Pause for breath amid bear steepening

The equity market rally paused for breath last week amid rising US treasury yields and Tuesday’s unexpected downgrade to the Fitch’s US government’s credit rating from AAA to AA+.

While the downgrade itself doesn’t have material impact to economic outlook, it feels like investors used this news as an excuse to reduce allocations to risky assets following a period of strong equity market performance.

As we highlighted last week, months of strong equity performance and low volatility had left investor sentiment move to overly euphoric levels (chart 1), so we are not surprised to have seen a pull back for stocks last week and for volatility to have risen from its lows.

Despite the recent increase in volatility, the macro picture remains supportive and are still positive on stocks for now. Investor sentiment has now gone back to healthier levels following last week’s moves and last Friday’s payrolls data suggests that while there are tentative signs of cooling, the labour market remains resilient.

Over recent sessions, we have seen a sharp bear steepening of the US yield curve, triggered by stronger data causing long-term yields to rise. This is in contrast to the bull steepening amid the Silicon Valley Bank (SVB) crisis in March, which was led by the two-year yields falling as investors panicked about the implications of this event on the health of the financial system (chart 2). We continue to hold a slight negative view on bonds.

For the time being, we remain data dependent. While it appears that we are starting to see impacts from rate hikes into corporate profitability of some companies, the extent remains to be seen.

Chart 1: Investor Sentiment coming down from overly euphoric levels

Source: Refinitiv Datastream as at 4 August 2023.

Royal London Asset Management Investor sentiment indicator includes factors related to market volatility, retail investor bullishness and US director dealing in shares in their own companies. A reading of -1 or lower indicates a market panic and contrarian buy signal, while a reading of +1 or above showcases overly euphoric mood in markets. The indicator measures how many standard deviations a particular data point is away from a distribution's mean.

Chart 2: Curves steepen, led by long dated repricing

Source: Refinitiv Datastream as at 7 August 2023.

Market summary

Global equities started off August on a weaker note as US credit rating downgrade and rising long-term yields weighed on risk assets. US stocks suffered their largest drop since the SVB fallout as the VIX Index rose from year-to-date lows. Negative Q2 results and cautious outlook from top European companies weighed on price action there, while Japanese stocks outperformed on strong earnings results. Increasing expectations for US treasury issuance and higher coupons offered saw long term yields rise across the globe, with Fitch’s US downgrade from AAA to AA+ as an additional catalyst.

Economics summary

The Bank of England joined the ranks of the European Central Bank and the US Federal Reserve in hiking 25 basis points (bps). The policy path now looks set to be particularly data dependent, with no clear signal about what they will do next. US data remains mixed with non-farm payrolls came in slightly softer than expected.

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