Fundamentals Versus Liquidity

June 14, 2020 — Mitul Kotecha

Markets took fright last week. The divergence between what fundamentals are telling us and what markets are doing has widened dramatically, but bulls will say don’t fight the Fed.  However, after an unprecedented run up from the late March lows, equity markets and risk assets appeared to react negatively to a sober assessment of the economic recovery by Fed Chair Powell at last week’s FOMC meeting. News of a renewed increase in Covid-19 infections in several parts of the US against the background of ongoing protests in the country, added to market nervousness.  On Thursday stocks registered their biggest sell off since March but recovered some composure at the end of the week. Volatility has increased and markets are looking far more nervous going into this week.

Exuberance by day traders who have been buying stocks while stuck in lockdown, with not much to do and government pay outs in hand, have been cited as one reason that equities, in particular those that were most beaten up and even in Chapter 11 bankruptcy, have rallied so strongly.  Many (those that prefer to look at fundamentals) believe this will end in tears, comparing the run up in some stocks to what happened just before the tech bubble burst in 2000/01.  The reality is probably somewhat more nuanced.  There’s definitely a lot of liquidity sloshing around, which to some extent is finding itself into the equity market even if the Fed would probably prefer that it went into the real economy.   However, buying stocks that have little intrinsic value is hard to justify and market jitters over the past week could send such investors back to the sidelines.

Stumbling blocks to markets such as concerns about a second wave of virus infections are very real, but the real question is whether this will do any more damage to the economy than has already happened.  In this respect, it seems highly unlikely that a second or even third round of virus cases will result in renewed lockdowns.  Better preparedness in terms of health care, contract tracing, and a general malaise from the public about being locked down, mean that there is no appetite for another tightening in social distancing restrictions.  The result is a likely increase in virus cases, but one that may not do as much economic damage.

Last week’s equity market stumble has helped the US dollar to find its feet again.  After looking oversold according to various technical indicators such as the Relative Strength Index (RSI) the dollar rallied against various currencies recently.  Sentiment for the dollar had become increasingly bearish (overly so in my view), with the sharp decline in US yields , reduced demand for dollars from central banks and companies globally amid an improvement in risk appetite weighing on the currency.  However, I think the dollar is being written off way to quickly.  Likely US economic and asset market outperformance suggests that the US dollar will not go down without a fight.

Posted in central banks, coronavirus, COVID-19, Currencies, Economics, Economy, emerging markets, equity markets, Europe, eurozone, Federal Reserve, Fiscal/Budget, FX, Interest rates, Monetary Policy, Trade, Trump, US, US administration. Tags: , , , , , , , , . Leave a Comment »

Don’t Fight The Fed, Markets Are Teflon Coated

June 7, 2020 — Mitul Kotecha

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.

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

May 31, 2020 — Mitul Kotecha

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.

 

 

 

Posted in Asia, Australia, Brexit, central banks, China, coronavirus, COVID-19, Currencies, ECB, Economics, Economy, emerging markets, equity markets, Europe, eurozone, FX, Hong Kong, Interest rates, Monetary Policy, Trade, Trump, UK, US, US administration. Tags: , , , , , , , , , , . Leave a Comment »

Tensions Take A Turn For The Worse

May 25, 2020 — Mitul Kotecha

As highlighted in my post last week markets face “Risks of a body blow” amid an intensification of tensions between the US and China.  Such tensions have worsened over recent days in the wake of the decision announced at the start of China’s National People’s Congress (NPC) to draft national security legislation for Hong Kong, which would reportedly bypass the territory’s Legislative Council.

The news prompted a slide in Hong Kong equities, demonstrations in Hong Kong and a strong reaction from the US Secretary of State. Attention will also turn to whether China’s decision will push the US administration into imposing sanctions based on the Hong Kong Human Rights and Democracy Act passed last year by Congress as well as remove the special trading status that Hong Kong enjoys with the US.

Unrelated to the above, but in line with the strengthening in non tariff measures being applied to China, the US Senate passed a bill that would effectively result in a de-listing any companies from the US stock exchange if they did not comply with US regulatory audits. In particular, Chinese company listings will be at risk given that many Chinese companies would fall into this category.  This follows hot on the heels of tougher restrictions on the sale of US technology, and the ordering of the main US federal government pension fund not to invest in Chinese equities.

Markets are right to be nervous, with tensions only likely to intensify ahead of elections, but as noted in my previous post, it seems highly unlikely that the US administration would want to tear up the “Phase 1” trade deal at this stage given the impact on domestic producers and consumers.  Instead expect more non trade measures, export controls, visa restrictions, etc, to move into place.  If the US economy/asset markets rebound more strongly, the risk of a breakdown in the trade deal will likely grow as the administration may have more confidence at that point.   Either way, the November 2020 presidential election will have a large bearing on policy towards China.

China can also not risk a major flare up in tensions at this stage given the pressure on its economy even as it has largely opened up post the Covid-19 lockdown measures.  The magnitude of the growth shock was on show last Friday, with the NPC dropping its growth target from its work report for the first time.  This was a prudent move given that growth this year is subject to much more uncertainty than usual in the wake of the Covid-19 shock, but it also suggests that Chinese authorities do not want to commit to the type of stimulus enacted in 2008, which resulted in a sharp build up in leverage in the economy.  GDP growth fell by 6.8% y/y in Q1 and is likely to come in at best around half of last year’s 6.1 rate.

As such, the risks to markets has moved from the virus (though second round infections remains a key risk to markets) to geopolitical.   Nor have economic risks have dissipated.  A cursory glance at data globally makes this obvious.  Markets have tried to look past the data, but risks remain high that growth recovery will be far more prolonged than is being currently priced in.  At some point, maybe soon, it will be hard to keep looking past the data, when what is in view is not pleasant at all.

 

 

Posted in Asia, China, coronavirus, COVID-19, Economics, emerging markets, equity markets, Federal Reserve, Monetary Policy, Trade, Trump, US, US administration. Tags: , , , , , , . Leave a Comment »

US-China tensions – Risks of a body blow to markets

May 17, 2020 — Mitul Kotecha

Tensions between the US and China are once again escalating, resulting in growing nervousness in markets and raising concerns of a further deterioration in global trade at a time when the world is increasingly reeling from the devastating economic impact of Covid-19.   As many countries open up their economies hopes that activity can finally begin to resume, has strengthened.  However, the economic cost is still mounting and as revealed in awful economic data globally over recent weeks the picture is a horrible one.

It will be a fine balancing act for the US administration between imposing more trade tariffs and in turn hurting US importers on the one hand and punishing China for accusations of concealing information about spreading Covid-19 on the other.  President Trump recently threatened to “cut off the whole relationship” with China, which threatens the “Phase 1” trade deal reached at the beginning of this year.   Recent moves by the US administration include instructing a federal pensions fund to shift some investments in Chinese stocks and tightening export controls on Chinese telecoms company Huawei and its suppliers, which the US administrations says are contrary to US national security.

However, the White House may want to keep trade separate from other measures including tighter export controls and investment restrictions.  Indeed recent talks between senior US and Chinese officials on implementing the Phase 1 deal appeared to be cordial and constructive while Larry Kudlow, director of the National Economic Council said on Friday that the trade deal is continuing.  This is logical.  Renewed tariffs on imports from China would hurt the US consumer, while likely retaliation from China would mean any chance of China increasing its purchases of US goods as part of the Phase 1 deal would disappear, inflicting more pain on the US economy.

One other major consequence of a new round of US tariffs on China would likely be a weaker Chinese currency.  So far China has avoided weakening the yuan, which could also provoke increased capital outflows from China (as it did in Jan 2015 and mid 2016) and a drain on FX reserves at a time when Chinese growth is slowing sharply.  However, China may yet opt for a sharp depreciation/devaluation of the yuan to retaliate against fresh tariffs and to support its exporters as it did when the US first imposed tariffs on the country.  Although this comes with risks for China as noted above, if it was sold as a one off move and was well controlled, it need not fuel an increase in capital outflows from China. This is something that the US will wish to avoid.

Although the US may want to avoid trade as the primary target of any pressure on China, this does not mean that tensions will not increase.  In fact it is highly likely that the relationship between the US and China will worsen ahead of US elections in November, especially as it is one issue which garners broad support among the US electorate. As such, US measures will likely skirt trade restrictions but will most probably involve a whole host of other measures including tightening export controls, student visa restrictions, investment restrictions, and other such measures.  Markets hardly need a reason to be nervous, but after a multi week rally, this is an issue that could prove to be a major body blow to risk assets.

Posted in Asia, Asian currencies, China, coronavirus, COVID-19, Currencies, Economics, Economy, emerging markets, equity markets, Trade, Trump, US, US administration. Tags: , , , , , , , , . Leave a Comment »
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