Risk Assets Swept Up in Rout as ‘Fear Gauge’ Soars

What You Need to Know

Goldman Sachs slashed its target for stocks, warning that a dramatic upward shift in the outlook for rates will weigh on valuations.
“It appears that traders and investors are going to throw in the towel on this week in what feels like ‘the sky is falling’ type of event,” said Kenny Polcari, chief strategist at SlateStone Wealth.
Investors are flocking to cash and shunning almost every other asset class as they turn the most pessimistic since the global financial crisis, according to Bank of America.

A selloff in the riskier corners of the market deepened as the U.K.’s plan to lift the economy fueled concerns about heightened inflation that could lead to higher rates, adding to fears of a global recession.

It was a sea of red across equity trading desks, with the S&P 500 breaching its June closing low. Chartists looking for signs of where the rout might ease had identified the level as a potential area for support. Yet the lack of full-blown capitulation may be a sign the drawdown isn’t over.

Goldman Sachs Group Inc. slashed its target for stocks, warning that a dramatic upward shift in the outlook for rates will weigh on valuations.

As risk-off sentiment took hold, Wall Street’s “fear gauge” soared toward a three-month high, with the Cboe Volatility Index topping 30. Throughout the year, the US equity benchmark has hit near-nerm lows when the VIX was above that mark, according to DataTrek Research.

A surge in the greenback to a fresh record swept aside global currencies. The euro slid to its weakest since 2002, while sterling hit its lowest in 37 years — with former U.S. Treasury Secretary Lawrence Summers saying that “naive” U.K. policies may create the circumstances for the pound to sink past parity with the dollar.

Treasury 10-year yields fell after earlier topping 3.8%.

‘Sky Is Falling’

“It appears that traders and investors are going to throw in the towel on this week in what feels like ‘the sky is falling’ type of event,” said Kenny Polcari, chief strategist at SlateStone Wealth. “Once everyone stops saying that they ‘think a recession is coming’ and accepts the fact that it is here already – then the psyche will change.”

Liz Truss’s new U.K. government delivered the most sweeping tax cuts since 1972 at a time when the Bank of England is struggling to rein in inflation, which is running at almost five times its target.

The plunge in gilts means that investors are now betting the central bank boosts its benchmark lending rate by a full point to 3.25% in November, which would be the sharpest increase since 1989.

‘Meaningful Drag’

Amid heightened fears over a hard economic landing, commodities got hammered across the board. West Texas Intermediate tumbled below $80 a barrel for the first time since January and was set for a fourth week of declines. Not even gold — a haven asset — was able to gain due to a surging dollar.

China’s yuan extended losses to a level closest to the weak end of its allowed trading band since a shock currency devaluation in 2015. With a hawkish Federal Reserve set to sustain the dollar at high levels, analysts say there’s only so much Beijing could do to shore up its currency at a time of economic difficulties.

The greenback’s strength has been unrelenting and will also exert a “meaningful drag” on corporate earnings — serving as a key headwind for stocks, said David Rosenberg, founder of his namesake research firm.

KKR & Co. sees potential trouble ahead, including a mild recession next year, with the Fed narrowly focused on driving up unemployment to tame inflation. The U.S. labor shortage is so severe that it’s possible the Fed’s tightening doesn’t work, wrote Henry McVey, chief investment officer of the firm’s balance sheet.

Flocking to Cash

Investors are flocking to cash and shunning almost every other asset class as they turn the most pessimistic since the global financial crisis, according to Bank of America Corp. Investor sentiment is “unquestionably” the worst it’s been since the crisis of 2008, with losses in government bonds being the highest since 1920, strategists led by Michael Hartnett wrote in a note.

“It’s a realization that interest rates are going to continue to rise here and that that’s going to put pressure on earnings,” said Chris Gaffney, president of world markets at TIAA Bank. “Valuations are still a little high even though they’ve come down, interest rates still have a lot further to go up and what impact that will have on the global economy — are we headed for a sharper recession than the recession everybody expected? I think it’s a combination of all of that, it’s not good news.”

Extreme Pessimism

Stocks are indeed still far from being obvious bargains. At the low in June, the S&P 500 was trading at 18 times earnings, a multiple that surpassed trough valuations seen in all previous 11 bear cycles, data compiled by Bloomberg show. In other words, should equities recover from here, this bear-market bottom will have been the most expensive since the 1950s.

Bleak sentiment is often considered a contrarian indicator for the US stock market, under the belief that extreme pessimism may signal brighter times ahead. But history suggests that equity losses may accelerate even further from here before the current bear market ends, according to Ned Davis Research.

The firm’s Crowd Sentiment Poll has been in an extreme pessimism zone since April 11, or 112 consecutive trading days that mark the third-longest streak of gloom since the data began in 1995.

Over the subsequent few months following those periods of extreme pessimistic sentiment, equity gains were fleeting, with negative median returns three and six months after the 100-day mark.

In another threat to stocks, different iterations of the so-called Fed model, which compares bond yields to stock earnings’ yields, show equities are least appealing relative to corporate bonds and Treasuries since 2009 and early 2010, respectively. This signal is getting attention among investors, who can now know look to other markets for similar or better returns.

“The next question is when and how far do earnings estimates decline for 2023,” said Ellen Hazen, chief market strategist and portfolio manager at F.L. Putnam Investment Management. “Earnings estimates for next year are too high, they really have not come down, and as that happens you’re going to have further equity pain because in addition to the multiple coming down via the yield mechanism, the earnings you’re applying that multiple to are going to come down as well.”

As slower growth and tighter financial conditions start catching up to companies, a wave of downgrades will come for the US investment-grade corporate bond market.

That’s according to strategists at Barclays Plc, who say companies are facing margin pressure thanks to high inventories, supply chain issues, and a strong dollar.

The firm expects the average monthly volume of downgrades to increase to $180 billion of bonds over the next half year. The current monthly average is closer to $40 billion.