Saturated by good news

We are currently moving into an environment where economic data is becoming less and less influential in moving markets and this could continue for some weeks.  The bottom line is that so much recovery news is in the price that the continuing run of better than forecast data are having only a limited impact.  Over recent days this run has included firmer than forecast readings on US manufacturing sentiment, consumer sentiment, housing activity and durable goods orders.  The market has become saturated with good news and is showing signs of fatigue.  

Just take a look at the reaction to the latest numbers. Equity markets barely flinched in reaction to positive data including a surge in new home sales and a jump in durable goods orders.  In Europe, the German IFO recorded its biggest increase since 1996.  Perhaps the subdued market reaction was due to the details of some of the reports which could have been considered as not as upbeat as the headlines suggested.  However, this explain is tenuous at best.  

News that China’s state council is studying restrictions on overcapacity in industries including steel and cement will not have helped market sentiment as concerns about Chinese growth are likely to resurface. Nonetheless, the most likely explanation for the lack of momentum in markets is fatigue.  There have been plenty of positive data surprises over recent weeks and markets have become increasingly desensitised to such news. 

Another explanation of the failure of positive data to boost sentiment is that risk appetite is almost back to pre-crisis levels according to many indicators I follow.  Indeed, further impetus for risk currencies will be more limited in the months ahead as the room for a further decline in risk aversion is becoming more limited.

This combined with growing fatigue will have interesting consequences. Firstly it suggests a degree of dollar and yen resilience over coming weeks and growing pressure on risk trades, especially commodity currencies which will suffer disproportionately to fears about Chinese growth and lower commodities demand. 

Nonetheless, consolidation in the weeks ahead rather than any sharp moves is the most likely path.  Although the overall trend of improving risk appetite will continue it is already becoming evident that it will take a lot more to drive risk appetite higher than a steady stream of data showing that the global economy is turning around. In any case, currencies have become less sensitive to the gyrations in risk suggesting that other influences will be sought in the months ahead.  In the meantime range trading will continue. 

The reduced swings in currencies have taken FX largely off the radar as far as policy makers are concerned and it is difficult to see the topic being a major issue at upcoming policy meetings. Lower currency volatility is clearly a boon for policy makers and reflects some “normalisaiton” in currency markets. It perhaps also reflects the fact that FX valuations are less of out synch than they were a few months back, with the USD far less overvalued against many currencies.

Risk appetite dented

The surprise decline in the Michigan reading of US consumer confidence which dropped to 63.2 in August put a dampener on risk appetite at the end of last week helping to fuel a sea of red for most US and European equity markets at the close of play on Friday.   Nonetheless, FX markets remained range-bound, albeit with the dollar taking a firmer bias at the end of the week.

The impact of the drop in confidence is likely to prove short lived as risk appetite continues to improve this week although don’t look for big market moves as summer trading conditions continue to dominate.  For the most part the data releases should not throw any spanners in the works over coming days as a positive tone to data is set to be retained.  

The highlights this week include more GDP data from Japan and Norway following surprise increases in growth from Germany and France in Q2 last week.  Japan’s release showed a marginally softer than expected 0.9% QoQ increase in GDP with growth led by external demand and government stimulus measures.  In contrast, capital spending continued to remain weak.  

US numbers are set to show further improvement as likely reflected in manufacturing surveys including the August Empire survey and the Philly Fed.  Similarly housing data including housing starts and existing homes sales will point to more stabilisation whilst Fed Chairman Bernanke is set to deliver a similar tone to the recent FOMC statement. 

The highlight of the European calendar is the German ZEW survey and flash August PMIs.  Firmer equities point to a higher ZEW whilst manufacturing indices are likely to reveal a slower pace of contraction.  In the UK the minutes of the BoE MPC meeting are likely to reveal a unanimous vote for extending QE policy. 

On balance, the beginning of the week is likely to see a bit of a risk aversion led sell off in risk currencies including commodity currencies such as the Australian and NZ dollars as well as weaker Asian currencies led by the likes of the Korean won but the pressure is unlikely to last for long.  Nonetheless, Commodity currencies will face another layer of pressure from the sharp drop in commodity prices at the end of last week as reflected in the drop in the CRB index.

News flow to remain volatile

In past posts I wrote that it will take positive news as opposed to less negative news to drive the rally in equity and credit markets forward.   Although I remain doubtful about the durability of the rally over coming months, there has been good news on the earnings front up until now, and equities have rallied strongly as a result.

Of the S&P 500 companies reporting Q2 earnings 74% have beaten forecasts.  Although there are still many companies scheduled to release earnings, if this pattern continues it would be the highest on record.  Data releases have also given reason for optimism even in Europe where manufacturing gauges and the closely watched German IFO showed some improvement.

Unfortunately, the news was not all unidirectional as Amazon and Microsoft spoiled the party somewhat with their below forecast earnings.  US consumer confidence dropped for the first time in 5 months according to the Michigan survey as rising unemployment in particular weighed on sentiment.  Meanwhile, in the UK GDP data revealed the severe and broad based nature of the recession.

The news flow will continue to remain volatile in the weeks ahead.  The bottoming out process for many economies will be drawn out and rising unemployment and tight credit will act to restrain consumers.  Banks will face spiralling defaults on credit cards and increasing loan delinquencies as some recent earnings have revealed.

Unlike past recessions emerging markets are leading the recovery, especially in Asia as recent data has revealed.  Nonetheless, unless the developed country consumer engine kicks back into life the sustainability of Asian and emerging market recovery remains in doubt.

It is telling that currency markets are not reacting too sharply to the recent positive earnings news.  On balance the usual losers, dollar and yen, in an environment of improved risk appetite, have come under pressure.  In contrast, risk currencies such as the Australian, NZ and Canadian dollars have strengthened. Other high beta currencies are also stronger. Nonetheless, for the most part currencies remain in well worn ranges and as liquidity thins further over summer, there appears to be little scope for new trends in FX markets.

I still favour some dollar resilience over coming weeks as renewed market doubts creep but this view is becoming increasingly difficult to hold.  The reality is that currencies will track equities, which in turn will be dependent on earnings.   If the current earnings trend continues the dollar will face even more pressure but not to the extent that it breaks out of recent ranges.

Watch out for the pitfalls in H2 2009

Equity and credit markets have begun the second half of 2009 looking quite fatigued, which is not a good sign ahead of the Q2 earning season.   Perhaps the fact that markets have come so far in such a short period of time has itself prompted a pause. An alternative explanation is that the summer lull is kicking in, with many investors taking the end of H1 2009 as an excuse to book profits and wait until activity picks up again post summer holidays.  A more worrying and more likely explanation is that the massive improvement in market sentiment seen in H1 2009 is  giving way to uncertainty.

Relief that there will be no collapse of the global financial system is not sufficient to keep the momentum in equity and credit markets going into the second half of the year. Until now there has been plenty of less negative news and use of the now worn phrase “green shoots”, but little information to judge the magnitude and speed of recovery going forward.

There are plenty of factors that will dampen recovery in the months ahead. Higher unemployment, massive wealth loss and increased savings will provide a clear downdraft to the global economy. Banks will be increasingly laden with bad loans due to credit card delinquencies, commercial real estate defaults and other sour loans and are unlikely to step up lending in a hurry. In addition, it is still unclear how quickly toxic debt will be removed from banks’ balance sheets, which will act as another impediment to recovery.

Risks outside the US remain significant. Although the outlook for China is improving it is unclear whether the momentum of growth in the country will continue once current stimulus measures are utilised. Much will also depend on whether China and other export economies can shift growth impetus from external demand to domestic demand.

Moreover, concerns about the dollar’s use as a reserve currency continue to intensify as various large reserve holders attempt to diversify away from the dollar.  Although a dollar collapse is unlikely the risk that foreign investors reduce their exposure to US Treasuries remains a threat to the dollar.   This could push up long term interest rates and in turn mortgage rates in the US.  

The European economy is a particular riskto global recovery, with only a gradual recovery expected.  In particular, the biggest Eurozone economy Germany is struggling in the wake of a collapse in exports and a lack of domestic demand. Moreover, banking sector issues remain unresolved especially as there has been little information on European bank stress tests. The relative strength of the euro and inability of some countries in the Eurozone to devalue their way out of the downturn will also dampen recovery prospects.   These factors suggest that Europe will lag the recovery in other countries such as the US and UK where the policy response has arguably been more aggressive.  

The jobs market will lag the recovery process but there are signs that things are becoming less severe.  The pace of job losses in many countries is lessening.   In the US for example, non farm payrolls report revealed that average monthly job losses in the second quarter of 2009 at 436k were much lower than the 691k average monthly job losses in the first quarter.  The bad news however, is that unemployment rates continue to rise.  In the US the unemployment rate is likely to head to around 10% from 9.5% currently and this will be echoed in Europe where the unemployment is at a 10-year high of 9.5% currently. 

The bottom line is that the market rally may have been justified so far but there is little to carry the momentum forward. Equity valuations dropped to low levels in March but can be hardly considered cheap at present. The improvements in indicators of market stress have also reached dramatic levels and going forward there will be plenty of pitfalls in the months ahead.

What the G8 communiqué didn’t say

There was a stark contrast between the outcome of the weekend’s G8 meeting in Lecce, Italy, and April’s G20 summit in London.  For a start, the tone was far more positive than in London, with Finance Minsters attending the meeting indicating that economic forecasts may need to be revised upwards rather than the steady stream of downward revisions seen over recent months.

The overall tone was one of cautious optimism.  The communiqué noted “there are signs of stabilization in our economies, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence”.  However, at the behest of the UK the comments “but the situation remains uncertain and significant risks remain to economic and financial stability” was inserted into the final communiqué.   Such an inclusion is logical and at least suggests that officials are not getting to carried away with the improvement in recent data. 

Officials also began discussing “exit strategies” in terms of withdrawing massive global monetary and fiscal stimulus and even requested the IMF look at the issue in more detail.  Whilst it is premature to even discuss exit strategies the comments were clearly aimed at easing bond market concerns about widening fiscal deficits and inflation risks.  As Tim Geithner highlighted, recovery would be stronger if “if we make clear today how we get back to fiscal sustainability when the storm has fully passed”.   Nonetheless, a mere discussion about exit strategy is highly unlikely to remove the current angst that has built up in bond markets globally. 

Additionally, the communiqué included a commitment to develop standards governing the conduct of international business and finance, international regulatory reform, exchange of information for tax purposes and a commitment to refrain from protectionism.   None of these points will move markets this week and all were unsurprising discussion points. 

So what was missing?  The issue of stress tests on European banks was left out of the final communiqué even though it was discussed at the meeting. Reported disagreements with Germany and France over transparency over the publication of stress test results meant that an agreement could not be reached.  This is a big disappointment.  I have written about the issue in two previous posts “European economy in a whole lot of trouble” and “Stress testing European and UK banks” on my blog Econometer.   The fact that more wasn’t done will mean that uncertainty about the health of balance sheets in particular of banks in Germany will remain a constraint to European recovery.  At the least it will make it increasingly likely that in addition to a sharp decline in European growth this year GDP could also drop in 2010.

In addition, economic data continues to lag in the Eurozone compared to the improving signs in the US and elsewhere as highlighted by the huge 21% annual drop in April Eurozone industrial production at the end of last week.  This data even led to another omission with reference to “encouraging figures in the manufacturing sector” previously included in the draft dropped in the final communiqué.   It is clearly too early to talk about manufacturing recovery.

Also missing in the final communiqué was any reference to currencies. Although it was always unlikely that FX would be a major topic at the meeting due to the absence of central bankers attending, the drop in the dollar and concerns from foreign official investors (see a recent post on my blog “Are foreign investors really turning away from US debt”) raised the prospect that there would be some international backing of the US “strong dollar” policy led by the US. 

In the event there wasn’t any comment, but dollar positive comments on the sidelines of the meeting will likely limit any pressure on the dollar this week.  The dollar will be helped by comments on the sidelines of the G8 meeting as well as important comments from Russian Finance Minister Kudrin who stated that he has full confidence in the dollar with no immediate plans to move to a new reserve currency. Ahead of the meeting of BRIC countries this week the comments from Russia add further evidence that there will be no plan to move away from the dollar. Moreover, geopolitical tensions including the protests over the results of Iran’s elections as well as more jawboning from North Korea will work in favour of the dollar this week. 

The euro could look especially vulnerable this week. The lack of attention on European banks stress tests will be a disappointment for those hoping for more transparency and will act as a further drag on the euro.  This is likely to see the euro struggle to make much headway this week, with the recent high above 1.43 likely to provide tough resistance to any move higher in EUR/USD, with a bigger risk of a pull back towards the 1.37-1.38 levels.

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