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.

Risk appetite firms

Despite the decision by Crimea’s parliament to formally request accession to Russia markets risk assets performed well overnight, with US and European equity markets registering solid gains. Consequently US yields rose overnight while the USD made gains against safe haven currencies.

Market relief probably reflected the fact that the referendum itself passed without violence while the reaction by the West in terms of sanctions was not seen to have a particularly detrimental impact on sentiment.

China’s decision to widen its currency band also passed with little fanfare given that such a move was largely anticipated. There will be some positive pass through into the Asian session from the gains in asset markets overnight although a degree of caution continues to be warranted given the still precarious situation in the Ukraine and ongoing tensions between Russia and the West.

Risk aversion edging higher

As the reverberations from China’s poor trade data, weaker loan growth and money supply, as well as continued tensions in the Ukraine ahead of a referendum next Sunday, spread through the market, risk aversion continues to edge higher according to our risk barometer.

Lingering questions over the weather impact on the US economy are also capping risk appetite even after the better than expected US jobs report at the end of last week. Although there is no sign of any panic selling of risk assets at present the tone is decidedly cautious.

Consequently safe haven assets remain in demand, with for example gold prices holding up well and US Treasury yields being capped. Additionally industrial commodity prices have taken a hit, with iron ore prices under major pressure.

There is little on the agenda today that will give a clearer picture for markets, with the Bank of Japan policy meeting and UK industrial production data, the key events for the day. As a result, caution is likely to prevail.

Ukraine fallout

So far most of the damage from the escalating crisis in the Ukraine and growing tensions between the West and Russia has been inflicted on Russian markets but global asset markets are also feeling increasing pain from the fallout. The most recent developments highlight that tensions have worsened further.

Equity markets in Europe were next in line for selling pressure, with sharp declines registered while US stock also dropped, but to a lesser degree. Commodity prices have also felt the shock, with European natural gas prices rising sharply and oil also higher. Gold has been a major beneficiary extending gains to around USD 1350.

US Treasury yields settled around 2.6% while the USD bounced as risk aversion spiked. My Risk Aversion Barometer rose over 3% while the VIX “fear gauge” jumped. Asian markets are likely to feel some pressure today although the impact is likely to be much less significant than elsewhere. Nonetheless, the lack of first tier data releases means that most attention will be focussed on developments in Ukraine over today’s trading session.

Weak US data overlooked

Although US stocks could not hold onto record highs overnight they still managed to close higher following on from gains in European equity markets. Firmer US equities will give a positive lead to Asian markets today although the gyrations in CNY and CNH will be watched closely. Our risk barometer as well as the VIX ‘fear gauge” indicate that risk appetite is on a positive trend while US Treasuries and the USD consolidate.

Weaker data in the US in the form of the Chicago Fed activity index and Dallas Fed activity index as well the Markit service sector PMI confidence index were shrugged off by the market, with weakness continuing to be attributed to harsh weather conditions. This theory will be tested over coming weeks as weather conditions normalise but for now markets are giving the US economy the benefit of the doubt.

Meanwhile, Eurozone inflation data yesterday highlighted the significant amount of room that the European Central Bank has to ease policy further. On tap today of note is the French INSEE survey and US consumer confidence, both for February and neither of which is likely to prove particularly market moving.

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