Analysis points to a near-term correction in sharemarkets

The bond market was reassured by a well-supported US Treasury auction and comments from several Federal Reserve officials.

JPMorgan’s ­Nikolaos Panigirtzoglou in Sydney. Picture: James Croucher

The bond market was reassured on Wednesday by a well-supported US Treasury auction and comments from several Federal Reserve officials arguing against any reduction of monetary policy support.

But while the dollar recovered to within 0.5 per cent of the 33-month high of US78.2c reached last week as the greenback fell, the local and US sharemarkets struggled for traction while awaiting details of US president-elect Joe Biden’s fiscal policy plans due on Thursday.

Whether the show of support from Fed officials and Treasury investors is enough to extend the massive rise in share prices and other risk assets that followed unprecedented fiscal and monetary policy stimulus after the COVID-19 pandemic hit in 2020 will need to be judged in terms of market positioning and the scale of bond issuance implied by Biden’s call for “trillions of dollars” of US fiscal stimulus, as well as the course of the pandemic and the success of vaccinations.

After surging 27 basis points to a 10-month high of 1.1855 per cent in just over a week as the outcome of Georgia run-off elections gave the Democrats more capacity to pass legislation through the Senate, the benchmark 10-year Treasury yield dipped to 1.1052 per cent after the bond auction and comments from four Fed officials along the lines that it was too soon to talk about tapering.

Australia’s S&P/ASX 200 index hit a four-day low after a flat close on Wall Street, as expensive defensives came off alongside growth stocks and bond proxies as the recent jump in bond yields tested valuations.

But the market recovered as resources rose after a bounce in commodity prices and price target upgrades from Goldman Sachs, while a strong trading update from Premier Investments boosted the retail sector, and the banking sector hit a 10-month high.

To judge how much upside ­potential could be left in the equities bull market over the medium term after a record-breaking 74 per cent rise in the S&P 500 since March, JPMorgan strat­egists are focusing on their most holistic measure of equity positioning — global non-bank investors’ holdings of bonds, equities and cash.

Their latest snapshot found that the group now has an equity allocation of 43.8 per cent.

That’s significantly above the average of 42.3 per cent in the ­period following the September 2008 collapse of Lehman Brothers, which marked the start of the global financial crisis. But it’s still well below the post-Lehman period high of 47.6 per cent seen in January 2008.

“This means there is still room in the current bull market,” says JPMorgan’s head of global quantitative & derivatives strategy, ­Nikolaos Panigirtzoglou.

Still, he cautions that retail investors have played a significant role in supporting equity market gains in December and so far in January, and overweight positioning by institutions has created “some near-term vulnerability to a correction if retail investors’ ­equity buying slows from here”.

He sees the post-Lehman average equity allocation of 42.3 per cent as a “neutral level”.

That was first breached in mid-November, and the “melt-up” in equity markets since, combined with the sell-off in bonds, has shifted JPMorgan’s implied equity allocation further above neutral.

But on his calculations, the equity appreciation needed to shift the implied equity allocation of non-bank investors globally from its current level to the post-Lehman period high is a substantial 22.5 per cent for the MSCI All Country World index and 26.1 per cent for the S&P 500.

Interestingly, his equity upside calculation exhibits little sensitivity to a potential rise in bond yields. It’s more sensitive to his projection of money-supply expansion.

On that subject, the US investment bank’s base case is that the stock of cash or M2 money supply ex-China will rise by $US4.8 trillion ($6.2 trillion) this year, or half last year’s increase.

“Any big deviation from that projection of money supply expansion would have a significant impact on the implied equity upside,” Panigirtzoglou says.

However, he notes that institutionals appear to have entered 2021 with “elevated equity exposures and a very low short base”.

In particular, the equity beta or market sensitivity of equity long-short hedge funds last month rose to its highest point in almost three years. “This in our mind creates some near-term vulnerability to a correction if retail investors’ equity buying slows from here,” Panigirtzoglou says.

After looking at the implied beta of equity hedge fund returns relative to the MSCI All-Country World index, he found that from being quite underweight equities in October last year they largely covered those underweights in November as the beta returned to close to its long-term average of 0.5.

In December, the implied beta increased significantly above its long-term average, suggesting long-short funds have been “quite overweight equities” going into the turn of the year.

Similarly, for momentum-based investors, he found that the average of longer-term and shorter-term momentum for US, ­European, Asian equities positioning is “likely quite elevated for US and Asian equities, though it is still some way from extreme territory for European equities”.

Net speculative positions in equity futures contracts more broadly also suggests asset managers have been steadily increasing their net long equity exposures, with the net long in US equity futures as a share of total open interest returned levels last seen in late 2019.

And looking at a proxy for short interest — the quantity on loan as a proportion of total outstanding shares — Panigirtzoglou found that after a brief spike higher around year-end, short interest has now returned to levels last seen before the pandemic early last year.

“In other words, the sharp rise in short interest in March 2020 has been fully unwound,” he says.

Finally, for risk parity and US balanced mutual funds, he found that while they began the year with below-average exposure to equities, month-to-date returns of risk parity funds at 1.2 per cent and US balanced mutual funds at 1.6 per cent, versus benchmark returns of 0.8 per cent and 0.9 per cent respectively, suggests they now have above-average equity exposure, particularly in the case of 60:40 balanced mutual funds given the negative month-to-date returns for bonds.

“As a result, we aim off the message implied by the partial betas,” Panigirtzoglou says. “In all, similar to the section on overall non-bank investor positioning, the above indicators suggest institutional investors have started the year overweight equities.”