Markets Moving into Overshoot Mode

According to Citi’s Credit/Equity Clock framework, financial markets are moving into phase 3, a period where reasonable equity returns come with higher volatility.

All the great equity market bubbles of the last 30 years had occurred in Phase 3 of the Credit/Equity Clock. As equity markets move into overshoot mode, risks are rising. While investors can stay invested to enjoy the ride, they may not want to be complacent. Investors can consider taking profits from concentrated positions and continue to keep portfolios diversified.

Market Performance

In the US, the S&P 500 stayed flat while the Nasdaq Composite gained 1.14%. Currency strength weighed on the European and Japanese equity markets. The European Stoxx 600 fell 1.08% while the Nikkei 225 and the Topix declined 1.47% and 0.55% respectively.

The MSCI Emerging Markets outperformed, up 2.09% in August. Emerging Europe outperformed, up 7.2% as the Russian market gained 8.51%. Latin America rose 4.71% as Brazil rallied 8.13%. MSCI Asia ex Japan rose 0.53%, led by the Thai stock market which rose 2.7%.

• Citi's Credit/Equity Clock is a framework that looks at the relationship between credit and equity markets.
• This framework is premised on the belief that bond markets are leading indicators for equity markets. In the last 3 market cycles since 1988, high yield bond spreads started falling before the equity markets began to rise while rising bond spreads warned of the imminent end of the equity rallies.

"As equity markets move into overshoot mode, risks are rising."

• There were two episodes in recent history where widening credit spreads did not lead to equity market corrections. In 2011-2012 and 2015-2016, global central banks, notably the European Central Bank stepped in to stop the widening of credit spreads through its asset purchase program.
• With the Federal Reserve and the ECB poised to taper its balance sheet in the coming months, Citi analysts believe that financial markets are entering into Phase 3. In this phase, despite widening credit spreads, equities can still generate reasonable returns. However, those returns are likely to be accompanied by higher volatility and market dips may get bigger and more frequent. Phase 3s have lasted as short as 4 months in 2007 and as long as 32 months in the 1980s.
• What could be the potential signposts to warn investors that Phase 4 is approaching? According to Citi analysts, investors may want to become more watchful when spreads on US high yield credit and US Investment Grade bonds reach 600 basis points and 400 basis points respectively. At current levels, 400 basis points for US high yields and 110 basis points for US Investment Grades, it is still too early to call the move into Phase 4.