Market stress or financial crisis?

We think there are four variables to keep high in your radar screen: two control variables (oil price and Fed Funds) and two potentially worrying markets (US HY and EM).

(1) First oil price: Saudi Arabia could stabilise oil prices with production cuts. A return to more normal pricing would probably be seen as positive for the markets.

(2) Second Fed Funds: the recent Fed statement calmed markets, but the longer the Fed waits, the more abrupt the adjustment when it comes. Eventually a re-pricing of the curve seems almost unavoidable to us and the issue is that the curve is pricing a very sanguine scenario for now.

(3) The two markets also to keep on your radar screen, because they are the “weakest link” are US HY due to its exposure to energy and EM assets. In both cases our central case scenario is that the pricing reflects very low oil prices already. So absent a liquidity crisis (a plausible scenario, but NOT our central case) these markets should not generate a systemic crisis.

How to play it?

The economic imbalances are here to stay and the fundamentally destabilising factors will endure: we are fundamentally cautious, especially on EM space. Equally we acknowledge that valuations are now low and reflect a very poor scenario and we do not think it is tactically appropriate to aggressively cut risk in such a low liquidity environment. The recent move re-enforces our fundamental convictions: we prefer DM to EM, we prefer quality in EM.

We re-iterate our sector preferences from our Q- Series® note on oil, namely: we see winners in European Beverages, General Retail, Transportation and Pharma, US Consumer Discretionary and Consumer Staples and in Asia we like Airlines. Conversely we see mostly losers in European Energy and Utilities, US Materials and Energy and Asian Commodities and Chemicals. We also include a detailed list of European companies with high exposure to Russia.

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