Lingering Disappointment

Another soft close to US stock markets at the end of last week sets up for a nervous start to the week ahead.  The S&P 500 has now declined for a third straight week, with tech stocks leading the way lower as more froth is blown way from the multi-month run up in these stocks.  Lingering disappointment in the wake of the Federal Reserve FOMC meeting is one factor that has weighed on risk assets.  More details on how the Fed plans to implement its new policy on average inflation targeting will be sought. Markets will also look to see whether the Fed is pondering any changes to its Quantitative Easing program. This week Fed officials will get the opportunity to elaborate on their views, with several Fed speeches in the pipeline including three appearances by Fed Chair Powell. 

Disappointment on monetary policy can be matched with a lack of progress on the fiscal front, with hopes of an agreement on Phase 4 fiscal stimulus ahead of US elections fading rapidly.  A loss of momentum in US economic activity as reflected in the NY Fed’s weekly economic index and declining positive data surprises as reflected in the Citi Economic Surprise Index, are beginning to show that the need for fresh stimulus is growing.  On the political front, the situation has become even more tense ahead of elections; following the death of Supreme Court justice Ruth Bader Ginsburg attention this week will focus on President Trump’s pick to replace her, adding another twist to the battle between Democrats and Republicans ahead of the election.    

Another major focal point ahead of elections is US-China tensions, which continue to simmer away. China’s economy and currency continue to outperform even as tensions mount.  August’s slate of Chinese data were upbeat and China’s currency (CNY) is increasingly reflecting positive economic momentum, with the CNY CFETS trade weighted index rising to multi week highs.  There is every chance that tensions will only get worse ahead of US elections, likely as the US maintains a tough approach in the weeks ahead but so far Chinese and Asian markets in general are not reacting too much.  This may change if as is likely, tensions worsen further. 

After last week’s heavy slate of central bank meetings, this week is also going to see many central banks deliberate on monetary policy.  The week kicks off with China’s Loan Prime Rate announcement (Mon), followed by policy decisions in Hungary and Sweden (both Tue), New Zealand, Thailand, Norway (all on Wed), and Turkey (Thu).  Markets expect all of the central banks above to keep policy unchanged as was the case with the many central banks announcing policy decisions last week.  The lack of central bank action adds further evidence that 1) growth is starting to improve in many countries and 2) the limits of conventional policy are being reached.  While renewed rounds of virus infections threaten the recovery process much of the onus on policy action is now on the fiscal front. 

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.

Tough Times for the US Dollar

The US dollar had an awful July, with the USD index dropping by around 5% over the month, its worst monthly performance in 10 years. A range of factors can be cited for USD weakness including an asset allocation shift to assets outside of the US, worsening news on US Covid cases over recent weeks, improved risk appetite, US election concerns, lower real yields and fiscal cliff worries, among other factors.  Gold has been a particularly strong beneficiary of the malaise in the USD and declining real yield yields.  The Fed’s pledge to keep on aggressively supporting the economy and likely strengthening of forward guidance in the months ahead suggest that any increase in US interest rates could be years off.

It is still difficult to see the recent weakness in the USD resulting in a deterioration in its dominant reserve currency status though the longer the factors noted above remain in place, the bigger the danger to longer term confidence in the USD. As a reminder of such risks Fitch ratings downgraded US AAA credit rating to a negative outlook.  I do not expect markets and the USD to be impacted by the move, but it does highlight a worsening in US fundamentals.  While other currencies are still a long away from displacing the USD dominance in FX reserves, financial flows, FX trading and trade, the longer term risks to the USD are clear.

That said, the USD caught a bid at the end of last week resulting in a sharp retreat in the euro (EUR) from heavily overbought technical levels.  It is unlikely to be a coincide that this occurred as US Covid cases showed signs of peaking while cases in many parts of Europe began to accelerate, resulting in delays to opening up or renewed tightening of social distancing measures there.  US stocks have also continued to perform well, despite much discussion of a rotation to value stocks.  Solid earnings from US tech heavyweights solidified their position as leaders of the pack.  It is too early to say that this is the beginning of a USD turnaround, but the currency is heavily oversold in terms of positioning and technicals, which point to room for some respite.

Turning to the week ahead attention will be on July global Purchasing Managers Indices (PMI) data beginning with China’s private sector Caixin PMI (consensus 51.1), and the US ISM survey (consensus 53.6) tomorrow.  Central bank decisions include the Reserve Bank of Australia (Tue), Bank of England (Thu), Reserve Bank of India (Thu) and Bank of Thailand (Wed).  No change is likely from the RBA, BoE and BoT, but expect a 25bp cut from RBI.  At the end of the week two pieces of data will take precedence; US July jobs data and China July trade data.  US-China tensions will come under further scrutiny after President Trump vowed to ban TikTok in the US while pouring cold water on a sale to a third party.

 

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.

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