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.

Tensions Take A Turn For The Worse

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.

 

 

Waiting For The Fed To Come To The Rescue

COVID-2019 has in the mind of the market shifted from being a localized China and by extension Asia virus to a global phenomenon.  Asia went through fear and panic are few weeks ago while the world watched but did not react greatly as equities continued to rally to new highs outside Asia.  All this has changed dramatically over the last week or so, with markets initially spooked by the sharp rise in cases in Italy and Korea, and as the days have progressed, a sharp increase in the number of countries recording cases of infection.

The sell off in markets has been dramatic, even compared to previous routs in global equity markets.  It is unclear whether fading the declines is a good move given that the headline news flow continues to worsen, but investors are likely to try to look for opportunity in the malaise.   The fact that investors had become increasingly leveraged, positioning had increased significantly and valuations had become stretched, probably added more weight to the sell-off in equity markets and risk assets globally.  Conversely, G10 government bonds have rallied hard, especially US Treasuries as investors jump into safe havens.

Markets are attempting a tentative rally in risk assets today in the hope that major central banks and governments can come to the rescue.  The US Federal Reserve on Friday gave a strong signal that it is prepared to loosen policy if needed and markets have increasingly priced in easing , beginning with at least a 25bps rate cut this month (19 March).  The question is now not whether the Fed cuts, but will the cut be 25bp or 50bp.  Similarly, the Bank of Japan today indicated its readiness to support the economy if needed as have other central banks.

As the number of new infections outside of China is now increasing compared to new infections in China, and Chinese officials are promising both fiscal and monetary stimulus, China is no longer the main point of concern.  That said, there is no doubt that China’s economy is likely to tank this quarter; an early indication came from the sharp decline in China’s official manufacturing purchasing managers’ index, which fell to a record low of 35.7 in February, deep into contraction territory.  The imponderable is how quickly the Chinese economy will get back on its feet.  The potential for “V” shape recovery is looking increasingly slim.

Volatility has also risen across markets, though it is notable that FX volatility has risen by far less than equity or interest rate volatility, suggesting scope for catch up.  Heightened expectations of Fed rate cuts, and sharp decline in yields, alongside fears that the number of virus cases in the US will accelerate, have combined to weigh on the US dollar, helping many currencies including the euro and emerging market currencies to make up some lost ground.  This is likely to continue in the short term, especially if overall market risk appetite shows some improvement.

Markets will likely struggle this week to find their feet.  As we’re seeing today there are attempts to buy into the fall at least in Asia.  Buyers will continue to run into bad news in terms of headlines, suggesting that it will not be an easy rise. Aside from watching coronavirus headlines there will be plenty of attention on the race to be the Democrat Party presidential candidate in the US, with the Super Tuesday primaries in focus.  UK/Europe trade talks will also garner attention as both sides try to hammer out a deal, while OPEC will meet to deliberate whether to implement output cuts to arrest the slide in oil prices.  On the data front, US ISM manufacturing and jobs data will be in focus.

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.

Looking At Central Banks For Direction

This week feels as though its one where markets have gone into limbo waiting for developments on the trade war front, and for direction from central bankers.  So far there has been no indication that a date or even location has been set to finalise details of a Phase 1 deal between the US and China.  While officials on both sides suggest that progress is being made, markets are left wondering if a deal will even be signed this side of the new year.  Despite such uncertainty there does not seem to be too much angst in markets yet, and if anything, risk assets including equities look rather resilient.

Central bankers and central bank minutes will garner plenty of attention over coming days.   Overall it looks as though major central banks led by the Fed are moving into a wait and see mode and this means less direction from these central banks to markets over the next few weeks and likely into year end.

Fed FOMC minutes this week will give more information on the Fed’s thinking when it eased policy in October, and markets will be looking for clues as to what will make them ease again.  In his recent Congressional testimony Fed Chair Powell highlighted that he sees little need to ease policy at the December meeting, strongly suggesting no more easing from the Fed this year.

Reserve Bank of Australia minutes overnight highlighted that the Bank will also now wait to assess past monetary easing measures before cutting rates again while still holding the door open to further cuts if necessary.  While the RBA noted that a case could have been made for easing this month, it doesn’t appear that they are in a rush to move again, with easing now becoming more likely next year than in December.

Another central bank in focus is the ECB, with ECB President Lagarde delivering the keynote address at the European Banking Congress in Frankfurt.  This will be an opportunity for markets to see whether her views are in line with previous ECB President Draghi and also to see how she reacts to criticism of the ECB’s decision from outside and within the governing council, to ease policy further at the September meeting, when it cut the deposit rate to -0.5% and restarted asset purchases.

Another central bank in focus over coming days includes the PBoC in China.  The PBoC cuts its 7-day reverse repo rate by 5bps this week, the first decline in this rate since 2015 in an attempt to lower funding cots to banks.  While the move is small the direction of travel is clearly for lower rates and this is likely to be echoed in the release of the new Loan Prime Rate tomorrow, which could also reveal a small 5bps reduction.  China is likely to maintain this path of incremental easing in the weeks ahead.

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