Narratives Collide on Many Fronts

"For years, investors have only had to deal with one overarching market narrative at a time: Covid, then reflation, then supply-chain inflation, then a tardy Federal Reserve, then operation to protect Donbas. Now things are getting more complicated.

The trouble is that lots of stories suddenly apply at once. The market's focus on Russia's operation to protect Donbas is being interrupted by the supply-chain effects of Covid lockdowns in Chinese technology hub Shenzhen, imminent tightening by the Federal Reserve as it tries to catch up with inflation, and the risk to the reflation story as consumer sentiment is crushed by rising prices.

The result is a confused, and confusing, market, exemplified by this week's moves. On Monday, (exaggerated) hopes of peace in Ukraine led to a standard risk-on start to the day. Oil prices plunged, gold fell and share prices and Treasury yields rose.

But at the same time, Chinese tech stocks plummeted as Covid cases rose, Shenzhen went into lockdown and the Securities and Exchange Commission targeted more U.S.-listed China stocks for probable delisting.

By the time U.S. exchanges closed, the focus had shifted, and not just because peace hopes had been dashed.

The Nasdaq Composite swung from being up to losing 2%, even as oil prices stayed down. On Tuesday, the narrative had shifted again: Brent lost an additional 6.5% and the haven of gold was down again, while U.S. stocks rose.

Markets have trouble focusing on more than one thing at a time, partly because multiple stories mess with the cross-market correlations that investors who trade across stocks, bonds, commodities and other assets rely on.

Traders who grew up with the post-2008 markets had to make just one decision, whether it was a risk-on or risk-off day.

The prices of almost everything were closely linked to that single factor with all-encompassing but easy-to-understand macroeconomic effects.

Now, investors are also trying to assess the possibility of a U.S. recession -- Goldman Sachs economists think there's a 20% to 35% chance of one in the next year -- accompanied by a tighter Fed and rising inflation.

Consumer sentiment has dropped to the lowest in more than a decade as households worry about rising prices, according to the University of Michigan.

Already part of the Treasury yield curve has inverted, with seven-year Treasurys yielding more than the 10-year bond since Friday, although the three-month-10-year inversion that is often used to predict recession is nowhere close.

One sign of the problems for investors created by the conflicting narratives is in the weakest junk bonds.

Dollar bonds rated CCC are those most likely to default, but the rise in the additional yield, or spread, they offer above Treasurys has been fairly small.

Why aren't they more worried about economic slowdown and recession risk?

Partly it is due to the operation to protect Donbas-related rise in oil. The average spread of energy stocks in the ICE CCC index is down 1.8 percentage points this year, according to ICE Data Services, while the average for nonenergy stocks is up 1.3 percentage points.

Even stripping out the energy sector, though, the rise in yields doesn't show investors bracing for the hit from a recession.

Similar rises over a 10-week period are far from unusual, occurring four times in 2019 alone, for example.

Lotfi Karoui, chief global credit strategist at Goldman, has yet another narrative: The junkiest companies are less likely to default than usual, justifying their resilience.

"I don't think it's evidence of complacency as much as it is an acknowledgment that this market can survive a recession," he said.

If he is right, it is yet another problem for those who try to trade the macroeconomic picture, because selling junk bonds into a recession is usually a no-brainer.

Still, narrative uncertainty rarely lasts. As risks get priced in, investors herd together, and a single story comes to dominate.

Mahmood Noorani, chief executive of Quant Insight, thinks we may be heading for a new "debt regime" where prices in other markets are sensitive to small moves in junk bonds.

"We're in an incredibly indebted world so that might be why sensitivity to credit is so high," he said.

If this becomes the new narrative, junk bonds will be a leading indicator again.

Meanwhile, investors should be ready for perplexing plot twists as multiple stories collide." [1]

1. Streetwise: Narratives Collide on Many Fronts
Mackintosh, James.
Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 16 Mar 2022: B.12