Setting Up For A More Volatile Q4

After a disappointing September for risk assets, markets at least found some relief at the end of last week, with the S&P 500 ending up over a 1% while US Treasury yields fell and the US dollar also lost ground.  However, sentiment in Asia to kick of the week has been poor, with Evergrande concerns coming back to the forefront.

There was positive news on the US data front, with the Institute of Supply Management (ISM) manufacturing index surprising to the upside in September, rising modestly to 61.1 from an already strong level at 59.9 in August (consensus: 59.5) though the details were less positive.  In particular, the rise in supplier delivery times and prices paid reflects a re-emergence of supply chain issues. 

Separately, the infrastructure can was kicked down the road as infighting within the Democratic party on the passage of the bipartisan $1.2 trillion infrastructure bill and larger $3.5tn package, led to a further delay of up to one more month. It is likely that the eventual size of the proposed $3.5tn spending plan will end up being smaller, but there still seems to be some distance between the progressives in the Democratic party want and what the moderates want. Separately, the debt ceiling issue is likely to go down to the wire too.

China’s Evergrande remains in focus, with the company reportedly suspended from trading in Hong Kong pending “information on a major transaction”. According to China’s Cailian news platform another developer plans to acquire a 51% stake in the property services unit. The sale is likely a further step towards restructuring the entity and preventing a wider contagion to China’s property sector and economy.

Over the rest of the week attention will turn to the US September jobs report, which will as usual likely be closely eyed by Federal Reserve policymakers.   A pickup in hiring relative to the 235,000 rise in August is expected, with the consensus looking for a 470,000 increase. It would likely take a very poor outcome to derail the Federal Reserve’s tapering plans in my view.  

Several central banks including in Australia (Tue), New Zealand (Wed), Poland (Wed) and India (Fri) will deliberate on policy.  Among these the most eventful will likely be the RBNZ, with a 25 basis points rate hike likely while the others are all set to remain on hold.  Other data includes the European Central bank (ECB) meeting accounts of the September meeting (Thu), US ISM Sep services index (Tue) and Turkey September CPI (today). 

Overall, going into the fourth quarter investors will have to contend with host of concerns including weakening global activity especially in the US and China, supply chain pressures, persistent inflation risks, Evergrande contagion and related China property developer woes, China’s regulatory crackdown, raising the debt ceiling, difficulties in passing the US infrastructure bills, Fed tapering, and ongoing COVID concerns.  This may set up for a much rockier and more volatile quarter ahead for markets especially amid a growing wave of more hawkish G10 central banks.

Inflation Angst

US equities fell for a fifth straight day on Friday enduring their worst week since June.  Asian markets faced a tough start to the week after US losses and amid further Chinese regulatory measures, with Alipay in focus as regulators are reportedly (FT) looking to break it up while the Biden administration is reported to be looking at starting a new probe into Chinese industrial subsidies.  Worries about the persistent impact of the Delta variant on the services and tourism sector globally are adding to the sense of malaise in markets. 

Data wise, US Aug Producer Price Index (PPI) data dented confidence following a bigger than expected 0.7% m/m, 8.3% y/y increase, with yet more evidence of the impact of supply pressures impacting the data even as the core measure slowed.  It is worth noting that China’s outsized increase in PPI inflation in August released last week sent a similar message.  Such fears may have been attributable to the move in bonds, with US Treasury yields rising on Friday, giving back the gains in the wake of the strong 30- year auction, despite the fall in equities. 

Following the US PPI, there will be a number of other releases this week which could potentially add to nervousness over lingering inflation pressures.  The plethora of inflation data kicks off with India’s August consumer price index (CPI) today for which a 5.6% y/y increase is expected, a level which will likely continue to make India’s central bank (RBI) uncomfortable.  US August CPI scheduled for tomorrow is likely to show another strong rise in food and energy prices though core CPI likely rose at its slowest pace since February.  Canada August CPI (Wed) is likely to drift higher while UK August inflation (Wed) is likely to reveal a jump after a sharp decline last month.  On balance, the inflation releases this week will do little to calm market’s inflation fears.

Other key data this week will likely show weakening activity.  The slate includes US August retail sales (Thu). The data is likely to add to evidence that the boost to goods spending in the US from fiscal stimulus has peaked.  China activity data including August retail sales and industrial production (Wed) will likely show further moderation especially to retail sales which was likely impacted by lockdowns in various provinces.  Australia employment data (Thu) is likely to have revealed a decline while NZ GDP (Thu) is likely to show firmer economic momentum than the RBNZ’s forecast.

Weaker China data and Delta Concerns

The same old discussion continues to afflict equity investors as lofty valuations balance against a wall of liquidity.  So far liquidity is winning out as US equity indices are trading around record highs despite a surprise 13.5% plunge in August US consumer confidence released last Friday, which marked one of the largest declines ever in the University of Michigan series. In fact confidence fell to a level even below the COVID low, likely due to Delta variant concerns. 

The confidence data fuelled a bull flattening in US Treasuries and USD sell off.  As reflected in the confidence data, the Delta variant is increasingly threatening recovery and evidence of sharply rising virus cases even in highly vaccinated countries sends a worrying sign of what to expect going forward. 

Geopolitics will be in focus after the Taliban effectively took over Afghanistan after marching into Kabul yesterday.  This will have major repercussions in South Asia and the rest of the region.  Separately, Canada’s PM Trudeau has called a snap election on Sep 20 while Malaysia’s PM Yassin has resigned today.  Geopolitics, weak US confidence data, China’s regulatory crackdown and ongoing Delta variant concerns, with Philippines and Thailand registering record virus cases in Asia led to a cautious start to the week for Asia. 

Further direction came from China’s July data slate released today.  The data revealed weaker than expected outcomes across the board, with industrial production and retail sales alongside other data revealing further softening.  The releases provided more evidence that Chinese consumer caution has intensified in the wake of targeted lockdown measures in several provinces while industrial activity is being hampered by supply constraints and weakening demand for exports.

The Chinese data will likely provide more support to expectations of further easing in liquidity from the central bank (PBOC) and even policy rate cuts. Separately, China’s regulatory crackdown has extended further, weighing on Chinese and regional assets, but there is little sign that officials are looking to step back.   More broadly, weaker Chinese data will likely contribute to a near term tone of risk aversion afflicting global market sentiment amidst worsening Delta variant concerns, rising growth worries and geopolitical risks.

Over the rest of the week Fed FOMC minutes (Wed), in particular views on the shape of quantitative easing tapering, as well as central bank decisions in New Zealand (Wed), Indonesia (Thu) and Norway (Thu) are in focus.  The RBNZ is likely to be the most eventful among these, with a 25bp hike in its policy rate (OCR) expected amid firming data and rising inflation pressures.  Key data this week includes US July retail sales (Tue), with falls in both the headline and control group readings likely as the boost to spending from stimulus and reopening fades. 

Regulatory Crackdown

How much can global markets withstand the combined US and Chinese regulatory onslaught on Chinese tech stocks and Chinese companies listed in the US? Notably Chinese regulators have called for talks with the US Securities and Exchange Commission over the decision to halt US IPOs of Chinese companies. Given that regulators on both sides do not seem to be letting up, the risks are skewed towards increased contagion though Chinese stocks have already fallen sharply over recent weeks, with the CSI 300 down around 15% since its high in February.

Unfortunately Chinese stocks and investors in these stocks are the casualties of a regulatory crackdown on consumer internet stocks and more recently Chinese private education companies. While the idea is not to provoke market volatility, regulators in China are unlikely to back off quickly even as the tone of the crackdown is likely to be less aggressive in the weeks ahead.

Stocks ended last week and began this week softer amid such concerns while the softer than expected US Q2 GDP print last week didn’t help matters.  More evidence that peak US growth has passed was delivered yesterday, with the US ISM manufacturing index surprising to the downside in July, declining to 59.5 — its lowest level since January but still at a relatively high level. US economic surprises (according to the Citi index) are negative and at their lowest in over a year.

The below consensus outcome for China’s manufacturing purchasing manager’s index which slipped closer towards contraction is unlikely to be helpful for markets either as the data adds to signs of moderating economic growth in China.  China’s softer July PMI releases have left a sour taste for Asian markets given more evidence of moderation in activity while the spread of the Delta variant amid low vaccination rates, still points to underperformance of regional markets. 

US dollar sentiment has continued to improve as reflected in speculative futures data (CFTC IMM data on non-commercial futures) which shows that the market holds the biggest net aggregate USD long position since March 2020.  Nonetheless, it still seems difficult to see dollar upside momentum increase given very low US real yields.  Moreover, the fact that the market is now long USD according to the IMM data, means scope for any short covering rally has dissipated.

Key data and events this week include the Bank of England (Thu) and Reserve Bank of India (Fri) policy decisions and US jobs July report (Fri).  No rate changes are likely from any of these as was the case with today’s decision by the Reserve Bank of Australia. As for US payrolls, the consensus expectation looks for a strong 900,000 increase in July and for the unemployment rate to fall to 5.7%.  

Absorbing The Fed’s Message

Markets absorbed a high inflation reading in the form of US core Personal Consumption Expenditure (PCE) price index without flinching at the end of last week, further acknowledgement that the Fed’s “transitory” inflation message is belatedly sinking in to the market’s psyche.  Core PCE inflation exceeded expectations for April, surging 0.7% m/m after a 0.4% gain in March (consensus: 0.6%). On a y/y basis, core PCE inflation surged to 3.1%—its highest level in almost three decades. High inflation readings are likely to persist over the near-term, if for no other reason than base effect, but price pressures will likely ease by the end of the year. 

The market’s sanguine reaction has helped US Treasury yields to continue to consolidate.  Also helping to restrain yields is the fact that positive US economic surprises (data releases versus consensus expectations) are close to their lowest level since June 2020 and barely positive (according to the Citi index), in contrast to euro area economic surprises, a factor that is helping to support the euro.

Cross-asset volatility measures remain very low, with the glut of liquidity continuing to depress volatility across equities, interest rates and FX.  Given that markets’ inflation fears has eased, it is difficult to see what will provoke any spike in volatility in the near term.  All of this this does not bode well for the USD.  Sentiment as reflected in the latest CFTC IMM speculative data on net non-commercial futures USD positions, remains downbeat.  This is corroborated in FX options risk reversal skews (3m, 25d) of USD crosses. 

In particular, USDCNY will be closely watched after strong gains in the renminbi lately.  Chinese officials are trying to prevent or at least slow USD weakness vs. CNY. The latest measure came from China’s central bank, the PBoC instructing banks to increase their FX reserve requirements by 2% to 7% ie to hold more foreign currency as a means of reducing demand for the Chinese currency.  Expect official resistance to yuan appreciation pressures to grow.      

Data so far this week has been mixed. China’s May NBS manufacturing purchasing managers index released yesterday slipped marginally to 51.0 from 51.1 previously (consensus 51.1) while the non-manufacturing PMI increased to 55.2 from 54.9 previously. Both remained in expansion, however indicative of continued economic expansion. China’s exports are holding up particularly well and this is expected to continue to fuel manufacturing expansion while manufacturing imports are similarly strong. 

Today’s Reserve Bank of Australia decision on monetary policy delivered no surprises, with policy unchanged and attention shifting to the July meeting when the bond purchase program will be reviewed.  On Friday it’s the turn of the the Indian central bank, Reserve Bank of India (RBI), with an unchanged policy outcome likely despite the growth risks emanating from a 2nd wave COVID infections cross the country and attendant lockdowns.  Last but not least, is the May US jobs report for which consensus expectations are for 650,000 gain in non-farm payrolls and the unemployment rate falling to 5.9% from 6.1% previously.

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