Not much good news

There are a plethora of issues weighing on asset markets though sentiment has improved slightly today.  Weak Chinese trade data over the weekend and a revision lower to Japanese GDP data yesterday added to growing global growth concerns, against the background of waning hopes of a resolution to the US-China trade war.

US administration comments that there was a hard deadline for trade talks have not helped sentiment either.  News today that Chinese Vice Premier Liu He spoke with US Treasury Secretary Mnuchin and US Trade Rep Lighthizer on a timetable and road map on trade talks provided some relief, however.

In the US, growth expectations are undergoing a shift and talk of a Fed pause is growing.  This would be considered as good news for EM if it wasn’t for the fact that a pause could be due to US growth concerns rather than any sense that the Fed was approaching its terminal rate.  US November CPI, retail sales, and industrial production data will give more clues, but I still think the Fed policy rates next week.

In the UK, Brexit worries have intensified following the decision by Prime Minister May to the delay the vote on a deal in parliament given she would most likely would have faced a defeat had it gone ahead.  May will now go on a tour of European capitals to try to improve the Brexit deal but prospects don’t look good, especially as European Council president Tusk has already ruled out any negotiation of the deal and in particular the Irish backstop.

GBP was pummeled as a result of the delay and will continue to struggle in the short term given the lack visibility.  A revised deal appears difficult while a hard Brexit and even a new referendum are all on the table.

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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.

US dollar weakness providing relief

The US dollar index has weakened since mid-August 2018 although weakness in the broad trade weighted USD has become more apparent since the beginning of this month.  Despite a further increase in US yields, 10 year treasury yields have risen in recent weeks to close to 3.1%, the USD has surprisingly not benefited.  It is not clear what is driving USD weakness but improving risk appetite is likely to be a factor. Markets have been increasingly long USDs and this positioning overhang has also acted as a restraint on the USD.

Most G10 currencies have benefitted in September, with The Swedish krona (SEK), Norwegian Krone (NOK) and British pound (GBP) gaining most.  The Japanese yen (JPY) on the other hand has been the only G10 currency to weaken this month as an improvement in risk appetite has led to reduced safe haven demand for the currency.

In Asia most currencies are still weaker versus the dollar over September, with the Indian rupee leading the declines.  Once again Asia’s current account deficit countries (India, Indonesia, and Philippines) have underperformed most others though the authorities in all three countries have become more aggressive in terms of trying to defend their currencies.  Indeed, The Philippines and Indonesia are likely to raise policy interest rates tomorrow while the chance of a rate hike from India’s central bank next week has risen.

As the USD weakens it will increasingly help many emerging market currencies.   The likes of the Argentinian peso, Turkish lira and Brazilian real have been particularly badly beaten up, dropping 51.3%, 38.5% and 18.8%, respectively this year.  Although much of the reason for their declines have been idiosyncratic in nature, USD weakness would provide a major source of relief.  It’s too early to suggest that this drop in the USD is anything more than a correction especially given the proximity to the Fed FOMC decision later, but early signs are positive.

 

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.

Equities weaker, US yields lower, USD softer

The US Federal Reserve’s rejection of capital raising plans by several banks taken together with further confrontation between the US and Russia and a disappointing US durable goods orders report were sufficient to result in a sell off in equity markets, lower US yields and a weaker USD.

Gold failed to benefit in yet a further sign that its bull run has ended, with the metal honing in on its 200 day moving average at 1296.71. On the US data front headline February US durable goods orders beat expectations (2.2%) but core orders (-1.3%) were weaker than expected.

Although the lead for Asia is a weak one markets may still find some resilience due to expectations of policy stimulus from China. Similarly dovish talk from the European Central Bank will offer further support to market sentiment while undermining the EUR somewhat. On the data front today the main releases are US Q4 GDP revision (upward revision likely), and UK retail sales (rebound likely).

Chronology of a Crisis – endgame?

Please see below an extract from my forthcoming book Chronology of a Crisis (Searching Finance 2012).

The departure of Greece from the Euro is by no means a forgone conclusion but if it happens it is not clear that global policy makers have much ammunition left to shield markets from the resulting fallout.

Stimulus after stimulus has only left governments increasingly indebted. The price of such largesse is now being paid in the form of higher borrowing costs. Even central banks do not have much ammunition left. Admittedly further rounds of quantitative easing, and central bank balance sheet expansion may help to shore up confidence but the efficacy of such policy actions is questionable. Moreover, policy support may only help to buy time but if underlying structural issues are not resolved pressure could resume quickly.

Against this background Europe is under intense pressure and there is little time left before it results in something catastrophic for global markets via a disorderly break up of the Eurozone. EU leaders and the European Central Bank (ECB) have to act to stem the crisis. However, at the time of writing the ECB under the helm of Mario Draghi is steadfastly refusing to provide further assistance to the Eurozone periphery either directly via lower interest rates or securities market purchases or indirectly via another Long term refinancing operation (LTRO). Any prospect of debt monetization as carried out already by other central banks including the Fed and Bank of England is a definite non-starter. The reason for this intransigence is that the ECB does not want to let Eurozone governments off the hook, worrying that any further assistance would allow governments to slow or even renege upon promised reforms.

Whether this is true or not it’s a dangerous game to play. The fact that the previously unthinkable could happen ie a country could exit the Eurozone should have by now prompted some major action by European officials. Instead the ECB is unwilling to give ground while Germany continues to stand in the way of any move towards debt mutualisation in the form of a common Eurobond and/or other measures such as awarding a banking license to the EFSF bailout fund which would effectively allow it to help recapitalize banks and purchase peripheral debt. Germany does not want to allow peripheral countries to be let off the hook either, arguing that they would benefit from Germany’s strong credit standing and lower yields without paying the costs.

To be frank, it’s too late for such brinkmanship. The situation in The Eurozone is rapidly spiraling out of control. While both the ECB and Germany may have valid arguments the bottom line is that the situation could get far worse if officials fail to act. As noted above there are various measures that could be enacted. Admittedly many of these will only buy time rather than fix the many and varied structural problems afflicting a group of countries tied together by a single currency and monetary policy and separate fiscal policies but at the moment time is what is needed the most. Buying time will allow policymakers to enact reforms, enhance productivity, reform labour markets, increase investment funds etc. Unfortunately European policy makers do not appear to have grasped this fact. Now more than at any time during the crisis much depends on the actions of policy makers. This is where the major uncertainty lies.

If officials do not act to stem the crisis, economic and market turmoil will reach proportions exceeding that of even the Lehmans bust.

Is gold losing its lustre?

Hopes and expectations of more Fed quantitative easing in the wake of a run of weak US data, including the US May jobs report, has been attributable to the bounce in gold prices over recent weeks. However, Fed Chairman Bernanke dampened such hopes in his speech to Congress, in which he did not indicate a desire to move towards more QE. The Fed is unlikely in my view to embark on more QE any time soon.

Clearly, should the Fed implement more QE it will help to renew the attraction of gold. Once again markets will see the consequences of Fed QE as a means to debase the USD. A shift in Fed stance cannot be ruled out if US economic conditions worsen further and/or the Eurozone crisis escalates. Assuming no more QE and no more USD debasement, gold prices ought to decline over coming months.

One of the biggest factors putting downward pressure on gold prices has been the strength of the USD. While I do not expect the USD to continue to strengthen at the same pace as it has done recently, further gradual gains in the currency are likely. My FX forecasts predict a further small gain for the USD index by the end of the year but I also believe that the recent run up in the USD may have been too rapid. Assuming that the USD continues on a gradual upward trajectory I expect it to exert a negative influence on gold prices.

Gold appears to have lost its sensitivity to risk aversion. Indeed, gold’s relationship with risk has actually inverted over recent months, with a negative but significant relationship registered over the past 3 months between gold prices and my Risk Aversion Barometer. In other words as risk aversion goes up, gold prices actually drop.

The lack of reaction to higher risk aversion shows that the lustre of gold as a safe haven has faded as investors pull capital out of this as well as many other asset classes. However, gold’s drop is not unusual when compared to other commodity prices, with oil and copper prices falling too and gold maintaining a strong correlation with these commodities.

Some deterioration in sentiment towards gold prices has been reflected in the drop in speculative appetite for the commodity. Speculative demand for gold hit a cyclical high in August 2011 but since then there has been a steady reduction in appetite for gold from these investors. Indeed, CFTC IMM data reveals that speculative gold positioning dropped well below its three-month average. However, positioning is still well above its all time lows reached in February 2005, suggesting if anything, there is scope for more declines.

On top of the drop in speculative appetite for gold the technical picture has turned bearish. Since March 2009 at the height of the financial crisis the 100 day moving average price of gold had been trading above the 200 day moving average. On 27 March 2012 the 100 day moving average crossed below the 200 day moving average. Moreover, gold is now trading below both the 100 and 200 day moving average prices which sends a bearish technical message. Over the near term some key levels to look for are the 100 day moving average around 1658 on the topside and trendline support around the 1530 level on the bottom.

Another determinant of gold prices is demand from India and China. Growth in both countries is slowing, suggesting that gold demand is also weakening. While I certainly do not expect a collapse in demand from either country I have no doubt that compared to last year the strength of demand will be softer over coming months. Although I still look for a soft landing in China the Indian economic picture has clearly deteriorated while the Indian rupee has weakened. A weaker INR means that has become increasingly more expensive to import gold to India for domestic purchasers.

Overall, a weaker real demand picture taken together with reduced speculative appetite implies little support for gold prices. Moreover, a firmer USD in general will continue to weigh on prices. Perhaps a dose of inflation would help gold prices but there is little risk of this given the still sizeable amount of excess capacity in major economies.

Uncertainty about QE will help to limit any downside pressure on gold prices but elevated risk aversion will provide little assistance to gold. If however, the Eurozone and global picture deteriorates further gold will find itself with a lifeline but only if this means more currency debasement and a Fed engineered lower USD. If not, a further decline is on the cards and I forecast a drop in gold prices to around USD 1475 by the end of the year.

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