Market Volatility Continues To Compress

The US Independence Day holiday kept trading, market activity and volatility subdued for much of last week.  In any case equity markets and risk assets have been struggling on the topside and appear to be losing momentum.  Markets are being buffeted by conflicting forces; economic news has beaten expectations. For example, the US June jobs report was better than expected though total job gains of 7.5 million in recent months are still only around a third of total jobs lost.  In contrast, worsening news on Covid 19 infections, with the WHO reporting a one day record high in global infections, threatens to put a dampener on sentiment.  Consolidation is likely, with Summer trading conditions increasingly creeping in over the weeks ahead. As such volatility is likely to continue to be suppressed, aided by central banks’ liquidity injections.

Over recent weeks geopolitical risks have admittedly not had a major impact on markets but this doesn’t mean that this will remain the case given the plethora of growing risks.  China’s installation of new security legislation into Hong Kong’s basic law and the first arrests utilizing this law were in focus last week.  A US administration official has reportedly said that the president is considering two or three actions against China, and markets will be on the lookout for any such actions this week, which could include further sanctions against individuals are more details of what the removal of HK’s special trading status will entail.  Meanwhile the US has sent two aircraft carriers to the South China Sea reportedly to send a message against China’s military build up in the area, with China’s PLA conducting a five-day drill around the disputed Paracel Islands archipelago.

Data releases and events this week are unlikely to lead to a change in this dynamic.  At the beginning of the week attention will focus on further discussions between the UK and EU over the post Brexit landscape while in the US the June non-manufacturing ISM survey will garner attention.  So far talks on a trade deal between the UK and EU have stalled though there were hints of progress last week, even as officials admitted that “serious divergencies remain”.  The US ISM non-manufacturing survey is likely to move back to expansion (above 50) but is increasingly being threatened by the increase in Covid infections, which could yet again dampen service sector activity. On the policy front there will be fiscal updates from the UK and Canada on Wednesday against the backdrop of ramped up spending, and monetary policy decisions by the Reserve Bank of Australia (RBA) and BNM in Malaysia on Tuesday.  The RBA is widely expected to keep policy unchanged while BNM may cut rates by 25 basis points.

 

Don’t Fight The Fed, Markets Are Teflon Coated

The rally in equity markets since their late March lows has been tremendous.  Despite an unrelenting chorus of doomsayers who like me have worried about the shape of recovery, markets have been impervious to bad news.  At the end of last week the May US employment report provided the latest catalyst to boost markets, after the release of data showing a shock 2.5 million increase in non-farm payrolls compared to consensus expectations of a 7.5 million decline.  The unemployment rate also surprisingly fell, to 13.3%, compared with 14.7% in April.  The data was taken as an indication that the US economy was resuming activity more quickly than expected.   As a result, the S&P 500 closed 2.6% higher on the day and almost 5% higher over the week. Another support factor for markets over the week was the European Central Bank’s expansion of its stimulus package, adding a more than expected EUR 600 billion to its asset purchase programme.

The lesson here is to not fight the Fed.  While many of us have been looking at fundamentals and surmising that fundamentals do not justify the rally in stocks, the reality is that this rally is not about fundamentals, well at least fundamentals in the traditional sense of the word.  The Fed and global central banks have been pumping in vast quantities of liquidity via quantitative easing, and this has led a massive increase in money supply in excess of economic growth.  This excess has had to find a home and equities have been such a home.  As of last week the S&P 500 recorded its biggest ever 50-day rally, up 37.7% and shows no sign of turning even as forward price/earnings ratios look increasingly stretched and economic activity appears likely to return only slowly, not withstanding the jump in May payrolls.

There are clearly plenty of risks on the horizon as mentioned in my previous blog posts, with a key one being the fraught relationship between the US and China.  However, for now markets don’t really care or at least are choosing not to care.  What started as a narrowly based risk rally has increasingly drawn in a wider base of investors who have increasingly been caught in what is commonly termed as FOMO or the fear of missing out.  This is dangerous to say the least, as it suggests that investors are only jumping on to avoid missing out on the rally rather than due to any fundamental rationale.  Nonetheless, the risk of not joining the rally is to miss out on even further potential gains.  The rally in risk assets has continued to hurt the dollar, which slid further over the last week, but is looking somewhat oversold based on some technical indicators.

Direction this week will come from the FOMC meeting on Wednesday although it seems unlikely that the Fed will announce anything new.  Markets will be particularly watchful for any indication on whether the Fed is moving towards enhancing its forward guidance.  In the Eurozone, the Eurogroup meeting will garner attention as Finance Ministers discuss the EU’s proposed Recovery Fund.  In Asia, China’s May trade released earlier today data will set the tone for the week.  The data revealed that China’s May exports fell less than expected, dropping 3.3% y/y USD terms, while imports dropped much more than expected, falling by 16.7% y/y.   Importantly, Chinese imports from the US declined further, highlighting the lack of progress towards the targets set out in the “Phase 1” trade deal.

Revoking Hong Kong’s Special Status – Data/Events This Week.

In a further escalation of US-China tensions, President Trump revoked Hong Kong’s (HK) “Special Status” as revealed in a speech on Friday.  What does this mean? At this stage there is scant detail to go on.  Trump also promised to implement sanctions against individuals in China and HK who he deems responsible for eroding HK’s autonomy, but no names were given. Markets reacted with relief, with US equities closing higher on Friday, perhaps in relief that that the measures outlined by Trump were not more severe, or that the lack of detail meant that there could be various exemptions.

On the face of it, removing Hong Kong’s “Special Status” would deal a heavy blow to Hong Kong’s economy and to US companies there, while hurting China’s economy too.  However, while still an important financial centre, Hong Kong’s economy relative to China is far smaller than it was at the time of the handover in 1997, at around 3%.   As such, removing Hong Kong’s “Special Status” could be less painful on China than it would have been in the past.  This may explain why the US administration is focusing on other measures such as student visa restrictions, sanctioning individuals, restricting investment etc.  Even so, tensions will continue to cast a shadow over markets for some time to come and will likely heat up ahead of US elections in November.

Data wise, the week began with the release of China’s May manufacturing and non-manufacturing purchasing manager’s indices (PMIs) today.  The data revealed a slight softening in the manufacturing PMI to 50.6 in May from 50.8 in April, indicating that manufacturing activity continues to remain in expansion.  However, the trade related components were weak, suggesting that China’s exports and imports outlook is likely to come under growing pressure, weighing on overall recovery.  China’s currency, the renminbi, has been weakening lately against the US dollar and against its peers, though it rallied against the dollar on Friday.  Further gradual weakness in the renminbi looks likely over coming weeks.

This week there will be attention on various data releases and events including US May jobs data, ISM manufacturing, European Central Bank (ECB) and Reserve Bank of Australia (RBA) policy decisions and UK-EU Brexit discussions.  Of course markets will remain tuned into Covid-19 developments as economies around the world continue to open up.   While the US jobs and ISM data will likely remain very weak, the silver lining is that the extent of weakness is likely to lessen in the months ahead.  Consensus forecasts predict a massive 8 million drop in US non-farm payrolls and the unemployment rate to increase to close to 20%.  The RBA is likely to leave policy unchanged at 0.25% while the ECB is expected to step up its asset purchases. Meanwhile UK-EU Brexit discussions are likely to continue to be fraught with difficulty.

 

 

 

Covid-19 Economic Toll Worsening

Unease about the economic toll of Covid-19 is starting to dent the rebound in equity markets.  The disconnect between the strength of the rally in equities and the reality on the ground has become increasingly visible following recent earnings releases including from tech heavyweights Apple and Amazon, and dismal economic data which included sharp falls in US and Eurozone Q1 GDP data.  Q2 will look even worse as most of the economic damage was inflicted in April, suggesting that the pain is just beginning.

Meanwhile geopolitical tensions between the US and China are adding another layer of pressure on markets, with US President Trump stating that he had seen strong evidence that Covid-19 originated from a laboratory in Wuhan.  Trump’s comments have raised the spectre of a renewed trade war between the two countries at a time when in any case it was looking increasingly difficult for China to live up to its end of the agreement to purchase a substantial amount of US goods in the wake of a Phase 1 deal.

Some of the economic pain emanating from the shutdowns will be on show this week, with the US April jobs report likely to reveal a sharp rise in the jobless rate and massive decline in non-farm payrolls, with markets looking for an increase to around 16% and a drop of 22 million, respectively.  Already jobless claims have risen to over 30 million, with the only silver lining being that the rate of increase in claims has declined over recent weeks.  The extremely sharp deterioration in job market conditions threatens to weigh heavily on recovery.

The US dollar fell towards the end of March due in part to month end rebalancing (given US equity and bond market outperformance over the month), but also due to a general improvement in risk sentiment, reducing any safe have demand for dollars.  If as is likely markets become increasingly nervous about the sustainability of the rally in risk assets, the USD is likely to move higher during the next few weeks. Even in an environment where global equities sell off, US assets are still better placed in terms of return potential than those elsewhere, implying US dollar outperformance.

In terms of data and events focus this will turn to the Bank of England and Reserve Bank of Australia policy meetings.  Neither are likely to cut interest rates further, but the BoE could announced a further increase in asset purchases, while conversely the RBA is likely to maintain its asset purchases tapering path.  Aside from the US jobs data noted above, the other piece of data globally that will be watched carefully is China’s April trade report.  A weak outcome is likely for sure, but the extent of deterioration in exports and imports, will have very negative global consequences.

China Data Fuels A Good Start To The Week

Better than expected outcomes for China’s manufacturing purchasing managers indices (PMIs) in November, with the official PMI moving back above 50 into expansion territory and the Caixin PMI also surprising on the upside gave markets some fuel for a positive start to the week.   The data suggest that China’s manufacturing sector has found some respite, but the bounce may have been due to temporary factors, rather than a sustainable improvement in manufacturing conditions.  Indeed much going forward will depend on the outcome of US-China trade talks, initially on whether a phase 1 deal can be agreed upon any time soon.

News on the trade war front shows little sign of improvement at this stage, with reports that a US-China trade deal is now “stalled” due to the Hong Kong legislation passed by President Trump last week as well as reports that China wants a roll back in previous tariffs before any deal can be signed.  Nonetheless, while a ‘Phase 1’ trade deal by year end is increasingly moving out of the picture, markets appear to be sanguine about it, with risk assets shrugging off trade doubts for now.  Whether the good mood can continue will depend on a slate of data releases over the days ahead.

Following China’s PMIs, the US November ISM manufacturing survey will be released later today.  US manufacturing sentiment has come under growing pressure even as other sectors of the economy have shown resilience.  Another below 50 (contractionary) outcome is likely.  The other key release in the US this week is the November jobs report, for which the consensus is looking for a 188k increase in jobs, unemployment rate remaining at 3.6% and average earnings rising by 0.3% m/m. Such an outcome will be greeted positively by markets, likely extending the positive drum beat for equities and risk assets into next week.

There are also several central bank decisions worth highlighting this week including in Australia, Canada and India.  Both the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) are likely to keep monetary policy unchanged, while the Reserve Bank of India (RBI) is likely to cut its policy rate by 25bps to combat a worsening growth outlook.  Indeed, Q3 GDP data released last week revealed the sixth sequential weakening in India’s growth rate, with growth coming in at a relatively weak 4.5% y/y. Despite a recent food price induced spike in inflation the RBI is likely to focus on the weaker growth trajectory in cutting rates.

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