Hellish Start To 2016 Has Many Rethinking Views - Analysis

Between oil prices dipping below $30 per barrel and Chinese equity and FX market volatility that caused negative spillover effects on global stock and fixed income markets, it has been a hellish start to 2016.

In light of recent happenings, optimists have been rethinking their previously held views, and pessimists have had their dreams more than fulfilled.

"The continued fall in commodity prices, renewed volatility in Asian FX markets, and return to panic in Global Risk Appetite have darkened our outlook for growth and risky assets worldwide," said strategists at Credit Suisse.

"It is likely that global growth expectations, policy profiles and market price action will all be negatively impacted until there is some perceived stability in China," they said.

In terms of equity holdings, Credit Suisse reduced their weighting to a small overweight - "our most cautious strategic stance in seven years," the strategists said.

"We raise GEM equities to a small overweight and reduce the size of our overweight of Japan, making Contintental Europe our favorite region," they said.

Credit Suisse have a China GDP forecast for 2015 is 6.8% and their 2016 forecast is 6.5%.

"The growth rebound in 4Q 15, triggered by government-sponsored infrastructure projects and interest rate cuts, seems more muted than previously anticipated," the strategists said.

CS continued "to project a further 75 bps of rate cuts and a 200 basis point reduction in RRR in China." they said.

As for other causes of market turmoil, BNP Paribas strategists said "the steady rise in corporates' borrowing costs" has been "behind the recent correction in equity markets.

While "the government bond market receives a lot of attention," 10-year U.S. Treasury yields have "not risen much (roughly 25 basis points) over the past year."

In contrast, "the U.S. corporate bond index (6.5 year rated A-) yield has risen from 3.10% to 3.65% over the same period (it even reached 3.80% at the end of 2015)," they said.

BNPP pointed out that when earnings are on the rise, thus "providing an offset," then rising borrowing costs are not a problem, "but U.S. companies' earnings growth has, in fact, weakened, reducing the premium equities offer relative to corporate debt."

For the equity premium to bounce back, "profits had to rise, borrowing costs had to ease or equity prices had to fall," they explained.

"With profits capped by the strength of the dollar, and with the prospect of tightening U.S. monetary policy and re-leveraging of U.S. corporates putting a floor under borrowing costs, the only adjustment possible was a drop in equity prices," BNPP concluded.

Falling oil prices also have wreaked havoc in the new year, creating new concerns about the effect on inflation and equities.

This week, Barclays strategists said "a marked deterioration in oil market fundamentals in early 2016 has persuaded us to make some large downward adjustments to our oil price forecasts for 2016."

While Barclays still looks for oil prices to move higher in H2 2016, they may do so "from a lower base than we previously envisaged and on a much shallower gradient," they said.

Barclays looked for "Brent and WTI to both average $37 per barrel in 2016, down from our previous forecasts of $60 and $56, respectively."

Both West Texas Intermediate and ICE Brent dipped below $30 per barrel this week, WTI for the first time since December 2003 and Brent since April 2004.

WTI settled Thursday at $31.20 per barrel and Brent at $31.03 per barrel.

In terms of risk sentiment, market players remained wary of positioning and preferred to fence sit a while longer before entering into new trades.

They were keeping an eye on risk indicators such as the CBOE's volatility index or VIX, which at 23.41 in late afternoon action, was on the low side of the day's range of 23.40 to 26.28, as well as on the low side of the over 20 and under 40 "neutral territory" range for the VIX.

This week, the index posted a high of 27.39 Monday, and stalled ahead of the Sept 28-29 highs at 28.33/28.20.

The 2015 VIX high was 53.29, seen August 24 in the wake of the larger China stock tumble, and the 2015 VIX low was 10.88, seen August 5.

While the VIX spent most of H1 2015 sub 20 or in "risk friendly" territory, the second half of 2016 saw several instances of the index moving into "neutral" territory, i.e. above 20 but under 40.

So far, other than August 24, when the VIX traded and closed above 40, the index last traded in "risk averse" territory (over 40) on a sustained basis in 2011, between early August and early October. The VIX has closed above 20 on seven occasions so far in 2016 after closing above 20 on four occasions in December.

At current VIX levels, the index clearly is not yet flashing warning signs (over 40).

However, players also were tracking the high-yield market, where one of the main exchange traded funds for the high yield corporate bond market, HYG, earlier posted a low of 78.28, not far from the 2015 low of 78.21, posted Dec. 14.

HYG, trading near 78.73 in late afternoon action, closed at 78.60 Wednesday, below the Dec. 14 close of 78.83 and the lowest close since July 2009.

As a reminder, the S&P 500 posted a low of 666.79 on March 6, 2009, a few months earlier, at the peak of the U.S. financial crisis.

As another barometer of risk, the Cleveland Federal Reserve's Financial Stress Indicator, which is released daily at 3:00 pm ET with a one-day lag, continued to show only modest signs of risk aversion, with the CFSI in Grade 3 or a "moderate stress period."

The latest CFSI, as per Wednesday Jan. 13 , showed the index at 0.92, i.e. within Grade 3, which requires a CFSI level greater than or equal to 0.503 and less than 1.855.

In 2015, for the first half of the year the CFSI mostly had a daily reading of Grade 2, which is a "normal stress period" and greater than or equal to -0.848 but below 0.503, but never moved back back into Grade 1, which is a "low stress period," i.e less than -0.848.

Once August rolled around, a Chinese yuan devaluation and China stock tumbled saw the CFSI rise into Grade 3, where it remained until late October, when the index reverted back to Grade 2 almost daily for the remainder of the year.

In 2016, the CFSI started out in Grade 2 and has moved into Grade 3 as uncertainty increased.

The last time the index was in Grade 4 or in a "significant stress period" with readings above 1.855, was in early February 2012.

The CFSI assesses 16 variables in six major types of financial markets (credit, equity, foreign exchange, funding, real estate and securitizations). The more positive the number, the greater the risk aversion and vice versa.

The Cleveland Fed has stressed that the values noted are not percentages, but rather "z-scores" or standard deviations. The various grade thresholds (Grades 1-4, from low stress to significant stress) are dynamic and do recalibrate, although they move very slowly.