Relief For Risk Assets, But How Long Will It Last?

Last week was one of considerable relief for risk assets; US equities recorded solid gains, with the S&P and Nasdaq up 6.2% and 8.2% respectively.  Conversely, oil (Brent) dropped by over 4% and the US dollar index dropped by around 1%.  Reflecting the improvement in sentiment, the VIX “fear gauge” has now dropped by around a third over the last couple of weeks to settle below 25.0.  The MOVE index of interest rates volatility has also fallen sharply.  All of this in a week when the Federal Reserve hiked policy rates by a quarter percent and promised more to come in a hawkish meeting. 

A lot of the bad news was clearly in the price including the pricing of several Fed rate hikes, but with the war in Ukraine ongoing, peace talks appearing to make little progress, stagflation fears intensifying and a renewed rise in COVID cases in many countries due to a new variant (BA.2), we’re still very far from an all clear signal for risk assets.  Separately, the US administration appears no closer to persuading China into supporting a stronger stance against Russia; no statement was issued after the call between Presidents Biden and Xi at the end of last week.

China’s neutral stance on the war in Ukraine still poses risks to its markets as indicated by the sharp outflows of foreign portfolio capital over recent weeks.  After pledges made by the authorities to provide much needed stability to China’s economy and markets, the coming weeks will be scrutinised for follow up action.  On this note, China’s Loan Prime Rates (LPR) outcome today was in focus.  There was a small chance that China’s Banks would lower their fixings but after the unchanged Medium Term Lending Facility (MLF) outcome last week, the prospects of a cut had lessened. Nonetheless despite no change in policy today, recent official pledges of support suggest its only a matter of time before there is a cut in the policy rate.

Over the rest of the week there will be several other central bank decisions in focus, mostly in emerging markets, including in Hungary (Tue), Philippines, Norway, South Africa and Mexico (all on Thu).  Most are expected to hike rates. A 25bp hike in Norway is likely, 50bp hike in Mexico, 25bp hike in South Africa and 150bp hike in Hungary.  There will also be several Federal Reserve speakers on tap this week including Chair Powell (Tue), as well as Williams, Bostic, Daly, Mester and Evans.  They are likely to provide more colour following last week’s Fed rate hike, with focus on comments on balance sheet reduction and the pace of further tightening ahead.  

Looking For The Silver Lining

As the end of the year approaches it would take a minor miracle of sorts to turn around a dismal performance for equity markets in December.   The S&P 500 has fallen by just over 12% year to date, but this performance is somewhat better than that of equity markets elsewhere around the world.  Meanwhile 10 year US Treasury yields have dropped by over 53 basis points from their high in early November.

A host of factors are weighing on markets including the US government shutdown, President Trump’s criticism of Fed policy, ongoing trade concerns, worries about a loss of US growth momentum, slowing Chinese growth, higher US rates, etc, etc.   The fact that the Fed maintained its stance towards hiking rates and balance sheet contraction at the last FOMC meeting has also weighed on markets.

A statement from US Treasury Secretary Mnuchin attempting to reassure markets about liquidity conditions among US banks didn’t help matters, especially as liquidity concerns were among the least of market concerns.  Drawing attention to liquidity may have only moved it higher up the list of focal points for markets.

The other major mover is oil prices, which have dropped even more sharply than other asset classes.  Brent crude has dropped by over 40% since its high on 3 October 2018.   This has helped to dampen inflationary expectations as well as helping large oil importers such as India.  However, while part of the reason for its drop has been still robust supply, worries about global growth are also weighing on the outlook for oil.

But its not all bad news and markets should look at the silver lining on the dark clouds overhanging markets.  The Fed has become somewhat more dovish in its rhetoric and its forecasts for further rate hikes.  US growth data is not weak and there is still sufficient stimulus in the pipeline to keep the economy on a reasonably firm growth path in the next few months.  Separately lower oil is a positive for global growth.

There are also constructive signs on the trade front, with both US and China appearing to show more willingness to arrive at a deal.  In particular, China appears to be backing down on its technology advancement that as core to its “Made In China 2025” policy. This is something that it at the core of US administration hawks’ demands and any sign of appeasement on this front could bode well for an eventual deal.

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