in a contrarian manner.

We keep the asset allocation unchanged.

Fed suddenly shows flexibility
After a fickle market environment, which is rarely seen over the usually relatively quiet year-end, Fed Chair Jerome Powell has managed to calm financial markets. On the occasion of a panel discussion last week, he hinted that the Fed could pause interest-rate increases. He indicated that the US central bank will be patient, and watch how the economy evolves, stressing that the Fed has no preset path for its monetary policy. Therefore, it will be prepared to adjust monetary policy quickly and flexibly if necessary to maintain the expansion.

With regard to the Fed’s balance sheet reduction, which appears to be more worrying to investors than the Fed, he said the Fed would not hesitate to make changes to its reduction plan if it saw it as a problem.  With these interventions, Jerome Powell has managed to pacify financial markets. It remains to be seen whether the Fed will now follow a more cautious approach or whether it will resort to a more hawkish tone again, should equity markets rebound significantly.

Chinese manufacturing sector shows weakness
In China, both the official and the Caixin Manufacturing Purchasing Manager Index (PMI) for December dropped below 50, the threshold that separates growth from contraction, for the first time in several months. This was due to declining domestic and external orders in particular.

The non-manufacturing sector held up relatively well, as both the official and the Caixin leading indicators surprisingly rose. They suggest that recent stimulus efforts may already be starting to have some effect. More stimulus measures are needed to prevent the economy from slowing down further. Therefore, the People’s Bank of China cut the Reserve Requirement Ratio (RRR) by another 1%, while the government announced a high-speed railway infrastructure plan worth more than USD 125 billion, and a tax reform aimed at boosting consumption.

We stick to our strategic position in Chinese equities, which are likely to profit from superior growth rates in China in the years ahead, and which increase diversification of the portfolio.

Italy and the EU agree on a budget
After weeks of haggling the Italian government and the EU finally agreed on a budget compromise. The Italian parliament later passed the budget, ending a period of uncertainty over the country’s fiscal future. While the populist Italian coalition had initially aimed for a budget deficit of 2.4% in 2019, Italy and the EU eventually compromised more or less in the middle at 2.04%. Given that Italy is no longer subject to the Excessive Deficit Procedure, credit spreads between Italian and German government bonds have significantly tightened. So far, they have remained at elevated levels based on fears that the uneven Italian government coalition is fragile.

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