Markets climbing the wall of worry setting the stage for another big leg down

Last week’s big sell-off began in Chinese stocks followed a disappointing leadership reshuffle under President Xi Jinping who seemed to have left off most pro-market reform politburo members from the core leadership group in favour of his staunch loyalist. As we have long argued, this growing ideological divide that really leaves no other outcome but another cold war has remained misunderstood by many outside market participants who have generally underestimated Xi’s emphasis on national security, Zero Covid strategy and longevity of China’s Communist Party.

To be sure, the recalibrations of supply chains that remove China’s factories out of the equation can only intensify from here representing big challenges to corporations that have already gone through Covid-related supply disruption hell. Moreover, countries like Germany and Japan which have for two decades benefited from booming exports of capital goods to China could be impacted the most from this rift. This is especially the case in technology which remains the epicentre of the unfolding cold war. 

Another source of US stock market anguish came from last bull market leaders better known as FANG stocks which have already led the market correction down, mainly from the top-down strategy of selling growth names this year. However, their earnings have begun to deteriorate more notably due to disappearing positives from Covid on the digital economy, global economic slowdown and the continued dollar strength. Indeed, as pressure to cut costs becomes unavoidable, we suspect we are likely to see data centre and cloud infrastructure-related spending begin to frail. 

We think this is the last shoe to drop in the near term which would probably spell the end of the rout in technology stocks which we expect to bottom sometime in H1 of next term. This is also why we think the most recent rebound in shares of technology materials, components and semiconductor-related names will likely prove short lived, especially given the still unknown impact of broadening export restrictions to China which have yet to ripple through to existing large order backlogs. 

However, with markets remaining predominantly macro-led, investors have been also piling back into other more traditional cyclicals as hopes are growing that we are closing in on peak rate hikes and as we approach what markets perceive to be terminal interest rates. However, we believe probabilities for central banks pivoting towards looser monetary policy in the foreseeable future seem very low given inflationary pressures have yet to be tamed and as we have also warned, food and energy prices could yet again spike given the highly unstable geopolitical backdrop and the war still raging in eastern Europe. 

Nevertheless, growing fears of missing out on an end of the year rally given highly elevated cash positions are leading stock markets to climb the big wall of worry led by short covering. Like early summer, we think this is setting us up for another major leg down, most likely in early next year, especially as the next earnings season looks certain to look far worse than the current one. For now, however, it does seem that we are going through yet another bear market rally that could hurt alpha generation of defensively positioned portfolios.