Host Of Central Banks In Focus

Well, last week, tech stocks had their worst week since March, with stability far from returning.  While the jury is still out, most still view the pull back in tech stocks as a healthy correction following a prolonged period of gains, blaming increased options activity over recent months for the magnitude of the decline. The buy on dip mentality is likely to continue to prevail, though tech stocks have not yet show any sign of wanting to make a convincing pull back.   

Signs of nervousness are clear; equity volatility remains elevated, but many investors are still sitting on healthy gains over recent months.  Given the low cost of funding, low returns in government bonds, alongside continued strong demand for stay at home electronics and a vaccine that could still take months to arrive, it is hard to see the tech sector falling too far.   

The fall in the pound sterling has been quite dramatic over recent weeks, both against the US dollar and euro.  Fears over a collapse in trade talks with the European Union have intensified.  The sudden waking up of the market to these risks has been provoked by the prospects that the withdrawal agreement with the EU will be torn up, prompting threats of legal action by the EU.

Time is running out to get a deal on the table before the end of the Brexit transition period at the end of the year, but UK Prime Minister Johnson has said that the internal market bill is necessary to prevent “a foreign of international body from having the power to break up our country.” The new legislation is already facing a rebellion in parliament. Against this background its hard to see GBP rally, with the currency likely to be particularly volatile over the coming weeks.

Attention this week will turn to several central bank decisions, with monetary policy makers in Poland (Tue), US (Wed), Brazil (Wed), Japan (Thu), Indonesia (Thu), Taiwan (Thu), South Africa, (Thu), UK (Thu) and Russia (Fri) all scheduled to announce their decisions.  After months of policy easing globally, this week will look rather boring, with none of the above likely to ease further.   

The Fed FOMC meeting will likely capture most attention, but there is potential for disappointment if the Fed does not provide further details on its shift to average inflation targeting in its forward guidance, even as the accompanying statement and Chair Powell’s press conference are likely to sound dovish. The US dollar has continued to stabilize, aided by the drop in GBP, but a dovish Fed could limit further upside in the short term. 

Aside from central bank decisions attention will be on US election polls, which take on more importance as the election creeps closer.  US fiscal stimulus talks have hit a wall, with little chance of progress this week, while US pressure on China and Chinese companies is likely to continue to be unrelenting as elections approach.  On the political front the race to take over Japan’s prime minister following the resignation of Shinzo Abe will conclude this week (Wed).   

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. 

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.

Waiting For The Fed To Come To The Rescue

COVID-2019 has in the mind of the market shifted from being a localized China and by extension Asia virus to a global phenomenon.  Asia went through fear and panic are few weeks ago while the world watched but did not react greatly as equities continued to rally to new highs outside Asia.  All this has changed dramatically over the last week or so, with markets initially spooked by the sharp rise in cases in Italy and Korea, and as the days have progressed, a sharp increase in the number of countries recording cases of infection.

The sell off in markets has been dramatic, even compared to previous routs in global equity markets.  It is unclear whether fading the declines is a good move given that the headline news flow continues to worsen, but investors are likely to try to look for opportunity in the malaise.   The fact that investors had become increasingly leveraged, positioning had increased significantly and valuations had become stretched, probably added more weight to the sell-off in equity markets and risk assets globally.  Conversely, G10 government bonds have rallied hard, especially US Treasuries as investors jump into safe havens.

Markets are attempting a tentative rally in risk assets today in the hope that major central banks and governments can come to the rescue.  The US Federal Reserve on Friday gave a strong signal that it is prepared to loosen policy if needed and markets have increasingly priced in easing , beginning with at least a 25bps rate cut this month (19 March).  The question is now not whether the Fed cuts, but will the cut be 25bp or 50bp.  Similarly, the Bank of Japan today indicated its readiness to support the economy if needed as have other central banks.

As the number of new infections outside of China is now increasing compared to new infections in China, and Chinese officials are promising both fiscal and monetary stimulus, China is no longer the main point of concern.  That said, there is no doubt that China’s economy is likely to tank this quarter; an early indication came from the sharp decline in China’s official manufacturing purchasing managers’ index, which fell to a record low of 35.7 in February, deep into contraction territory.  The imponderable is how quickly the Chinese economy will get back on its feet.  The potential for “V” shape recovery is looking increasingly slim.

Volatility has also risen across markets, though it is notable that FX volatility has risen by far less than equity or interest rate volatility, suggesting scope for catch up.  Heightened expectations of Fed rate cuts, and sharp decline in yields, alongside fears that the number of virus cases in the US will accelerate, have combined to weigh on the US dollar, helping many currencies including the euro and emerging market currencies to make up some lost ground.  This is likely to continue in the short term, especially if overall market risk appetite shows some improvement.

Markets will likely struggle this week to find their feet.  As we’re seeing today there are attempts to buy into the fall at least in Asia.  Buyers will continue to run into bad news in terms of headlines, suggesting that it will not be an easy rise. Aside from watching coronavirus headlines there will be plenty of attention on the race to be the Democrat Party presidential candidate in the US, with the Super Tuesday primaries in focus.  UK/Europe trade talks will also garner attention as both sides try to hammer out a deal, while OPEC will meet to deliberate whether to implement output cuts to arrest the slide in oil prices.  On the data front, US ISM manufacturing and jobs data will be in focus.

Cautious Sentiment Towards A Trade Deal

Markets continue to focus on the potential for a “Phase 1” trade deal between the US and China.   The stakes are high. President Trump who stated that tariffs on Chinese goods would be “raised very substantially” if no deal was struck between the two sides.  US officials also poured cold water over comments by Chinese officials at the end of last week that there had been an agreement to reduce tariffs in phases.  Markets will take a cautious tone given such comments but it is still likely that a deal of sorts will agreed upon in the next few weeks.

Both sides want a deal and while Trump has said that China wants one more than he does, the US administration may want to avoid fueling market turmoil as attention increasingly turns to next year’s US elections.  This suggests that a Phase 1 deal is more likely than not, but agreement on later Phases will be much harder given that there are various structural issues that remain unresolved such as technology transfers, intellectual property theft and state subsidies.

For now what is important is that markets believe that there is progress towards a deal and an eventual signing probably sometime in December.  Despite the harder rhetoric from the US side this still looks like the most likely outcome which in turn suggests that equities and other risk assets have room to rally.  In the meantime, the situation in Hong Kong where protests have intensified will weigh not just on Hong Kong’s markets but markets across the region adding another reason for market caution in the short term.

On the data and events front attention will be on US October CPI, retail sales and a crop of Fed speakers including Fed Chair Powell who is unlikely to change the view the Fed is on pause for the time being.  Elsewhere Chinese data has been less than impressive this week, with October aggregate financing and new yuan loans both coming in weaker than expected.   This is likely to be echoed by the retail sales and industrial production data this week too.

On the FX front, the US dollar has made up around of its October losses amid some deterioration in risk appetite.  Further moves will depend on the progress towards a trade deal, with the USD likely to be pressured should it become clearer that a deal is likely to be signed and vice-versa.  US retail sales data will also have some impact in the short term, but with the Fed on pause and US data holding up the USD the will be driven by driven by the gyrations in risk assets.

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