Calm after the storm

After yesterday’s carnage, global equity markets have recovered some of their poise. Whether this is a pause before another wave of pressure or something more sustainable is debatable. It appears that US equities are finally succumbing to a plethora of bad news.  Higher US yields have driven the equity risk premium lower.  Also there’s probably a degree of profit taking ahead of the onset of the Q3 US earnings season.

At the same time valuations have become increasingly stretched.  For example, the S&P 500 price/earnings ratio is around 6% higher than its 5 year average while almost all emerging market price/earnings ratios are well below their 5 year averages.  While strong US growth prospects may justify some or even all of this differential, the gap with emerging markets has widened significantly.

While US President Trump blames an “out of control” US Federal Reserve, it would have been hard for the Fed to do anything else but raise policy rates at its last meeting.  If the Fed didn’t hike at the end of September, bond yields would like have moved even higher than the 3.26% reached on the 10 year US Treasury yield earlier this week as markets would have believed the Fed is falling behind the curve.   However, as US yields rise and the equity risk premium reacts, the opportunity cost of investing in equities rises too.

In the FX world the US dollar could succumb to more pressure if US equities fall further but as we saw yesterday, USD weakness may mainly be expressed versus other major currencies (EUR etc).  Emerging market currencies continue to face too many headwinds including higher US rates and tightening USD liquidity, as well as trade tariffs.  The fact that emerging market growth indicators are slowing, led by China, also does not bode well for EM assets.  Unfortunately that means that emerging market assets will not benefit for the time being from any rout in US assets despite their valuation differences.

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Sour end to the week

It’s a sour end to the week for markets. Just as emerging markets (EM) were beginning to see some signs of stability, a surge in US Treasury bond yields (hitting a high of 3.23%) acted to fuel another round of pressure, pushing bond yields higher globally while denting equity market sentiment.   As a result EM equities took another beating and EM currencies fell against a resurgent USD.

The surge in US yields followed a run of strong US data including a gauge of service sector sentiment (ISM non-manufacturing index hit a new expansion high) and strong private sector jobs data (ADP jobs report).  Constructive comments from Fed Chairman Powell on the economy, supporting expectations that US interest rates will be hiked again in December, added to the upbeat mood on the economy.   At the time of writing attention is focused on the US September jobs report which is unlikely to detract from the upbeat US growth story.

US-China tensions are another factor weighing on sentiment.  While there has been no sign of any progress on trade talks even as the US agreed trade deals with Canada and Mexico, criticism by US Vice President Mike Pence on Chinese policy, has weighed on Asian markets.  There appears to be no sign of any appeasement between the two countries, suggesting that tensions will not easy anytime soon.

Any hope of a recovery in risk assets especially in emerging markets as we go into the final quarter of the year are beginning tofade.   After losing ground over much of September the USD has bounced back with a vengeance, while US assets continue to outperform much of the rest of the world, attracting even more capital.  While heavy long USD positioning and increasingly stretched US equity valuations hold risks against further gains in both, markets are not yet willing to run from US assets.

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.

Respite for Asian currencies

Pressure on policymakers in developed economies to orchestrate more predictable exits from unconventional monetary policies has intensified as reflected in comments at the Jackson Hole symposium the wake of the intense volatility in emerging market assets over recent weeks. While it is unlikely that a crisis is looming there is no doubt that mixed messages and lack of clarity over exit policies is having a demonstrable impact on EM assets.

Such clarity is unlikely to come this week. However, a pull back in core bond yields from recent highs will likely contribute to a calmer tone to markets at the turn of the week and some further near retracement in a positive direction for risk assets. Whether this lasts will depend on the clarity of the message from central bankers and in this respect speeches by four Fed officials over coming days, ECB’s Weidmann today and BoE governer Carney on Wednesday, will be scrtutinized.

The data slate is not particularly heavy but looks skewed towards relatively more positive Eurozone releases. In the US a likely drop in July durable goods orders today and pull back in consumer confidence tomorrow will provide little support to US asset markets including the USD while the trend of positive data surprises in Europe including likely gains in August economic sentiment indices and German IFO will add further evidence that growth will turn positive in Q3.

In Japan labor market data will reveal relative strength, with a low unemployment rate, helping to support the consumer. Inflation is set to rise further too, suggesting that policy measures are garnering some success. However, the upward trend in inflation is by no means guaranteed and ultimately renewed aggressiveness on the JPY will be needed as inflation tops out.

How will this leave currency markets? The USD is likely to continue to fare poorly against the EUR and GBP especially given the less than impressive data releases expected this week while the JPY is likely to remain on the back foot, pressured in part by firmer risk tone.

On the Asian currency front, further short term retracement is likely, especially for those currencies that have been beat up the most, namely INR and IDR. However, gains will likely prove limited, with tapering concerns and capital outflows showing little sign of reversing. Additionally, a likely disappointing Q2 GDP release in India at the end of the week will be unhelpful for the INR.

Global Themes

It’s definitely been a strange start to the year, with markets taking plenty of time to get their bearings. Some general themes have developed but none have provided clear direction. As a result, the path over coming weeks and months is likely to remain highly volatile and in this respect, currencies, equities and bonds will continue to see strong gyrations.

One theme that has been evident since the start of the year is an improvement in sentiment towards the eurozone periphery as hopes of an enlargement/extension of the European Union bailout fund (EFSF) have increased. This is a key reason why the EUR has strengthened this year although nervousness on this front appears to have returned over recent days (note the recent widening in peripheral bond spreads, drop in EUR and European Central Bank purchases of Portuguese debt). It seems that a lot of good news has already been discounted in relation to the eurozone periphery and now markets are in wait and see mode for the EU Council meeting on 24/25 March. There is a strong chance that eventually market expectations will prove overly optimistic and the EUR will drop but more on that later.

The second theme is global inflation concerns, driven by higher food and energy prices. Certainly this has had an impact on interest rate expectations and in some cases resulted in a hawkish shift in central bank language, notably in the eurozone and UK. Although European Central Bank (ECB) President Trichet has toned down his comments on tighter monetary policy compared to the more hawkish rhetoric following the last ECB council meeting, expectations for monetary tightening in the eurozone still look overly hawkish, with a policy rate hike currently being priced in for August/September this year, which looks way too early. The EUR has benefitted from the relative tightening in eurozone interest rate expectations compare to the US but will suffer if and when such expectations are wound down.

Elsewhere in many emerging markets the impact of higher food prices is finding its way even more quickly into higher inflation, forcing central banks to tighten policy. In Asia, the urgency for higher rates is even more significant given that real interest rates (taking into account inflation) are negative in many countries. China has accelerated the pace of its rate hikes over recent months and looks set to continue to tighten policy much further to combat inflation. In India, worries about inflation and the need for further monetary tightening have clearly weighed on equity markets, with more pain to come. Although not the sole cause by any means, in the Middle East and Africa higher food prices are feeding social tensions such as in Egypt.

Another clear theme that has developed is the improvement in US economic conditions. The run of US data over recent months has been encouraging, confirming that the economy is gaining momentum. Even the disappointing January non-farm payrolls report has not dashed hopes of recovery, with many other job market indicators pointing to strengthening job conditions such as the declining trend in weekly US jobless claims. Manufacturing, business and consumer confidence measures have strengthened whilst credit conditions are easing, albeit gradually. The US economy is set to outperform many other major economies this year, especially the eurozone, which will be beset with a diverging growth outlook between northern and southern Europe.

Although the US dollar has not yet benefitted from stronger US growth given the still dovish tone of the Fed and ongoing asset purchases in the form of quantitative easing, the rise in US bond yields relative to other countries, will likely propel the dollar higher over 2011 after a rocky start over Q1 2011. In contrast, the EUR at current levels looks too strong and as noted above, hopes of a resolution of eurozone peripheral problems look overdone. EUR/USD levels above 1.3500 provide attractive levels to short the currency. Other growth currencies that will likely continue to do well are commodity currencies such as AUD, NZD and CAD, whilst the outlook for Asian currencies remains positive even despite recent large scale capital outflows. The JPY however, will be one currency that suffers from an adverse yield differential with the US as US bond yields rise relative to Japan.

Econometer.org has been nominated in FXstreet.com’s Forex Best Awards 2011 in the “Best Fundamental Analysis” category. The survey is available at http://www.surveymonkey.com/s/fx_awards_2011

Q1 Economic Review: Elections, Recovery and Underemployment

I was recently interview by Sital Ruparelia for his website dedicated to “Career & Talent Management Solutions“, on my views on Q1 Economic Review: Elections, Recovery and Underemployment.

Sital is a regular guest on BBC Radio offering career advice and job search tips to listeners. Being a regular contributor and specialist for several leading on line resources including eFinancial Careers and Career Hub (voted number 1 blog by ‘HR World’), Sital’s career advice has also been featured in BusinessWeek online.

As you’ll see from the transcript of the interview below, I’m still cautiously optimistic about the prospects for 2010 and predicts a slow drawn out recovery with plenty of hiccups along the way.

Sital: Mitul, when we spoke in December to look at your predictions for 2010, you were cautiously optimistic about economic recovery in 2010. What’s your take on things after the first quarter?

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Who’s going to follow in Brazil’s footsteps?

Last week saw a sell off in some emerging market currencies and whilst this may simply have been profit taking attributable to some large hedge funds it did coincide with the imposition of a tax on portfolio inflows in Brazil.  The tax dented sentiment as it quickly fuelled speculation that it would be followed elsewhere, especially in countries that had seen rapid FX appreciation.  

The BRL is one of the best performing currencies this year against the USD whilst the stock market has surged on strong capital inflows.  The huge increase in USD liquidity globally and substantial improvement in risk appetite has fuelled strong capital inflows into Brazil especially as the country has proven to be one of the most resilient during the crisis.

Although on the margin the tax will have a negative impact on speculative flows into Brazil it is unlikely to have a lasting impact.  Previous such measures have done little to prevent further appreciation.  The BRL is clearly overvalued by around 25-30 at present, but the tax in itself will not be sufficient to result in a move back to “fair value”. 

At best it may act a temporary break on currency appreciation and could limit the magnitude of further gains in the real but this could be at the cost of distorting resource allocation and market functioning.   The longer term solution is to enhance productivity but this will not help in the interim. The tax may make investors a little more reluctant to pile into Brazilian assets, which is what the authorities will desire but already the BRL is back on its appreciation path suggesting a short lived reaction. 

Other countries that could follow include South Africa, Turkey or South Korea but South Africa has already denied that it has any plans to move in this direction.  In South Korea’s case the central bank has chosen to intervene in currency markets to prevent the further strengthening in the won but that also has implications for sterilizing such flows limiting the extent that intervention can be carried out.    

The bottom line is that the broad based improvement in risk appetite is proving to be a strong driver of capital flows into emerging markets and the reality is that many emerging economies such as Brazil and many in Asia have been much more resilient than feared. 

Although there is clearly a limit on the extent that these countries want to allow their currencies to strengthen versus USD the upward pressure will continue, leading to more FX intervention and potential imposition of taxes or restrictions such as implemented in Brazil.   Despite this the outlook for most emerging currencies remains positive and the authorities will face an uphill struggle. 

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