Turbulence has many Investor Fear for the Worst

The volatility across markets is likely to last until at least next few hours when the Bank of Japan and the Federal Reserve give their latest decision on interest rates. While bonds and equities have both been hit since last few days, the pain in parts of the market points to the wide range of concerns troubling investors.

Japanese long bonds
This year’s historic debt rally is faltering, but the real pain has been in long bonds. And the chief source of anguish is Japan, where there is speculation the Bank of Japan may pull back from buying long bonds in an effort to shield banks that historically have relied on a steep yield curve for profits.

The yield on the 30-year JGB has climbed from a low of 0.047 per cent in early July to 0.57 per cent, and a chunk of it has come in the past few days. That trimmed gains for the bonds to a mere 22 per cent this year from the even giddier 35 per cent at the peak of their rally.

And no one so far, is buying the dip.  Market consensus seems that may not see global long ends gain traction until we get the BOJ and the Fed meeting hours after it, is behind us.

Energy shares
A sinking oil price had a starring role in the market turmoil at the start of the year. Its current slide is central to the much more modest squall this week. Shares of US energy producers have been among the hardest hit. The energy sector’s 5.4 per cent drop since Friday is more than double that of the S&P 500. US crude has tumbled 6.7 per cent.
Exploration and production groups have sustained steep drops, as investors judge them as being especially sensitive to swings in oil. Marathon Oil and Murphy Oil, for example, have both had double digit declines since last week.

Just as anxiety has flared over whether central banks will sustain their monetary largesse, so has fear that the outlook for the oil price is deteriorating. Those worries were amplified on Tuesday after the International Energy Agency forecast the global oil glut may bleed well into 2017.
Periphery bonds

Although two sharp daily declines in the S&P 500 since last couple of days have grabbed attention, investors’ current disquiet began in the debt markets after the European Central Bank failed late last week to announce an extension of its bond buying programme.

Some of the Eurozone’s weakest economies, including Italy, Spain and Portugal, are still feeling the effects. The extra yield investors demand to hold Italy’s benchmark 10-year bonds instead of German debt has jumped from 1.17 percentage points last week to 1.27.
Spain has seen the spread between its bonds and German equivalents rise 13 basis points to 1.04 per cent, while the spread in Portugal, where investors are growing increasingly worried about the extent of a bank bailout required, has increased by over 20 basis points.

Market participants feel that   the ECB to ultimately extend its stimulus measures to staunch a deeper sell off.

US real estate

American real estate shares shed more light on what is gnawing away at investors. The sector has dropped 5.2 per cent since late last week. Yes, it has been shunned because the shares’ steady dividend streams may be less attractive in a world in which interest rates are rising.

But there is also cyclical component to their under performance, the summer saw the first drop in annual home sales since last November, raising fears among some economists that the rebound in home sales is running out of steam.

Risk parity funds

Risk parity funds have enjoyed a bounce this year after a torrid 2015, but have been hit badly in the latest turbulence.

The strategy involves investing in a broad pool of diversified asset classes according to their mathematical volatility, the idea being that they mostly move in different directions, but over time, should provide healthy returns. But when both bond and stock markets fall the pain can be severe.

The Salient Risk Parity Index had gained over 20 per cent this year until early September, thanks to central bank policies buoying bonds and equities, but has traded water since July, and since Thursday has fallen nearly 5 per cent.
Some analysts fear the funds will pare their exposure to keep their riskiness constant, leading to a feedback loop as their automated selling weighs further on markets in the coming weeks.

_ Farzan Ghadially