Looking For The Silver Lining

As the end of the year approaches it would take a minor miracle of sorts to turn around a dismal performance for equity markets in December.   The S&P 500 has fallen by just over 12% year to date, but this performance is somewhat better than that of equity markets elsewhere around the world.  Meanwhile 10 year US Treasury yields have dropped by over 53 basis points from their high in early November.

A host of factors are weighing on markets including the US government shutdown, President Trump’s criticism of Fed policy, ongoing trade concerns, worries about a loss of US growth momentum, slowing Chinese growth, higher US rates, etc, etc.   The fact that the Fed maintained its stance towards hiking rates and balance sheet contraction at the last FOMC meeting has also weighed on markets.

A statement from US Treasury Secretary Mnuchin attempting to reassure markets about liquidity conditions among US banks didn’t help matters, especially as liquidity concerns were among the least of market concerns.  Drawing attention to liquidity may have only moved it higher up the list of focal points for markets.

The other major mover is oil prices, which have dropped even more sharply than other asset classes.  Brent crude has dropped by over 40% since its high on 3 October 2018.   This has helped to dampen inflationary expectations as well as helping large oil importers such as India.  However, while part of the reason for its drop has been still robust supply, worries about global growth are also weighing on the outlook for oil.

But its not all bad news and markets should look at the silver lining on the dark clouds overhanging markets.  The Fed has become somewhat more dovish in its rhetoric and its forecasts for further rate hikes.  US growth data is not weak and there is still sufficient stimulus in the pipeline to keep the economy on a reasonably firm growth path in the next few months.  Separately lower oil is a positive for global growth.

There are also constructive signs on the trade front, with both US and China appearing to show more willingness to arrive at a deal.  In particular, China appears to be backing down on its technology advancement that as core to its “Made In China 2025” policy. This is something that it at the core of US administration hawks’ demands and any sign of appeasement on this front could bode well for an eventual deal.

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US dollar under pressure

US stocks have clawed back almost all their losses registered in the wake of the mini emerging markets crisis in January. The S&P 500 closed at 1838.63, up 0.48% on Friday. The rally in stocks is impressive considering the run of weaker than forecast US data releases over recent weeks although investors appear to be placing much of the blame on poor weather conditions. The gains in US stocks echoes the generalized improvement in risk appetite, with sentiment towards emerging markets also having stabilized.

The USD continues to be a casualty of the firmer risk tone, with a lack of upward momentum in US yields also not helping the currency (10 year US Treasury yield around 2.7428%). The USD index is now close to its lows for the year around 80.00, with the JPY and commodity currencies the biggest gainers so far this year among major currencies. In terms of emerging market currencies the Indonesian rupiah and Thai baht have been the best performers versus USD.

Despite the firmer tone to risk, gold prices have continued their ascent, closing above their 200 day moving average at the end of last week. As I wrote in Gold breaches its 200 day moving average, I don’t expect the rally in gold prices to be sustained. Some market consolidation is likely today with a lack of key data releases and a US holiday (President’s Day) keeping activity subdued.

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The Week Ahead

Equity markets and risk trades have generally performed well over the last couple of weeks, with for example the S&P 500 around 7.5% higher since its late August low, whilst equity and currency volatility have been generally low, the latter despite some hefty FX intervention by the Japanese authorities which did provoke a spike in USD/JPY volatility last week.

Risk appetite took a knock at the end of last week in the wake of worries that Ireland may seek EU / IMF assistance although this was denied by Irish officials. A similar worry inflicted Portugal, and as a result peripheral bond spreads were hit. Sovereign worries in Europe have not faded quickly and bond auctions in Greece, Spain and Portugal will garner plenty of attention this week. Renewed worries ahead of the auctions suggest that the market reception could be difficult.

Attention will swiftly turn to the outcome of the Fed FOMC meeting tomorrow and in particular at any shift in Fed stance towards additional quantitative easing following the decision at the August FOMC meeting to maintain the size of the Fed’s balance sheet. Given the recent improvement in US economic data the Fed is set to assess incoming data before deciding if further measures are needed.

Housing data in the US will also garner plenty of attention, with several releases scheduled this week. Increases in August housing starts, building permits, existing and new home sales are also expected. Whilst this may give the impression of housing market improvement, for the most part the gains will follow sharp declines previously, with overall housing market activity remaining weak following the expiry of the government tax credit.

Weakness in house prices taken together with a drop in equity markets over the quarter contributed to a $1.5 trillion drop in US household net wealth in Q2. Wealth had been recovering after its decline from Q2 2007 but renewed weakness over the last quarter will not bode well for consumer spending. Household wealth is around $12.4 trillion lower than its peak at the end of Q2 2007.

Aside from the impact of renewed sovereign concerns, European data will not give the EUR much assistance this week either, with Eurozone September flash PMIs and the German IFO survey of business confidence set to weaken as business and manufacturing confidence comes off the boil. If the Fed maintains its policy stance whilst risk aversion increases over coming days the USD may find itself in a firmer position to recoup some of its losses both against the EUR and other currencies.

This will leave EUR/USD vulnerable to drop back down to around support in 1.2955 in the very short-term. As indicated by the CTFC IMM data there has been further short EUR position covering last week whilst sentiment for the USD deteriorated, suggesting increased room for short-USD covering in the event of higher risk aversion.

The impact of Sweden’s election outcome over the weekend is unlikely to do much damage to the SEK despite the fact that the coalition government failed to gain an outright majority. EUR/SEK has edged higher over recent days from its low around 9.1528 but SEK selling pressure is unlikely to intensify following the election, with EUR/SEK 9.3070 providing tough technical resistance.

Quantitative easing and the USD

US earnings are coming in ahead of expectations, with Q2 income at the 42 S&P 500 companies reporting so far beating estimates by 11% whilst revenues are 3.3% ahead of forecasts, according to Bloomberg. The overall tone to equities looks positive helped by expectations of an agreement by BP to sell some of its assets and strong earnings reported by Apple after the close of US trade.

Market sentiment was also boosted by speculation that the Fed will embark on fresh monetary stimulus measures. Although there has been no indication that Fed Chairman Bernanke will announce such measures at his semi-annual testimony to the Senate today and to the House tomorrow, speculation of Fed action is rife and there is likely to be some questioning of Bernanke on the issue in the Q&A. If in any way quantitative easing is hinted at by Bernanke, it will act to undermine the USD.

US economic data is helping to compound expectations of further quantitative easing, with yet another weaker than forecast release in the form of a 5.0% drop in June housing starts as hinted at by the bigger than expected drop in homebuilders confidence on the previous day. Separately ABC consumer confidence declined more than expected in the week to July 18, its third consecutive weekly decline, supporting the evidence that consumer confidence is deteriorating once again.

In the absence of major data releases Bernanke’s testimony will be the main driver for markets but earnings from Coca-Cola and Morgan Stanley will also be of interest. Elsewhere the minutes of the Bank of England’s July MPC meeting will be under scrutiny. MPC member Sentance is expected to have voted for a rate hike at the meeting, but any sign that other members joined him, will give GBP a lift. Sentiment for European assets continues to improve, with Greece concluding a well received T-bill auction and Ireland auctioning EUR 1.5bn in 6 and 10-year bonds. Both were heavily oversubscribed although concerns over Hungary continue to linger.

There continue to be various leaks about the European bank stress tests. Banks are expected to detail three scenarios in the results including estimated Tier 1 capital ratios under a benchmark for 2011, an adverse scenario and finally, a “sovereign shock”, according to a document from the Committee of European banking Supervisors. Importantly and perhaps a factor that could hit the credibility of the tests, the sovereign shock scenario is said to not include a scenario of default on sovereign debt.

I continue to see downside risk for the EUR in the wake of the test results, with a “buy on rumour, sell on fact” reaction likely. EUR/USD is vulnerable to a short-term drop to technical support around 1.2763 but much depends on Bernanke’s speech today. Leaks, suggest that around 10-20 banks could fail the bank stress tests, with a total funding requirement in the region of EUR 70-90 billion. Confirmation will have to wait for the official release on Friday ahead of which most currencies are likely to remain range-bound.

For A Few Dollars More…

…or should I say a few EUR more.   This is what the Greek authorities must be wondering.  Once again Greek worries weighed on equities and risk appetite as a whole.  Although the saga is turning into one big yawn, markets have not had their fill with the bad news coming from this small eurozone economy.  Talks between Greek officials, International Monetary Fund (IMF), European Central Bank (ECB) and European Union (EU) began yesterday but are expected to go on for several days or weeks until a joint text is issued on May 15, just days ahead of a EUR 8.5 billion bond redemption by Greece. 

The talks have done nothing to prevent Greece’s bond yields moving higher, with the yield on 10-year bonds pushing well over 8% whilst the spread with Germany debt also blew out to over 500bps.  The main fear in the market is that Greece will ultimately end up restructuring its debt.  Moreover, contagion fears have dealt a blow to southern European sovereign CDS especially Portugal.  It wasn’t plain sailing for German bonds either, with yesterday’s auction of EUR 3 billion of 30-year Bunds failing to sell the full amount. 

Another casualty of ongoing Greece concerns is the EUR, with the currency under performing other majors and still on its path towards EUR/USD 1.3300 in the near term and onto 1.3150 after.   EUR also looks vulnerable on the crosses and EUR/GBP in particular is one to watch, with the 28 January low around 0.86029 likely to be targeted over the near term.  UK employment data gave some relief to GBP yesterday, with further direction coming from retail sales data today and the next televised leaders’ debate.  

At some point the market will become fatigued with consensus beating earnings and the positive impact on equities will become less marked.  This point is approaching but we’re not quite there yet.  Apple, Morgan Stanley and Boeing did not disappoint, with earnings easily beating forecasts.  Boeing’s earnings in particular helped industrials to be the best performing sector on the S&P 500 although the overall index closed marginally lower.

Earnings today include Amazon.com, American Express, Credit Suisse, Microsoft, Nokia, and PepsiCo.  It is becoming plainly obvious that market expectations for earnings are too pessimistic but as noted above the positive market impact of good earnings is likely to wane. 

On the data front, highlights include March existing home sales, jobless claims and Producer Price Index (PPI).   There will be less focus on PPI given that the Consumer Price Index (CPI) over the month has already been released whilst claims are likely to resume a path lower following the jump over the past couple of weeks.   Existing home sales are likely to post an impressive gain as indicated by firm pending home sales data.   

Overall, it appears that risk appetite is creeping back into the market psyche but the ongoing battle between positive earnings/data versus European/Greek woes suggests that there will be no clear direction for markets.  Improving risk appetite will ultimately win but current conditions will leave currencies trading within well worn ranges, with the exception of the underperforming EUR. In contrast the USD index is likely to remain supported, taking solace from positive data releases.

What To Watch This Week

Well so much for a “risk on” week. Market sentiment soured at the end of last week following The US Securities and Exchange Commission (SEC) civil action against Goldman Sachs, in which they accused the bank of fraud. The impact reverberated across markets and risk trades were pulled back as a consequence. Bulls shouldn’t be too downhearted though as the drop in risk trades followed several days of gains and part of the pullback could be attributed to profit taking.

Speculation of similar probes in Europe by financial regulators will cast a shadow over markets early this week. Nonetheless, direction will at least in part come from earnings. So far the run of earnings looks upbeat, with around 83% of the 48 S&P 500 companies reporting, beating analysts’ estimates. Overall profits are forecast to increase by around 30% from a year ago but are on track to easily beat this estimate. Bellwether names including IBM, Apple, Coca-Cola, Boeing, Microsoft, and AT&T report this week.

The meeting between Greek officials, ECB, IMF and EU has been delayed until Wednesday. There is little likelihood of Greece seeing any loan money soon as the need for parliamentary approval in some EU countries and upcoming regional elections in Germany on 9 May will put a spanner in the works. An issue of EUR 1.5bn of 3-month Greek debt tomorrow will act another test of market confidence but the recent widening in Greek debt spreads suggests a less positive reception than the previous sale.

There are also a few central bank meetings to contend with this week including Canada, Sweden, India, Philippines and Thailand. The only Bank likely to hike interest rates out of this bunch is the RBI in India with another hike expected, following closely on the heels of the March move. Canada and Sweden are unlikely to shift policy until at last after the end of Q2 whilst protests in Bangkok, Thailand, and the knock on impact on consumer confidence, have effectively sealed the case for no rate move there.

On the data front, attention will turn to US housing market activity. Markets will be able to gauge further clues to whether recovery in the housing market has stalled. An increase in both existing (Thu) and new home sales (Fri) in March is expected, which may allay some concerns although any improvement is likely to continue to fragile against the background of tight credit and high foreclosure levels.

In Europe, aside from the ongoing Greek sage, sentiment surveys will garner most attention, with the release of the German ZEW (Tue) and IFO (Fri) surveys as well as manufacturing and service sector purchasing managers indices (PMIs) across Europe. On the whole the surveys are likely to reveal some improvement as confidence.

Risk aversion will be slightly elevated at the beginning of this week but strong earnings and improving data will help to prevent too much damage. Consequently Risk currencies will start the week under pressure but any pullback will be limited. Given that speculative positioning in risk currencies such as the AUD, NZD and CAD is well above their three-month average according to the latest Commitment of Traders’ IMM data there will be some scope for profit taking. EUR speculative sentiment has seen some improvement but EUR/USD remains vulnerable to a further pull back to technical support around 1.3302 this week.

Euro Still Vulnerable

Markets have become rather skittish, with attention gyrating between sovereign deficit/debt concerns on the one hand and better news on the corporate and economic front on the other.  This week the latter appears to be gaining the upper hand helped by an easing of concerns about Greece. Although the Greek saga is by no means close to an end, especially given the new deadlines set by the EU Commission on adherence to budget cuts, the chances of the worst case scenario of default or pull out from the EU looks to have diminished. 

Renewed attention on other EU members, especially in light of the derivatives transactions carried out by Greece and potentially by other European countries to disguise the extent of their budget problems suggests that there is still more pain ahead. Nonetheless, it is increasingly clear that investors are differentiating between Europe and the rest of the world much to the chagrin of the EUR.  

Differentiation between the eurozone and the US was particularly apparent in the wake of stronger than forecast earnings and data in the US. Two more companies joined the three-quarters of S&P 500 companies beating earnings forecasts whilst economic reports including US January industrial production and housing starts came in ahead of forecasts.  This pattern is set to continue today, with the US Philly Fed manufacturing index set to increase to around 17 in February from 15.2 in January. 

In contrast, data in Europe has been much less impressive, with for example, the February ZEW survey of investor confidence recording its 5th consecutive decline in February.  The eurozone economic news may look a little better in the form of likely increases in manufacturing Purchasing Managers Indices (PMIs) but unless the data reveals particularly strong readings the growing perception that Europe is falling behind in the recovery process will remain in place.

Despite the improvement in risk appetite the USD has taken a firmer tone, appearing to react more to positive data and implications for a reduction in policy accommodation by the Fed.  In particular, the USD was spurred by the FOMC minutes of the January 26-27 meeting, in which the Fed debated its exit strategy from quantitative easing.  Some officials even went as far as pushing for asset sales in the “near future” to reduce the size of the Fed’s balance sheet.

Even though the USD has taken a firmer tone it will continue to be buffeted by the conflicting forces of improved risk appetite and shifting interest rate expectations.  Correlations reveal that risk is still the dominant FX factor suggesting that there may still be some further downside left for the USD as risk appetite improves. 

Although commodity currencies have also come under pressure due to the generally firmer USD tone overnight, the downside in these currencies is likely to prove limited especially given strong data releases.  For example, data overnight revealed that business confidence rose to its highest level in 15 years in Australia.  Added to upbeat comments from RBA deputy governor Lowe and strong labour market data, it highlights the growing probability of a March rate hike by the RBA.

The EUR remains the weak link and although it may benefit from easing Greek concerns the growing evidence of a relatively slower economic recovery in the eurozone suggests any upside in the EUR will be limited.  Having dropped below technical support around 1.3580, EUR/USD looks vulnerable to a further push lower in the short-term.

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