Will Stability Return?

After a very nervous end to last week, with US tech stocks leading the sell-off in US equity markets amid lofty valuations, heavy positioning and stretched technical indicators, markets will look for signs that stability will return in the days ahead.  However, the November US election is increasing in prominence as a market driver, something that is beginning to manifest itself in equity volatility and will likely play more of a role for FX and rates markets volatility going forward. 

The fact that there has been little progress between Democrats and the US administration on further fiscal stimulus adds to the uncertainty for markets ahead of US elections.  Also after Fed Chair Powell’s Jackson Hole speech in which he unveiled a new average inflation strategy, markets will look for this to be reflected in forward guidance. This could happen as early as this month’s FOMC meeting on September 16 but will more likely take place later.

After a torrid several weeks the US dollar made some recovery last week amid short covering, but underlying sentiment remains weak (latest CFTC IMM data shows speculative USD positioning languishing around multi-year lows).  Whether the USD can make a more sustainable recovery remains doubtful in the weeks ahead of US elections and is more difficult given the Fed’s more dovish shift.  However, in the near term there may be more scope for short covering.

Key highlights this week are China Aug trade data today, US Aug CPI (Fri), Bank of Canada meeting (Wed), European Central Bank (ECB) and Bank Negara Malaysia (Thu).  Among these the ECB meeting will be interesting; while a policy change is unlikely the ECB will probably highlight its readiness to act further to address downside inflation risks.  The ECB may also be more vocal about the recent strengthening of the euro to a two-year high, but aside from jawboning, there is little the ECB is likely to do about it. 

Emerging markets assets have benefitted from a weaker USD and but with growth remaining under pressure as likely to be revealed in weak Russian and South African GDP data this week while Covid cases in many EM countries continue to rise rapidly, risks remain high.  China’s trade data will give some early direction this week, but with US-China trade tensions only likely to escalate further, the outlook for emerging markets assets is clouded in uncertainty. 

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.

 

US-China tensions – Risks of a body blow to markets

Tensions between the US and China are once again escalating, resulting in growing nervousness in markets and raising concerns of a further deterioration in global trade at a time when the world is increasingly reeling from the devastating economic impact of Covid-19.   As many countries open up their economies hopes that activity can finally begin to resume, has strengthened.  However, the economic cost is still mounting and as revealed in awful economic data globally over recent weeks the picture is a horrible one.

It will be a fine balancing act for the US administration between imposing more trade tariffs and in turn hurting US importers on the one hand and punishing China for accusations of concealing information about spreading Covid-19 on the other.  President Trump recently threatened to “cut off the whole relationship” with China, which threatens the “Phase 1” trade deal reached at the beginning of this year.   Recent moves by the US administration include instructing a federal pensions fund to shift some investments in Chinese stocks and tightening export controls on Chinese telecoms company Huawei and its suppliers, which the US administrations says are contrary to US national security.

However, the White House may want to keep trade separate from other measures including tighter export controls and investment restrictions.  Indeed recent talks between senior US and Chinese officials on implementing the Phase 1 deal appeared to be cordial and constructive while Larry Kudlow, director of the National Economic Council said on Friday that the trade deal is continuing.  This is logical.  Renewed tariffs on imports from China would hurt the US consumer, while likely retaliation from China would mean any chance of China increasing its purchases of US goods as part of the Phase 1 deal would disappear, inflicting more pain on the US economy.

One other major consequence of a new round of US tariffs on China would likely be a weaker Chinese currency.  So far China has avoided weakening the yuan, which could also provoke increased capital outflows from China (as it did in Jan 2015 and mid 2016) and a drain on FX reserves at a time when Chinese growth is slowing sharply.  However, China may yet opt for a sharp depreciation/devaluation of the yuan to retaliate against fresh tariffs and to support its exporters as it did when the US first imposed tariffs on the country.  Although this comes with risks for China as noted above, if it was sold as a one off move and was well controlled, it need not fuel an increase in capital outflows from China. This is something that the US will wish to avoid.

Although the US may want to avoid trade as the primary target of any pressure on China, this does not mean that tensions will not increase.  In fact it is highly likely that the relationship between the US and China will worsen ahead of US elections in November, especially as it is one issue which garners broad support among the US electorate. As such, US measures will likely skirt trade restrictions but will most probably involve a whole host of other measures including tightening export controls, student visa restrictions, investment restrictions, and other such measures.  Markets hardly need a reason to be nervous, but after a multi week rally, this is an issue that could prove to be a major body blow to risk assets.

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.

Eurozone contagion spreading quickly

Contagion from the eurozone debt crisis is spreading quickly, threatening to turn a regional crisis into a global crisis. As highlighted by Fitch ratings further contagion would pose a risk to US banks. Consequently risk assets continue to be sold but interestingly oil prices are climbing. Taken together with comments earlier in the day from the Bank of England that failure to resolve the crisis will lead to “significant adverse effects” on the global economy, it highlights the risks of both economic and financial contagion.

Predominately for some countries this is becoming a crisis of confidence and failure of officials to get to grips with the situation is resulting in an ever worsening spiral of negativity. Although Monti was sworn in as Italian Prime Minister and Papademos won a confidence motion in the Greek parliament the hard work begins now for both leaders in convincing markets of their reform credentials. Given that there is no agreement from eurozone officials forthcoming, sentiment is set to worsen further, with safe haven assets the main beneficiaries.

EUR/USD dropped sharply in yesterday’s session hitting a low around 1.3429. Attempts to rally were sold into, with sellers noted just below 1.3560. Even an intensification of bond purchases by the European Central Bank (ECB) failed to prevent eurozone bond yields moving higher and the EUR from falling.

Against this background and in the absence of key data releases EUR will find direction from the Spanish 10 year bond auction while a French BTAN auction will also be watched carefully given the recent increase in pressure on French bonds. Having broken below 1.3500, EUR/USD will aim for a test of the 10 October low around 1.3346 where some technical support can be expected.

US data releases have been coming in better than expected over recent weeks, acting to dampen expectations of more Fed quantitative easing and in turn helping to remove an impediment to USD appreciation. While the jury is still out on QE, the USD is enjoying some relief from receding expectations that the Fed will forced to purchase more assets. Further USD gains are likely, with data today including October housing starts and the November Philly Fed manufacturing confidence survey unlikely to derail the currency despite a likely drop in starts.

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