Host Of Central Banks In Focus

Well, last week, tech stocks had their worst week since March, with stability far from returning.  While the jury is still out, most still view the pull back in tech stocks as a healthy correction following a prolonged period of gains, blaming increased options activity over recent months for the magnitude of the decline. The buy on dip mentality is likely to continue to prevail, though tech stocks have not yet show any sign of wanting to make a convincing pull back.   

Signs of nervousness are clear; equity volatility remains elevated, but many investors are still sitting on healthy gains over recent months.  Given the low cost of funding, low returns in government bonds, alongside continued strong demand for stay at home electronics and a vaccine that could still take months to arrive, it is hard to see the tech sector falling too far.   

The fall in the pound sterling has been quite dramatic over recent weeks, both against the US dollar and euro.  Fears over a collapse in trade talks with the European Union have intensified.  The sudden waking up of the market to these risks has been provoked by the prospects that the withdrawal agreement with the EU will be torn up, prompting threats of legal action by the EU.

Time is running out to get a deal on the table before the end of the Brexit transition period at the end of the year, but UK Prime Minister Johnson has said that the internal market bill is necessary to prevent “a foreign of international body from having the power to break up our country.” The new legislation is already facing a rebellion in parliament. Against this background its hard to see GBP rally, with the currency likely to be particularly volatile over the coming weeks.

Attention this week will turn to several central bank decisions, with monetary policy makers in Poland (Tue), US (Wed), Brazil (Wed), Japan (Thu), Indonesia (Thu), Taiwan (Thu), South Africa, (Thu), UK (Thu) and Russia (Fri) all scheduled to announce their decisions.  After months of policy easing globally, this week will look rather boring, with none of the above likely to ease further.   

The Fed FOMC meeting will likely capture most attention, but there is potential for disappointment if the Fed does not provide further details on its shift to average inflation targeting in its forward guidance, even as the accompanying statement and Chair Powell’s press conference are likely to sound dovish. The US dollar has continued to stabilize, aided by the drop in GBP, but a dovish Fed could limit further upside in the short term. 

Aside from central bank decisions attention will be on US election polls, which take on more importance as the election creeps closer.  US fiscal stimulus talks have hit a wall, with little chance of progress this week, while US pressure on China and Chinese companies is likely to continue to be unrelenting as elections approach.  On the political front the race to take over Japan’s prime minister following the resignation of Shinzo Abe will conclude this week (Wed).   

Gold Loses Its Shine (For Now)

The drop in the gold price over recent days has been dramatic. It is no coincide that it has occurred at a time when the US dollar is consolidating and real yields have increased again.  Gold buying had accelerated over recent weeks, resulting in a sharp and what has proven to be, an unsustainable rally.  The subsequent drop in gold prices (around 9% from its peak around $2075) may yet turn out to be a healthy correction from overbought levels amid heavy positioning.  However, in the near term it is not advisable to catch a falling knife, with some further weakness likely before any turnaround.

Prospects for gold further out remain upbeat despite the current correction.  Continued ultra easy monetary policy from the Fed and other major central banks, likely persistent low real bond yields amid central bank bond buying, continuing virus threats and importantly ongoing pressure on the US dollar, all suggest that the correction in gold prices will be met by renewed buying for an eventual upward test of $2000.  However, in the near term the pull back in gold likely has more room, with the 61.8% Fibonacci retracement level around $1835 and the 50 day moving average around $1829 important support levels.

As noted, it is no coincidence that that the dollar has strengthened at the same as gold has collapsed.  The dollar has looked increasingly oversold both from a positioning and technical perspective and was due for a correction.  Whether the correction in the dollar can turn into a sustainable rally is debatable, however.  Unless there is a sustainable turn in real yields higher or signs that the US economy will move back to outperforming other major economies, it seems likely that the dollar will struggle to recover, especially ahead of US elections and all the uncertainty that they will bring in the next few months, especially if the result of the elections is a contested one.

Another trend that is taking shape in markets is the rotation between momentum and value stocks.  Recent market action has shown a marked underperformance of tech stocks relative to value stocks. Stocks that benefit from re-opening are increasingly in favour though their performance is still far behind that of tech stocks over recent months.  Much still depends on how quickly the virus can be bought under control, which in turn will signify how well re-opening stocks will do going forward. There are encouraging signs in the US that the pace of increase is slowing but it is still early days and as seen globally the virus is hard to suppress.

Fundamentals Versus Liquidity

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.

A Lot Of Moving Parts

There are lot of moving parts driving market sentiment at present.  US economic news has helped to buoy markets this week after US Q3 GDP was revised higher in its second estimate, to 2.1% q/q while October durable goods orders came in stronger than expected.  However, the news that President Trump signed the Hong Kong Human Rights and Democracy Act after almost unanimous passage in Congress, has fueled some cautious.  Investors now await any retaliation from China and whether the Bill will get in the way of a Phase 1 trade deal.

On the trade front both the US and Chinese governments have said that there are closing in on a Phase 1 deal but as yet there has been no confirmation, with less and less time to agree a deal before the end of the year and more importantly before the next phase of tariffs kicks in on December 15.  One sticking point between the two sides appears to be what extent will the US administration roll back tariffs, with China likely wanting not only the tariffs scheduled to be implemented in mid-December to be rolled back but also the ones implemented in August.

Such a roll back in tariffs would be take place in exchange for increased Chinese purchases of US goods and perhaps stricter intellectual property regulations, but more structural issues such as state subsidies, technology transfers etc may be put back to later deals.  In the meantime markets do not appear overly concerned, with risk assets and equities in particular continuing to rally and volatility continuing to decline.  If there is no deal announced in the weeks ahead, markets could face a set back, but if agreement on a deal is to be merely pushed back into Q1 2020, the damage will be limited.

After its sharp fall over October the US dollar has gradually clawed back ground over recent weeks, helped by US asset market outperformance and consequently strong inflows into US assets.  As we move towards the end of the year it appears that the USD will maintain its top spot, much to the chagrin of the US administration and their preference for a weaker USD.

Catching a falling knife

After a very long absence and much to the neglect to Econometer.org I am pleased to write a new post and apologise to those that subscribed to my blog, for the very long delay since my last post.   There is so much to say about the market turmoil at present, it is almost hard not to write something.

For those of you with eyes only on the continued strength in US stocks, which have hit record high after record high in recent weeks, it may be shocking news to your ears that the rest of the world, especially the emerging markets (EM) world, is in decidedly worse shape.

Compounding the impact of Federal Reserve rate hikes and strengthening US dollar, EM assets took another blow as President Trump’s long threatened tariffs on China began to be implemented.  Investors in countries with major external vulnerabilities in the form of large USD debts and current account deficits took fright and panic ensued.

Argentina and Turkey have been at the forefront of pressure due the factors above and also to policy inaction though Argentina has at least bit the bullet. Even in Asia, it is no coincidence that markets in current account deficit countries in the region, namely India, Indonesia, underperformed especially FX.  Even China’s currency, the renminbi, went through a rapid period of weakness, before showing some relative stability over recent weeks though I suspect the weakness was largely engineered.

What next? The plethora of factors impacting market sentiment will not just go away.  The Fed is set to keep on hiking, with several more rate increases likely over the next year or so.  Meanwhile the ECB is on track to ending its quantitative easing program by year end; the ECB meeting this Thursday will likely spell out more detail on its plans.  The other major central bank that has not yet revealed plans to step back from its easing policy is the Bank of Japan, but even the BoJ has been reducing its bond buying over past months.

The trade war is also set to escalate further.  Following the $50bn of tariffs already imposed on China $200 billion more could go into effect “very soon” according to Mr Trump. Worryingly he also added that tariffs on a further $267bn of Chinese goods could are “ready to go on short notice”, effectively encompassing all of China’s imports to the US.  China has so far responded in kind. Meanwhile though a deal has been agreed between the US and Mexico, a deal encompassing Canada in the form a new NAFTA remains elusive.

Idiosyncratic issues in Argentina and Turkey remain a threat to other emerging markets, not because of economic or banking sector risks, but due increased contagion as investors shaken from losses in a particular country, pull capital out of other EM assets.  The weakness in many emerging market currencies, local currency bonds and equities, has however, exposed value.  Whether investors want to catch a falling knife, only to lose their fingers is another question. which I will explore in my next post.

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