All Eyes On Jackson Hole

Following four weeks of gains, US equities lost ground last week while equity volatility (VIX) moved higher.  Equities look likely to struggle in the days ahead.  While investor participation in the rally has been limited amid thin summer liquidity, it has contributed to easing financial conditions, likely to the chagrin of the Fed.  However, nervousness ahead of the Jackson Hole symposium (25-27 Aug) has grown with many thinking Fed Chair Powell will sound hawkish. This has given risk assets pause for thought, helping US yields back up and the US dollar to reverse recent losses.  Indeed, the USD index (DXY) now has the 14 July high around 109.29 in its sights. 

Equities could struggle to push higher in the short term.  The 200-day moving average level around 4320 for the S&P 500 looks like it will provide resistance on the top side, while the relative strength indicator (RSI) suggests that the S&P 500 is close to overbought levels.   The narrative of a bear market rally remains in place and as economic conditions worsen, the outlook for earnings will also be less positive, potentially acting as a further drag on equity market sentiment.  A stronger dollar also acts as a headwind to US stocks. 

A plethora of Federal Reserve speakers has pushed back against more dovish market expectation, yet markets are still pricing in some Fed easing in the second half of 2023. At Jackson Hole, Fed Chair Powell is likely to reinforce the view that the Fed may still have to hike policy rates several more times in the months ahead and cut less quickly than markets expect next year.  As such, last week’s move ie. US dollar rally, US Treasury yields moving higher, and equities weakening, may extend further in the days ahead. 

Emerging market currencies in particular, had a poor week, with soft China data not helping.  Indeed, China’s July activity data were uniformly weak, highlighting that the economy is likely to fall well short of the official “around 5.5%” growth target for this year.  A heatwave in China is not helping.  Today’s small 5 basis points cut in banks 1 year loan prime rates and 15 basis points cut in the 5-year rate will do little to stimulate activity especially in the property market.  CNH has been impacted and is likely to fall further. A hawkish Powell may help to keep the pressure on emerging markets in the short term and limited policy action in China will do little to mitigate such pressures. 

Aside from Jackson Hole, key data and events this week include monetary policy decisions in Indonesia and Korea. Indonesia (Tue) is likely to keep its policy rate on hold while Korea (Thu) is likely to hike its policy rate by 25bp.  On the data front, US core Personal Consumption Expenditures (PCE) will likely reveal a sharper slowing in July compared to core CPI due to shelters weights (Fri) while purchasing managers indices (PMI) data globally will likely soften as growth pressures intensify, reflecting the slide towards or into recession in several economies including the US and Euro area. 

Going “The Extra Mile”

Risk assets ended last week on a soft note as Brexit uncertainties intensified amid a lack of progress towards a transition deal.  However, news overnight was a little more promising, as PM Johnson and EC President von der Leyen agreed to “go the extra mile” to try to agree up on a deal.  “Incremental” progress has reportedly been made and talks could now continue up to Christmas.  Sterling (GBP) rallied on the news and further gains are likely on any deal.  However, gains may prove short lived, with markets likely to focus on the economic difficulties ahead of the UK economy.  A no deal outcome is likely to result in a much sharper decline in GBP, however.

Progress towards fresh US fiscal stimulus progress faltered leaving US equity markets on shaky ground.  As it is, US stocks have struggled to extend gains over December after a stellar month in November and in recent days momentum has faded further.  Last week 9 out of 11 S&P sectors fell, suggesting broad based pressure.  Whether it is just a case of exhaustion/profit taking after solid year-to-date gains – for example, Nasdaq is up almost 38% and S&P up 13.4%, ytd – or something more alarming is debatable.  The massive amount of liquidity sloshing around and likely more dovishness from the Fed this week, would suggest the former.  

At the same time the US dollar (DXY) and broader BDXY are down almost 6% and 5% respectively, this year and most forecasts including our own look for more USD weakness next year.  Some of this is likely priced in as reflected in 27 straight weeks of negative aggregate USD (vs major currencies) positioning as a % of open interest (CFTC). The USD looks a little firmer this month, but gains are tentative and like equities this could simply reflect profit taking.  For example, in Asian currencies that have performed well this year such as the offshore Chinese yuan (CNH) and Korean won (KRW), fell most last week, partly due to increased central bank resistance. 

This week is a heavy one for events and data.  The main event on the calendar is the Federal Reserve FOMC meeting (Wed).  The Fed could include new forward guidance stating that quantitative easing (QE) will continue until there is clear-cut progress toward the employment and inflation goals.  The Fed may also lengthen the average maturity of asset purchases. Central bank decisions in Hungary (Tue), UK, Norway, Indonesia, Taiwan, Philippines (all on Thu), Russia, Japan and Mexico (all on Fri) will also be in focus though no changes in policy are likely from any of them.   On the data front China activity data (Tue), Canada CPI (Wed), US retail sales (Wed), and Australian employment (Thu) will be main highlights.

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.

Asian currencies vulnerable to equity outflows

Asian currencies are set to continue to trade cautiously. One big headwind to further appreciation is the fact that there has been a substantial outlook of equity capital over recent weeks. Over the last month to date Asian equity markets have registered an outflow of $3.3 billion in outflows. However, whilst Taiwan, South Korea, Thailand and India have seen outflows Indonesia, Philippines, and Vietnam have registered inflows.

The net result is that equity capital inflows to Asia so far this year are almost flat, a stark contrast from 2009 and 2010 when inflows were much higher at the same point in the year. The odds for further strong inflows do not look good, especially as the Fed ends QE2 by the end of June. While a sharp reversal in capital flows is unlikely, it also seems unlikely that Asia will register anywhere near as strong inflows as the last couple of years.

This will have a significant impact on Asian currencies, whose performance mirrors capital flows into the region. Almost all Asian currencies have dropped against the USD so far this month and could remain vulnerable if outflows continue. Given the relative stability of the USD over recent weeks and imminent end to QE2, the better way to play long Asia FX is very much against the increasingly vulnerable EUR.

The THB has been the worst performing currency this month but its weakness has been attributable to upcoming elections on July 3, which has kept foreign investor sentiment cautious. Thailand has seen an outflow of $812mn from its equity market this month. Polls show the PM Abhisit’s party trailing the opposition and nervousness is likely to persist up to the elections at least. THB weakness is not likely to persist over coming months, with USD/THB forecast at 29.2 by year end.

USD/KRW has been whipsawed over the past week but made up ground despite a continued outflow of equity capital over recent days. KRW has been particularly resilient despite a firmer USD environment and a drop in consumer sentiment in June. Next week the KRW will likely continue to trade positively, helped by a likely firm reading for May industrial production on Thursday. USD/KRW is set to trade in a 1070-1090 range, with direction likely to come from Greece’s parliament vote on its austerity measures.

TWD has traded weaker in June, having been one of the worst performing currencies over the month. USD/TWD does not have a particularly strongly correlation with movements in the USD or risk aversion at present but the currency has suffered from a very sharp outflow of equity capital over recent weeks (biggest outflow out of all Asian countries so far this month). Next week’s interest rate decision on Thursday by the central bank (CBC) will give some direction to the TWD but a 12.5bps increase in policy rates should not come as a big surprise. TWD is likely to trade with a weaker bias but its losses are likely to be capped around the 29.00 level versus USD.

Asian Currency Differentiation

Asian currencies have started the year in mixed form, but it would be wrong to generalize the performance of Asian currencies as weak. There have been marginal gains recorded year to date vs. USD in the KRW, TWD, MYR and SGD, reflecting strong capital equity inflows. This contrasts with losses in the IDR, INR, PHP and THB versus USD. Compared to the beginning of 2010 equity capital flows have been far weaker overall, with India, Indonesia, Philippines and Thailand, recording outflows, matching the performance of their currencies.

Clearly investors are discriminating more at the turn of 2011. For example Taiwan has recorded solid equity inflows over recent weeks (over $2 billion year-to-date), matching the strength of inflows registered at the beginning of 2010. It appears that Taiwan stocks have started the year as the Asian favorite, helped by growing expectations of further door opening to mainland investment and tourism. Korean equities have also registered inflows helping to support the KRW, which looks to be good buy over the short term above 1120.

This contrast with outflows registered in other Asian equity markets. A major concern responsible for some of the weakness in capital flows to Asia is the threat of inflation. For example, the selling of stocks in India appears to be closely related to inflation concerns and the hawkish rhetoric of the Reserve Bank of India, which is continuing its tightening path this year. Similarly, the PHP may be vulnerable over the short term following a failed T-bill auction on Monday. Inflation worries have clearly led to a push for higher yields but the bids were labeled as “unreasonable” by the government.

Over coming weeks, further EUR strength will likely give Asian currencies more support as the USD succumbs to further pressure. Continued strengthening in the CNY will also support other Asian currencies given that the CNY fixing has reached its highest level since the July 2005 revaluation.

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