Markets Facing a Test of Reality vs. Liquidity

Risk assets ended last week under pressure (S&P 500 fell 2.4%) as some US states including Texas and Florida began to reverse opening measures and Anthony Fauci, the infectious diseases expert, warned that some states may have to return to full “shelter in place”.  Banks were among the worst performers even as they came through the Fed’s stress tests in reasonably good shape.  The Fed did however, cap buybacks and dividend payouts for the 33 banks that underwent tests. However, the reality is that banks were hardly likely to increase dividends over the next few months, while the 8th biggest banks had already suspended buybacks.  Perhaps what spooked markets was the news of “additional stress analyses later in the year”.

It feels like equities and risk assets in general are facing a test of reality vs. liquidity. It’s hard to fight the growth in excess liquidity global (G4 central bank balance sheets minus GDP growth) which has risen to its highest rate since Sep 2009, coinciding with a solid run in global equities over that period.  Clearly forward earnings valuations have richened but while absolute valuations appear rich (S&P forward price/earnings ratio has risen to 24.16), relative valuations ie compared to low global rates, are more attractive. This hasn’t stopped the intensification of concerns that after a solid market rally over recent months, the entry of a range of speculative investors is leading to a Minsky Moment.

Investor concerns range from the fact that the rally has been narrowly based, both in terms of the types of investors (retail investors piling in, while institutional have been more restrained) and type of stocks (momentum vs. value), the approach of US Presidential elections in November and in particular whether there could be a reversal of corporate tax cuts, as well as the potential for renewed lockdowns. Add to the mix, geopolitical concerns and a certain degree of market angst is understandable. All of this is having a growing impact on the market’s psyche even as data releases show that recovery is progressing somewhat on track, as reflected for example in the New York Fed’s weekly economic index, which has continued to become less negative and the Citi Economic Surprise Index, which is around its highest on record.

China, which was first in and now looks to be first out is a case in point, with growth data showing ongoing improvement; data today was encouraging, revealing that industrial profits rose 6% y/y in May though profits in the first five months of the year still fell 19.3%, with state-owned enterprises recording the bulk of the decline.  While there are signs that Chinese activity post-Covid is beginning to level off, domestic consumption is gradually improving. This week, market activity is likely to slow ahead of the US July 4th Independence Day holiday but there will be few key data highlights that will garnet attention, including June manufacturing PMIs in China and the US (ISM), and US June non-farm payrolls.

ECB to Hike, BoJ, BoE & RBA on Hold

The better than expected March US jobs report will likely help to shift the debate further towards the hawkish camp in the Fed. There is little this week to match the potency of payrolls in terms of market moving data this week. Instead attention will focus on a raft of Fed speakers over coming days as well as the minutes of the March 15 FOMC meeting.

This week’s Fed speakers include Lockhart, Evans, Bernanke, Kocherlakota, Plosser and Lacker. Of these only Lockhart and Lacker are non voters. Given the intense focus on recent Fed comments FX markets will be on the lookout for anything that hints a broader Fed support for a quicker hike to interest rates and/or reduction in the Fed’s balance sheet.

In any case the USD may struggle to make much headway ahead of an anticipated European Central Bank (ECB) rate hike of 25 basis point on Thursday. Much will depend on the press statement, however. If the ECB merely validates market expectations of around 75bps of policy rate hikes this year the EUR will struggle to rally.

It may also be possible that once the ECB meeting is out of the way the EUR may finally be susceptible to pressure related to ongoing peripheral tensions. Last week the outcome of the Irish bank stress tests, and political vacuum in Portugal ahead of elections set for June 5 were well absorbed by the EUR but it is questionable whether the dichotomy between widening peripheral bond spreads and the EUR can continue.

The Tankan survey in Japan released today unsurprisingly revealed a deterioration in sentiment. The survey will provide important clues for the Bank of Japan (BoJ) at its meeting on April 6 & 7th. Although a shift in Japan’s ultra easy monetary policy is unlikely whilst strong liquidity provision is set to continue, pressure to do more will likely grow. This will be accentuated by a likely downward revision in the economic outlook by the BoJ.

The JPY will not take much direction from this meeting. Nonetheless, its soft tone may continue helped by foreign securities outflows (particularly out of bonds), with USD/JPY eyeing the 16 December high around 84.51. Speculative positioning as reflected in the CFTC IMM data reveals a sharp deterioration in JPY sentiment as the currency evidence that finally the currency maybe regaining its mantle of funding currency.

It is still too early for the Bank of England to hike rates despite elevated inflation readings and MPC members are likely to wait for the May Quarterly Inflation Report before there is decisive shift in favour of raising policy rates. Even then, members will have to grapple with the fact that economic data remains relatively downbeat as reflected in the weaker than expected March manufacturing purchasing managers index (PMI) data.

Today’s PMI construction data will likely paint a similar picture. The fact that a rate hike is not expected by the market will mean GBP should not suffer in the event of a no change decision by the BoE this week but instead will find more direction from a host of data releases including industrial production. GBP has come under growing pressure against the EUR since mid February and a test of the 25 October high of 0.89415 is on the cards this week.

Finally, congratulations to the Indian cricket team who won a well deserved victory in the Cricket World Cup final over the weekend. The celebrations by Indians around the world will go on for a long while yet.

Talk but no action

The eurozone periphery remains in the eye of the storm but markets may have to wait before any concrete action is taken. The possibility of increasing the size of the bailout fund (EFSF), preparation of new European bank stress tests and/or allowing the EFSF to purchase eurozone government debt are all on the table but so far agreement has been lacking. Ministers apparently rejected the idea of increasing the size of the fund from EUR 440 billion to EUR 750 billion whilst disagreement over stricter criteria may also be hampering any progress.

Nonetheless, the EUR has found renewed support, helped by the firm German IFO investor confidence survey and news that Russia is looking to buy EFSF bonds. EUR/USD upside may be face a hurdle around 1.3500 over the short term and gains above this level are likely to be difficult to sustain given the ongoing uncertainties about the EFSF none of which are likely to be resolved anytime soon. The bottom line is that talk but not action will not be sufficient to keep the EUR supported.

GBP is also doing well, partly on the coat tails of a firmer EUR but also in the wake of an acceleration in UK CPI inflation which came in at 3.7% YoY a two year high, surpassing the Bank of England’s (BoE) ceiling for the 10th straight month. Inflation is likely to remain elevated pushing closer to 4% due to the VAT hike to 20% which came into effect at the beginning of this year. The data puts the BoE in a difficult situation testing the Monetary Policy Committee (MPC) expectation that the jump in inflation will prove temporary. However, the market is increasing taking the stance that a rate hike is going to take placer sooner rather than later, with a growing probability of a rate hike.

Since the end of last year there has been a 25bps spread widening (between 2nd contract rate futures) as markets have become more hawkish on UK interest rate expectations. This has coincided with an increasing correlation with GBP/USD resulting in the currency pair cracking above the psychologically important 1.60 level. Much will depend on whether the BoE’s predictions come true. If inflation remains sticky on the upside the Bank may be forced into an earlier tightening. Whether this is good news for GBP will depend on the economy. The worst case scenario is premature monetary tightening just as austerity measures start to bite.

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.

The Week Ahead

As last week progressed there was a clear deterioration in sentiment as growth worries crept back into the market psyche. It all started well enough, with a positive reaction to China’s de-pegging of the CNY but the euphoria faded as it became evident that there was still plenty of two-way risk on the CNY. A change in Prime Minister in Australia, which fuelled hopes of a resolution to a controversial mining tax, and an austere budget in the UK, were also key events. However, sentiment took a hit as the Fed sounded more cautious on the US economy in its FOMC statement.

The US Congress finalised a major regulatory reform bill towards the end of the week and markets, especially financial stocks, reacted positively as the bill appeared to give some concessions to banks and was not as severe as feared. However, equity market momentum has clearly faded against the background of renewed growth concerns including sprouting evidence of a double-dip in the US housing market as well as fresh worries about the European banking sector. As if to demonstrate this US Q1 GDP was duly revised lower once again, to a 2.7% annualised rate of growth.

The US Independence Day holiday and World Cup football tournament will likely keep liquidity thin in the run up to month and half year end. However, there is still plenty to digest this week including the all important employment report and consumer confidence data in the US. In Europe economic sentiment gauges, purchasing managers indices and the flash CPI estimate will be in focus. Elsewhere, Japan’s Tankan survey and usual slate of month end Japanese releases, Switzerland’s KoF leading indicator and Australian retail sales will be of interest.

On balance, economic data this week is unlikely to relieve growth concerns, with Eurozone, US and UK consumer and manufacturing confidence indicators likely to post broad based declines due to a host of factors. The data will further indicate a slowing in growth momentum following Q2 2010, with forward looking surveys turning lower, albeit gradually. Whilst a double-dip scenario still seems unlikely there can be no doubt that austerity measures and the waning of fiscal stimulus measures are beginning to weigh on growth prospects even if there is still plenty of optimism for emerging market and particularly Asian growth prospects.

This suggests that Q3 could turn into a period of heightened uncertainty in which equity markets and risk assets will struggle to gain traction. In addition to growth worries, some tensions in money markets remain in place whilst banking sector concerns seem to be coming back to the fore, especially in Europe and these factors will prevent a sustained improvement in risk appetite from taking place over the coming quarter. Some more clarity may come from the results of European stress tests but much will depend on just how stressful the tests are.

In the near term, the main focus of attention will be on the US June jobs report released at the end of the week. Non-farm payrolls are set to record a decline over the month due to a reversal in census hiring, with a consensus expectation of a 110k fall. Private sector hiring is likely to record a positive reading, however, suggesting some improvement in the underlying trend in jobs growth, albeit a very gradual one. Downside risks to consensus suggest plenty of scope for disappointment.

Interestingly, weaker US data of late, has managed to restrain the USD, suggesting that cyclical factors and not just risk aversion are beginning to play into FX movements. Notably the USD was on the back foot against a number of currencies as last week progressed. Even the beleaguered EUR managed to end the week well off its weekly low and close to where it closed the previous week whilst risk currencies such as the AUD and NZD as well as GBP also posted firm performances.

Perhaps some reversal of the optimism towards US recovery prospects give USD bulls some cause for concern, but pressure is likely to prove temporary, especially given that the US economy is still on course to outperform many other major economies. Over the short-term, especially ahead of the US jobs report markets are set to remain cautious with range trading likely to dominate in the week ahead, suggesting that EUR/USD is unlikely to breach the key level of 1.2500. GBP performance has been robust but even this currency is likely to make much headway above GBP/USD 1.5000, where there are likely to be plenty of sellers.

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