Caution persists as financial markets hit the reset button

By Richard Leong

NEW YORK (Reuters) - After a miserable start to the year, financial markets are looking for a do-over.

Stocks, junk bonds and commodities were hammered throughout January and most of February, causing some investors to wave the recession flag, but now they've pretty much returned to levels that prevailed at the outset of 2016.

Investors and analysts, while encouraged, remain cautious on the prospect that riskier assets are poised for a prolonged rally. Some see the recent recovery as a temporary salve in what looks to be another poor year as the global economy continues to struggle, rather than a harbinger of better returns going forward.

"Sentiment is improving, but it could turn on a dime," said Kristina Hooper, U.S. investment strategist at Allianz Global Investors in New York.

Going forward, investors say the linchpins are oil, China, and the U.S. Federal Reserve. Oil slumped on Monday after Iran suggested a deal to reduce output among the world's biggest producers might take more time.

Other major assets have traded in lockstep with the price of crude, with investors using oil as a proxy for world economic health.

"Oil is the key to everything," Jeffrey Gundlach, chief executive officer at Doubleline Capital, told Reuters last week.

Oil has led the charge higher in the last month, notching a near 50-percent surge that has lifted inflation indicators, riskier credits, equities, and other commodity prices.

A preliminary oil output deal spearheaded by Saudi Arabia and Russia, together with encouraging signs on U.S. gasoline demand, propelled domestic crude prices above $38 a barrel last week.

A month earlier, U.S. oil futures tumbled to a near 13-year low of just above $26.

Iron ore and copper also booked impressive gains after hitting recent lows, rising 27 percent and 11 percent, respectively.

The commodity comeback led traders to take a second look at battered assets such as stocks as well as junk and inflation-protected bonds.

The Standard & Poor's 500 index is up over 9 percent from a near two-year low, paring its year-to-date loss to about 1 percent. Investors also poured a record $5 billion into junk bond funds in the week ended March 2, according to Lipper, a unit of Thomson Reuters.

At the same time, heartened investors lightened their holdings of safe but low-yielding U.S. Treasuries and slowed their accumulation of gold.

Positioning in futures markets, however, suggests the brisk market gains stem more from a reduction in excessive bearishness than a burst of investor optimism that would fuel a sustained rally in growth-oriented assets.

Hedge funds tracked by Credit Suisse show low gross exposures to equities - near three-year lows - so investors aren't yet levering up.

"Investors may be enjoying a bit of a respite from recent market weakness, but they should be under no illusion: Challenges remain. The economic signals are mixed at best and continue to confirm both the optimists' and pessimists' narratives," said Russ Koesterich, global chief investment strategist at BlackRock in San Francisco.

EYE ON CENTRAL BANKS

More spending by China's government and hopes for more stimulus from the European Central Bank also have stoked the appetite for riskier assets.

Last week, the ECB introduced a fresh suite of policy measures, although the jury is still out on whether they will stimulate spending and lending and weaken the euro enough to boost exports.

The ECB surprisingly aggressive move followed the unveiling of a Chinese stimulus plan aimed at engineering a soft landing for the Asian giant's slowing economy.

To a lesser extent, further upside or a limit on the downside for stocks and other riskier assets hinges on the outcome of the Fed's policy meeting this week.

The U.S. central bank raised interest rates in December, the first increase in nearly a decade, and telegraphed that further hikes this year would be gradual.

Since it's unclear how long the current rally in stocks and commodities will last, analysts are recommending that investors book some profits and stay nimble.

"Enjoy it while it's here," Allianz's Hooper said.

(Reporting by Richard Leong; Editing by Paul Simao)