Lingering Disappointment

Another soft close to US stock markets at the end of last week sets up for a nervous start to the week ahead.  The S&P 500 has now declined for a third straight week, with tech stocks leading the way lower as more froth is blown way from the multi-month run up in these stocks.  Lingering disappointment in the wake of the Federal Reserve FOMC meeting is one factor that has weighed on risk assets.  More details on how the Fed plans to implement its new policy on average inflation targeting will be sought. Markets will also look to see whether the Fed is pondering any changes to its Quantitative Easing program. This week Fed officials will get the opportunity to elaborate on their views, with several Fed speeches in the pipeline including three appearances by Fed Chair Powell. 

Disappointment on monetary policy can be matched with a lack of progress on the fiscal front, with hopes of an agreement on Phase 4 fiscal stimulus ahead of US elections fading rapidly.  A loss of momentum in US economic activity as reflected in the NY Fed’s weekly economic index and declining positive data surprises as reflected in the Citi Economic Surprise Index, are beginning to show that the need for fresh stimulus is growing.  On the political front, the situation has become even more tense ahead of elections; following the death of Supreme Court justice Ruth Bader Ginsburg attention this week will focus on President Trump’s pick to replace her, adding another twist to the battle between Democrats and Republicans ahead of the election.    

Another major focal point ahead of elections is US-China tensions, which continue to simmer away. China’s economy and currency continue to outperform even as tensions mount.  August’s slate of Chinese data were upbeat and China’s currency (CNY) is increasingly reflecting positive economic momentum, with the CNY CFETS trade weighted index rising to multi week highs.  There is every chance that tensions will only get worse ahead of US elections, likely as the US maintains a tough approach in the weeks ahead but so far Chinese and Asian markets in general are not reacting too much.  This may change if as is likely, tensions worsen further. 

After last week’s heavy slate of central bank meetings, this week is also going to see many central banks deliberate on monetary policy.  The week kicks off with China’s Loan Prime Rate announcement (Mon), followed by policy decisions in Hungary and Sweden (both Tue), New Zealand, Thailand, Norway (all on Wed), and Turkey (Thu).  Markets expect all of the central banks above to keep policy unchanged as was the case with the many central banks announcing policy decisions last week.  The lack of central bank action adds further evidence that 1) growth is starting to improve in many countries and 2) the limits of conventional policy are being reached.  While renewed rounds of virus infections threaten the recovery process much of the onus on policy action is now on the fiscal front. 

Everything But The Kitchen Sink

Since my last post there has been an even bigger onslaught of fiscal and monetary stimulus measures globally in an attempt to combat the devasting health and economic impact of COVID-19.  Fiscal stimulus in the US will amount to over 10% of GDP while the Federal Reserve’s balance sheet is set to grow further from an already large $6+ trillion at present as the Fed throws everything but the kitchen sink to combat the impact of the virus. There is already preparations underway for another phase of fiscal stimulus in the US.

Europe meanwhile, has struggled to agree upon a package given divisions between the North and South of the region, but eventually agreed upon EUR 500bn worth of fiscal stimulus while the ECB is undertaking renewed asset purchases in a new quantitative easing programme.  Many other countries have stepped up their efforts too.  All of this will provide an invaluable cushion, but will not prevent a massive economic downturn, nor will it stop the virus from spreading.

Markets have attempted to look past the growing economic risks, spurred by data showing that in many countries the rate of growth of coronavirus cases has slowed, including in those with a substantial number of deaths such as Italy and Spain.  Even in New York, which has been the epicentre of COVID-19 infections in the US, there are positive signs though it is an ominous sign that the US has now recorded the most deaths globally.

This move towards flattening of the curve has fuelled hopes that many countries will soon be able to emerge from lock downs.  In China, which was first in, most of the manufacturing sector has opened up, while there has even been some relaxation of measures to constrain movement of people.  The net result of all of the above last week, was the biggest weekly rally in US stocks since 1974.

While the 25%+ rally in US equities since their lows is reflecting this optimism, there is a major risk that this is a bear market rally given the risks ahead.  Economic growth estimates continue to be revised lower and the IMF’s revised forecasts scheduled to be published this week are likely to show a global economy on the rails, with growth likely to be at its worst since the Great Depression according to the IMF’s Managing Director.  Emerging markets, which do not have anywhere near the firepower or health systems of developed economies are particularly at risk.

At the same time earnings expectations have yet to reflect the massively negative impact on corporate profits likely in the months ahead; Q1 earnings to be released in the days ahead will be closely watched.  Not only are earnings expectations likely to be revised substantially lower, but many companies will simply not survive and many of those that do could end up in state hands if they are important enough.  Separately there is a risk that shutdowns last longer than expected or once economies begin to open up there another wave of infections.  These risk have not yet been fully appreciated by markets unfortunately.

US-China Trade War: The Gloves Are Off

The US-China trade war took another step for the worse over the weekend. China announced tariffs on the US of between 5- 10% on $75bn of US imports from September.  Chinese tariffs target 5,078 products including agriculture and small aircraft as well as crude oil. The US responded by increasing its tariffs on $250bn of Chinese imports from 25% to 30% while increasing duties from 10% to 15% on $300bn of Chinese imports to the US from September 1.   President Trump initially said he had “second thoughts” on additional tariffs, but these were clarified to state that “he regrets not raising the tariffs higher”.

The gloves are off on both sides. As indicated by the editorial in China’s People’s Daily states that China will fight the trade war to the end while influential Chinese journalist Hu Xijin said that “we have nothing more to lose, while the US is starting to lose China”, highlights China’s tougher stance.  Meanwhile President Trump is looking at the “Emergency Economic Powers Act of 1977” in forcing US companies to quit China.

Asia’s markets have responded in pain, with stocks and currencies falling while safe havens such as US Treasuries have been in demand.  Indeed the 10-year US Treasury yield has fallen to a three-year low.  Markets have priced in even further easing by the Fed FOMC, with almost three rate cuts by the PBoC discounted in by the end of this year.  Equity futures point to a weak opening in US equities today.

One casualty is the Chinese yuan, which took another leg lower today, having fallen by close to 7% since mid-April.  Further pressure on the yuan is likely, but China may not be too concerned as long as the pace of weakness does not get out of hand. China may try to control the pace of the decline to prevent a repeat of the FX reserves drain seen in mid-2015 and Jan 2016. At the least yuan depreciation will act as a buffer for Chinese exporters against increased US tariffs.  However, expect further yuan depreciation to be met with increased criticism and perhaps more US action, with the US already having labeled China a currency manipulator.

Chronology of a Crisis

Chronology of a Crisis
by Mitul Kotecha

Not many would have thought that the global financial crisis stemming from the sub-prime debacle in the US would have spawned such a massive degree of global contagion, the impact of which is being felt to this day. Indeed, it is evident that global markets have had to face crisis after crisis since the sub-prime saga began. It is equally evident that the chances of returning to the definition of normality that we knew prior to the crisis are extremely slim.

Fast forward to late 2012 and one could be forgiven for thinking that markets are still in the midst of crisis. The stark reality is that, despite the massive amount of fiscal and monetary stimulus enacted since 2008, the world economy remains very fragile and while the financial system is arguably in better shape, policy makers have far less ammunition in their pockets than they did at the beginning of the financial crisis. All is not so bad, however, with signs over recent months that the global economy is finally emerging from its quagmire. Even the crisis in the Eurozone is increasingly moving painstakingly towards some form of resolution.

In this book I give a month-by-month analysis of the period following the escalation of the financial crisis, attempting where possible to determine where and how things could have been handled differently. In assessing the market impact, particularly in relation to currency markets, the analysis will hopefully provide some insight into what can be learnt from the crisis and what to expect should a similar situation arise in the future.

Extreme Uncertainty

The level of uncertainty enveloping global markets has reached an extreme level. Who would have thought that close to 13 years after its introduction at a time when it has become the second largest reserve currency globally (26.7% of global reserves) as well as the second most traded currency in the world, European leaders would be openly talking about allowing countries to exit the EUR? No less an issue for currency markets is the sustainability of the USD’s role as the foremost reserve currency (60.2% of global reserves). The US debt ceiling debacle and the dramatic expansion of the Fed’s balance sheet have led to many official reserve holders to question their use of the USD. Perhaps unsurprisingly the JPY has been the main beneficiary of such concerns especially as global risk aversion has increased but to the Japanese much of this attention is unwanted and unwelcome.

The immediate focus is the travails of the eurozone periphery. Against the background of severe debt tensions and political uncertainties it is perhaps surprising that the EUR has held up reasonably well. However, this resilience is related more to concerns about the long term viability of the USD rather than a positive view of the EUR, as many official investors continue to diversify away from the USD. I question whether the EUR’s resilience can be sustained given that it may be a long while before the situation in the eurozone stabilises. Moreover, given the now not insignificant risk of one or more countries leaving the eurozone the long term viability of the EUR may also come into question. I believe a break up of the eurozone remains unlikely but such speculation will not be quelled until markets are satisfied that a safety net / firewall for the eurozone periphery is safely in place.

In this environment fundamentals count for little and risk counts for all. If anything, market tensions have intensified and worries about the eurozone have increased since last month. Politics remain at the forefront of market turmoil, and arguably this has led to the worsening in the crisis as lack of agreement between eurozone leaders has led to watered down solutions. Recent changes in leadership in Italy and Greece follow on from government changes in Portugal and Ireland while Spain is widely expected to emerge with a new government following elections. Meanwhile Chancellor Merkel has had to tread a fine line given opposition from within her own coalition in Germany while in France President Sarkozy is expected to have a tough time in elections in April next year. The likelihood of persistent political tensions for months ahead suggests that the EUR and risk currencies will suffer for a while longer.

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