US Dollar Sliding, Gold At Record Highs

Risk sentiment has turned south and the US stock rotation out of tech into value has gathered pace, with the Nasdaq ending down for a second straight week.  Gold is turning into a star performer, registering a record high today, while the US dollar continues to lose ground.  Economic activity is slowing, second round virus cases are accelerating in places that had previously flattened the curve, while US- China tensions are heating up.  Attention this week will centre on US fiscal discussions while US-China tensions remain a key focal point.

Reports suggest that Senate Republicans and the US administration have agreed on a $1 trillion coronavirus relief package.  This will be the opening offer in discussions with Democrats (who had passed a $3 trillion package in House in May), with less than a week before unemployment benefits expire.  Whether the $1 trillion on the table will be sufficient to satisfy Democrats is debatable and a figure of around $1.5 trillion looks plausible. Time is running out and pressure to reach a compromise is growing.   Further uncertainty will likely weigh on US markets in the days ahead.

US-China tensions remain a key focus for markets. Worries about a dismantling of the Phase 1 trade deal still looks premature even as China has fallen behind in terms of purchasing US imports.  The closure of the US consulate in Chengdu following the closure of the Chinese consulate in Houston will be seen as a proportionate move, that is unlikely to escalate matters.  Nonetheless, a further escalation is inevitable ahead of US elections in November, with a broad array of US administration officials becoming more aggressive in their rhetoric against China.  As such, further sanctions against Chinese individuals and companies could be on the cards.

The week could prove critical for the US dollar given that it is breaching key technical levels against a host of currencies, with the currency failing to benefit from rising risk aversion recently. While not a game changer the European Union “recovery fund” is perceived as a key step forward for the EU, a factor underpinning the euro.  Key data and events over the week include the Federal Reserve FOMC meeting (Wed), US (Thu) and Eurozone Q2 GDP (Fri) and China purchasing managers indices (PMI) (Fri).  US Q2 earnings remain in focus too.  Before these data releases, today attention turns to the German IFO survey (consensus 89.3) and US durable goods orders (consensus 6.8%).

 

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.

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.

Everything But The Kitchen Sink

Since my last post there has been an even bigger onslaught of fiscal and monetary stimulus measures globally in an attempt to combat the devasting health and economic impact of COVID-19.  Fiscal stimulus in the US will amount to over 10% of GDP while the Federal Reserve’s balance sheet is set to grow further from an already large $6+ trillion at present as the Fed throws everything but the kitchen sink to combat the impact of the virus. There is already preparations underway for another phase of fiscal stimulus in the US.

Europe meanwhile, has struggled to agree upon a package given divisions between the North and South of the region, but eventually agreed upon EUR 500bn worth of fiscal stimulus while the ECB is undertaking renewed asset purchases in a new quantitative easing programme.  Many other countries have stepped up their efforts too.  All of this will provide an invaluable cushion, but will not prevent a massive economic downturn, nor will it stop the virus from spreading.

Markets have attempted to look past the growing economic risks, spurred by data showing that in many countries the rate of growth of coronavirus cases has slowed, including in those with a substantial number of deaths such as Italy and Spain.  Even in New York, which has been the epicentre of COVID-19 infections in the US, there are positive signs though it is an ominous sign that the US has now recorded the most deaths globally.

This move towards flattening of the curve has fuelled hopes that many countries will soon be able to emerge from lock downs.  In China, which was first in, most of the manufacturing sector has opened up, while there has even been some relaxation of measures to constrain movement of people.  The net result of all of the above last week, was the biggest weekly rally in US stocks since 1974.

While the 25%+ rally in US equities since their lows is reflecting this optimism, there is a major risk that this is a bear market rally given the risks ahead.  Economic growth estimates continue to be revised lower and the IMF’s revised forecasts scheduled to be published this week are likely to show a global economy on the rails, with growth likely to be at its worst since the Great Depression according to the IMF’s Managing Director.  Emerging markets, which do not have anywhere near the firepower or health systems of developed economies are particularly at risk.

At the same time earnings expectations have yet to reflect the massively negative impact on corporate profits likely in the months ahead; Q1 earnings to be released in the days ahead will be closely watched.  Not only are earnings expectations likely to be revised substantially lower, but many companies will simply not survive and many of those that do could end up in state hands if they are important enough.  Separately there is a risk that shutdowns last longer than expected or once economies begin to open up there another wave of infections.  These risk have not yet been fully appreciated by markets unfortunately.

Fed, ECB, UK elections In Focus

An event filled week lies ahead.  Several central bank decisions including the Federal Reserve FOMC (11th Dec), European Central Bank (ECB) (12 Dec) and Swiss National Bank (SNB)  (12 Dec) are on the calendar.  All of these major central banks are likely to leave policy unchanged and the meetings should prove to be uneventful.  Fed Chair Powell is likely to reiterate the Fed’s patient stance, with last Friday’s strong US November job report (payrolls rose 266k) effectively sealing the case for no change in policy at this meeting, even as a Phase 1 trade deal remains elusive.

Similarly recently firmer data in Europe have pushed back expectations of further ECB easing, though President Lagarde is likely to sound cautious highlighting her desire to maintain an accommodative monetary policy stance.  The picture is rather different for emerging market central banks this week, with policy easing likely from Turkey (12 Dec), Russia (13 Dec) and Brazil (12 Dec) while Philippines (12 Dec) is likely to keep policy unchanged.

UK general elections on Thursday will be closely watched, with GBP already having rallied above 1.30 vs USD as polls show a strong lead for Boris Johnson’s Conservative Party.  The main question is whether Johnson will have gained enough of a share of the vote to gain a majority, allowing him to push ahead with his Brexit plans, with Parliament voting to leave the European Union by Jan 31.

Polls may not be as accurate as assumed in the past given surprises over recent years including the Brexit vote itself, but the wide margin between the two parties highlights the relatively stronger position of the Conservatives going into the election.  Nonetheless, given that a lot is in the price already, the bigger (negative) reaction in GBP could come from a hung parliament or Labour win.

This week is also crunch time for a decision on the threatened December 15 tariffs on China.  As previously noted there is little sign of any deal on any Phase 1 trade deal.  It appears that issues such as the amount of purchases of US goods by China remain unresolved.  Recent comments by President Trump suggest that he is prepared to delay a deal even as far as past the US elections in November 2020.

Whether this is tactic to force China to agree on a deal or a real desire not to rush a deal is difficult to determine, but it seems as though Phase 1 will deal will not be signed this year given the limited time to do so.  December 15 tariffs could be delayed but this is also not guaranteed.  President Trump’s attention will also partly be on the potential for an impeachement vote in the House this week.

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