Market Exuberance Faces Biggest Test Yet From Confluence of Risk

Markets may be headed for a wake-up call as scenarios that investors brushed aside to fuel a global rally move closer to reality.

These include seeing the rate of Covid-19 infections pick up in nations that have eased lockdowns, growing tension between the U.S. and China and corporate finances faltering. The number of defaults in Chinas dollar bond market is climbing and second-quarter earnings are just around the corner.

“I would add the growing realization that the official stimulus pipeline that has been feeding the risk rally is drying up,” said Valentin Marinov, head of Group-of-10, foreign-currency strategy at Credit Agricole. “Its a matter of critical mass of bad news that could tip the rally over and investors turn defensive again.”

The brief but sudden drop in stocks in Asian trading on Tuesday after White House adviser Peter Navarro sowed confusion over the U.S.-China trade deal is evidence that, despite the trillions of dollars in stimulus being pumped into global markets, risk sentiment may be fragile. Rabobanks Michael Every described the jolt as a “a taste of things to come.”

Yen Calm

“Its concerning how few tail risks are priced stemming from a second wave, the U.S. presidential election and a hard Brexit,” said Jordan Rochester, a Group-of-10 currency strategist at Nomura International Plc in London.

Before Tuesdays knee-jerk reaction in markets, stock and currency volatility had fallen to levels last seen before the virus, and the Japanese yen -- a globally recognized haven -- dropped below its five-year average, having underperformed almost all its Group-of-10 peers this quarter.

The gap between the Stoxx Europe 600 index and profit forecasts for its members is near the widest on record. Markets are on tenterhooks for second-quarter results, which will indicate how badly lockdowns have hurt companies. And bears have been retreating from the British pound, even as the prospect of a no-deal Brexit looms.

But the big risk that isnt priced in “is policy makers potentially slowing down the stimulus,” Rochester said. Those measures have helped high-yielding assets advance despite a plethora of negative data this quarter.

Bank of England Governor Andrew Bailey said in a Bloomberg Opinion article on Monday that the financial system mustnt become reliant on these extraordinary levels of reserves, with some monetary stimulus needing to be withdrawn as economies recover.

The BOE last week announced it would complete its asset-purchase program around the turn of the year, which could put further pressure on financial markets. Meanwhile, Federal Reserve data showed that its balance sheet contracted 1%, the first drop since late February.

Taking Profit

Markets may be starting to acknowledge a slower recovery, with stocks of companies that benefit from workers staying at home -- such as Netflix Inc. and Amazon.com Inc -- doing well on Monday, and gold prices rising for a third day Tuesday.

The pick up in euro-area economic activity after the lifting of lockdowns in June is doing little to change the picture of a long, slow recovery and rising unemployment.

“We have been taking profit,” said John Taylor, who manages $6.6 billion at AllianceBernstein in London and bought corporate bonds in April. “I wouldnt only worry about a second wave of Covid and any reversal of lockdown, but also how the economy holds up as governments start to ease back on the support.”

— With assistance by Anooja Debnath

(Adds context on euro-area economic activity in penultimate paragraph.)