Markets are waking up to the risks they have spent months ignoring

We have been worried about markets for some weeks, if not months. Things have just felt a bit strange; contradictory and unsustainable have been two words that have been used in this column perhaps more times than one would like.

Yet, despite the sense that something was amiss, markets remained calm. Then, last week, everything changed.

Last week’s extraordinary rally in government bonds across the spectrum – and vicious sell-off in equities – had all the hallmarks of a turning point. The yield on the benchmark US 10-year Treasury fell a massive 19 basis points to 4.96%, as investors scrambled into safe havens (bond prices move inversely to yields). The tech heavy Nasdaq meanwhile lost 2.6%.

South African assets were equally affected. The resource-heavy Top 40 lost 2.33% as gold shares were pummelled. Bullion was off almost 3% on rising oil prices, concern over the Fed hiking rates and general cross-market liquidation dynamics as investors getting routed in equities were forced into fire selling liquid assets.

SA bonds, however, were a different story. The SA 10-year benchmark bond reasserted its newfound haven credentials by strengthening over 20 basis points, from just below 9% to about 8.75%. Coming on the back of Enoch Godongwana’s upbeat and prudent Medium-Term Budget Policy Speech, where he announced a debt anchoring plan, South African debt is seemingly the new Switzerland.

The immediate question is what triggered the sell-off and sudden spike in volatility.

The Financial Times and Wall Street Journal were quick to identify the culprit; Meta’s enormous spending plans, they argued, had sparked another rotation out of stocks associated with the AI boom.

Mark Zuckerberg, everyone’s favourite tech bogeyman, had once again trashed the stock market. His delusions about the Metaverse were just the hors d’oeuvre to this AI excess.

There is some truth to this. But it confuses the catalyst with the underlying cause; markets rarely reverse this violently just on a capex announcement. Such moves typically occur because the foundations have already begun to shift.

To understand current markets, one must distinguish between structural realities driving markets and more superficial events. Meta may have provided the spark, but the tinder and wood have been building for months.

Market worries enter the bond market

Consider first the bond market. US Treasury yields, which have been rising all year, peaked in the first week of October and have been declining ever since. Broadly speaking, this could reflect one of two things: either investors expect lower inflation, or real yields are falling – the return on government bonds after accounting for expected inflation – perhaps because of concerns about economic growth or a flight to safety due to market risk.

Looking more closely, the decline in Treasury yields has been driven almost entirely by falling real yields. Inflation breakevens, the market’s implied measure of future inflation, have remained remarkably stable. This would suggest that the bond rally is less about lower inflation expectations than a broader reassessment of growth prospects and increasing market risk. 

Until recently, pessimism in the bond market had reached extraordinary levels, with investors convinced that not only was inflation on the up, but worries were growing about credit profiles of sovereigns such as the US and France. Government bonds had been relentlessly sold.

With US 10-year real yields above 3%, a level not seen since 2002, they were looking extremely attractive to investors who could lock in returns almost unimaginable for two decades. They were just missing a reason to buy.

The shift in sentiment in the equity market, more specifically tech stocks and the AI theme that had come to dominate everything, provided precisely that. Investors have shifted from worrying about the risks of holding government bonds to worrying about the risks of owning equities.

Fear re-enters equity markets

So let us revisit what has been happening over the last few months in the US equity market.

The first signs of trouble crept in at the end of May. Until then, investors could have almost doubled their money in something as dull as Caterpillar, simply because of the assumption that someone would need a huge number of yellow machines to build data centres.

But then the doubts started creeping in. By late August, the rally had narrowed dramatically. Now, it was only the tech giants themselves that were keeping the broader market afloat.

Then came the next round of casualties: the so-called neo-cloud companies, or those highly indebted companies that had borrowed enormous sums to build and lease the computing infrastructure for the hyperscalers. These admittedly riskier and more speculative plays have been punished.

Meanwhile, investors have been quietly returning to the distinctly unfashionable world of consumer staples and utilities. Despite a backdrop of AI casualties, almost three-quarters of S&P 500 companies had risen since 5 October.

The week on which everything hinges

This could be the most crucial week for markets so far this year. Investors must navigate potentially uncomfortable signals from the Federal Reserve about December rate hikes, earning announcements from Alphabet, Amazon and Microsoft, and a looming blockbuster IPO of Anthropic. Any suggestion that the stratospheric spending on AI investments is not yielding the returns expected could be earth-shattering.

There are reasons to remain hopeful. First, what has tended to happen through this cycle is that companies during earning seasons have managed to smooth-talk investors into remaining optimistic and to double down on their bullish bets. Occasionally this has subsequently unravelled if the Fed has come clean on a dire monetary outlook.

Second is the remarkable resilience of the global economy. We are still a long way from falling economic growth or even lower consumer spending. Corporate earnings are absolutely flying; according to FactSet, S&P 500 earnings are set to rise 33% this year and another 16% in 2027, which is almost unheard of.

It’s hard to imagine a proper sell-off taking hold while both things remain true. However, if one of these two supports falls away the picture starts to look awfully bleak. Talk remains rife of an “earnings bubble”.

Any downward revisions to profit expectations will be a good indication that we have a nasty winter ahead. If this week doesn’t go well expect the next few months to be very choppy indeed. DM