Risk retreat continues, may accelerate
Risk assets (stocks and commodities) continue to slide lower after topping out in early May on signs the global recovery was losing steam. Incoming data continues to highlight a slowdown in major developed economies, and the main question is whether this is only a temporary soft patch or the start of a more ominous deceleration in growth.
Optimists can point to temporary factors, like the surge in energy prices, as the cause for recent weakness in demand, and express confidence that growth will pick up shortly. Pessimists, on the other hand, highlight structural drags on growth, like high unemployment and the exit from fiscal stimulus and imposition of austerity measures as the roots of a more pronounced slowdown.
The reality lies somewhere in between, where temporary factors intensify the effects of the structural constraints on growth, but the overall trajectory is clearly one of slowing. This suggests to us that the pullback in risky assets has further room to run.
For the time being, the pullback in risk assets appears moderate and orderly, but there are plenty of potential developments that could trigger a much more severe collapse in risk markets. The game of chicken being played over Greek debt (see below) has the potential to trigger another financial and liquidity crisis that seems unlikely to remain confined to European shores. A resolution is needed before the June 23-24 EU summit in Brussels, and possibly before the June 20 finance ministers conclave.
The debate in the US on raising the debt limit, now with less than 8 weeks to go until the Aug 2 Treasury deadline, is another potential show stopper. An exodus of investors from emerging markets appears to be underway, and we would note the MSCI Emerging Market Index has dropped out of the daily Ichimoku cloud. Sentiment also appears to be building that China is at risk of a real estate bubble bursting, though timing that is extremely difficult. And all of these events are playing out against the backdrop of a deceleration in major economies.
Looking ahead, we anticipate further declines on a gradual basis, but we are on alert for event risks to trigger a much more severe collapse. Finally, we would note that the S&P 500 last week closed below the daily Ichimoku cloud (bearish), and this past week registered a close below the weekly Kijun line (bearish), suggesting potential lower to the weekly cloud top, currently at 1175.
We will continue to look for opportunities to get short risk assets on remaining strength. In concrete terms, we think shorts in AUD, CAD, and NZD against the USD and JPY from just above current levels offer attractive opportunities.
The ECB gives the market a reality check
The euro finished the week on a lull, breaking through the key 1.4500 mark on the back of firstly, a less hawkish than expected ECB and secondly, fears that private investors will take a hit if Germany gets its way over negotiations for a second bailout for Greece.
The ECB may have signaled a rate hike in July by using the words “strong vigilance” during its press conference on Thursday, but rather than cause the currency to surge the opposite thing happened and the euro dropped back below the critical 1.4500 mark. The market concentrated on the ECB staff macro-economic predictions. While growth for this year was higher, inflation for next year was revised lower to a range between 1.1 per cent and 2.3 per cent, much closer to the ECB’s 2 per cent target.
While interest rates have been a major driver of the currency in recent months the growth story is coming back to the fore. Even Germany, the currency bloc’s economic powerhouse, is not immune to the global moderation in growth. The Bundesbank expects a sharp drop in Germany’s growth rate between this year and next from a stellar 3.1 per cent in 2011 to 1.8 per cent next year.
With the ECB looking set to take its time over interest rate normalization then the interest rate premium that has been driving the single currency may start to be priced out as the chance of further rate hikes after July starts to moderate. European Inter-bank lending rates fell after the ECB’s press conference. But the outlook for monetary policy in the eurozone really depends on how well the global economy weathers the current malaise in growth. If growth picks up again later this year then the ECB may continue to hike rates.
However, the fact that EURUSD has only managed to stay above 1.4500 for brief spells of late suggests the currency is at risk of a longer-term contraction. While we don’t expect an imminent collapse, above 1.4850 now looks remote and we believe the downside is protected above 1.4000.
Germany risks raising ECB’s ire
Markets hate uncertainty but that hasn’t stopped the ECB and Germany staging a very public disagreement over how to bailout Greece. Without extra funds the troubled southern European nation may well have to default next month after the first bailout that was due to last until mid-2012 was shown to be woefully inadequate.
The markets may have given the various branches of power within the EU the benefit of the doubt that a mutually agreeable solution to the Greek crisis would be found, but as D-day for Greece approaches it is losing faith. This is likely to weigh on the single currency for the foreseeable future and has sent the cost to insure Greek debt against default to fresh record highs.
Germany wants private bondholders to share in the burden of further aid to Greece to the tune of EUR30bn or roughly 50 per cent of extra funds that are needed. However, haircuts or maturity extensions on bonds is totally unacceptable to the ECB for a viable reason.
Credit ratings agencies have said that if Germany gets its way and maturities on Greek debt are extended - possibly by 7 years - then this would constitute a default and credit ratings would be adjusted as needed. And it would not just be Greece who would suffer; Portugal and Ireland would also be at risk.
This is problematic for the ECB, which holds in excess of EUR75bn of peripheral debt on its balance sheet through its Securities Markets Program as well as holding more Greek and Irish debt as collateral in return for loans to these nations’ troubled banking sectors. Multiple rating downgrades would hit the ECB’s financial viability and possibly unleash a financial crisis just at the time that it would have limited means to support the currency bloc’s economy.
Right now we are at the loggerheads stage. The next few weeks will be interesting to see who wins out in the fight. But although Germany is the currency bloc’s paymaster, pushing for a technical default won’t help matters. Not only will it hurt the ECB it will also hurt the European banking sector with exposure to peripheral debt. Banks in Germany and France with big exposures to the periphery may require bailouts from their governments, so if Berlin gets its way it may well end up shooting itself in the foot.
A decision has to be made by June 24 – when EU leaders hold their monthly meeting. If further aid is not agreed then a default beckons for Athens.
Slim chance of a rate hike from the BOE
The BOE remained on hold last week as expected. We’ll have to wait until the 22 June for the minutes to see how the newest member of the MPC Ben Broadbent voted. Overall, we think that there wasn’t much change in the views: growth is slowing and inflation remains elevated – leaving the BOE between a rock and a hard place.
Signs that growth disappointed in the second quarter continued last week when production data for April fell. Manufacturing, which has been the success story of the UK’s recovery, fell sharply by 1.5 per cent on the month. While there was probably some disruption caused by the bank holidays, there is little doubt that the UK economy is fairly anemic at this stage of the recovery.
This was confirmed when the National Institute of Economic and Social Research released its latest GDP data that showed the economy rose by a miserable 0.4 per cent in the three months to May. The NIESR said that UK growth remains “subdued” and it does not think that GDP will reach its pre-recession peak until 2013.
This makes the BOE less likely to hike rates any time soon. While domestic factors argue for a weaker pound, in reality the direction of sterling will continue to depend on the US and the Federal Reserve’s extremely accommodative monetary stance along with the ECB and the Greek debt crisis.
No major changes expected from Bank of Japan
On Tuesday June 14, the Bank of Japan (BOJ) will conclude its two-day meeting and announce its monetary policy stance and economic assessment. As recent surveys such as the April METI survey and PMI surveys have indicated that production is expected to rebound in May and June, it gives evidence to the BOJ that economic activity may be picking up. With monetary policy already extremely loose with near zero interest rates, an upgrade to the economic assessment may reduce the immediate need for additional easing measures.
The International Monetary Fund (IMF) earlier this week said that more asset purchases by the BOJ could ease deflation and boost growth as the economy is still facing headwinds from the March earthquake. The IMF suggested that the BOJ could accelerate and expand its existing program of purchases of private assets such as corporate bonds, commercial paper and ETFs as well as lengthen the average maturity of government bond holdings. While the Bank of Japan is not expected to take any drastic measures, a small expansion of its asset purchase facilities may be likely. Small tweaks are not likely to see much of a reaction in the currency markets with the risk of a large increase in additional purchases which may weigh on the yen.
Technically, USD/JPY has moved back above the psychological 80.00 figure with significant support around the May lows of about 79.50 to the downside. A rally may face immediate resistance around the 80.90-81.00 area which is where the daily ichimoku cloud base, Kijun line and 21-day SMA can be found. Above this may see towards the 55 and 100-day SMA’s which currently converge around the 81.90-82.00 area as the next level of resistance. Should the pair see a sustained break below the 79.50 area, a move towards 78.50 may materialize.
Crude oil searching for direction
Following the epic May 5th collapse which saw WTI record its 2nd largest USD denominated daily loss, crude oil prices have stabilized as market participants have been in search of direction. The June 8th OPEC meeting was expected to be the compass for oil markets as speculation of an increase to production targets ramped up ahead of the committee’s decision.
Such rumors were proved false as OPEC ministers agreed to disagree. Production quotas were left unchanged and the oil market compass seemingly pointed north. WTI crude oil rallied to highs above $102/bbl and Brent to highs just above $120/bbl on the back of heightened concerns that supply would tighten even further. On Friday, however, crude oil prices sharply reversed as reports of increased Saudi production to 10mb/d soothed supply concerns stemming from Libyan production losses--WTI dipped back below $100/bbl and Brent below the $119/bbl level.
However, recent consolidation ranges remain intact – around $95/105 in WTI and $108/120 for BCO – suggesting further sideways price action may be in store, at least until range limits are upended. At the moment, a downside break for crude oil is seemingly more likely as risk appetites have turned sour on concerns that the U.S. economic recovery may be losing steam and fears of hard landing for China.
However, a more granular look at Saudi Arabia’s reported output increase suggests range bound conditions may persist. Saudi oil production is estimated to be around 9.1mb/d, an increase to 10mb/d would result in an additional +0.9mb/d which only replaces roughly half of Libya’s approximate 1.8mb/d output loss. Definitely better than nothing but Saudi’s output increase does not seem to be a game changer and it seems the oil market’s search for direction may drag on a little longer.
Key data and events to watch next week
- Monday – Fed’s Lacker and Fisher Speak
- Tuesday – May PPI, May Advance Retail Sales, April Business Inventories
- Wednesday – May CPI, June Empire Manufacturing, April TIC Flows, May Industrial Production
- Thursday – Weekly Initial & Continuing Jobless Claims, May Housing Starts & Building Permits, 1Q Current Account, June Philadelphia Fed
- Friday – June Univ. of Mich. Consumer Confidence, May Leading Indicators
- Tuesday –EU’s Barroso, Ciolos, Barnier, Rehn, Merkel and Sarkozy speak, ECB’s Draghi speaks
- Wednesday – EZ April Industrial Production, EU Parliament votes on Draghi’s ECB Candidacy
- Thursday – EZ May CPI, EZ 1Q Employment, EU’s Van Rompuy speaks
- Friday – EZ April Trade Balance, EU’s Merkel and Sarkozy speak
- Monday – May RICS House Price Balance, BOE’s Weale speaks
- Tuesday – May CPI, May Retail Price Index, May Nationwide Consumer Confidence
- Wednesday – May Jobless Claims & Claimant Count Rate, April ILO Unemployment Rate, BOE’s King speaks
- Thursday – May Retail Sales
- Monday – April Machine Orders
- Tuesday – 2Q BSI Larger Manufacturing & All Industry, BOJ Interest Rate Announcement, April Capacity Utilization, April Industrial Production
- Wednesday – May Machine Tool Orders
- Thursday – May Tokyo Condo Sales
- Friday – BOJ May Meeting Minutes, May Nationwide & Tokyo Department Store Sales
- Tuesday – 1Q Capacity Utilization Rate
- Wednesday – April Manufacturing Sales, Canada’s Flaherty speaks, BOC’s Governor Carney speaks
- Thursday – April International Securities Transactions
- Friday – April Wholesale Sales
Australia & New Zealand:
- Monday – NZ May REINZ House Sales
- Tuesday – NZ May Food Prices, AU May NAB Business Conditions & Confidence, NZ & AU 3Q Manpower Survey
- Wednesday – RBA’s Stevens speaks, NZ 1Q Retail Sales, AU April Westpac Leading Index, AU June Westpac Consumer Confidence, AU June Inflation Expectations, AU 1Q Dwelling Starts
- Thursday – NZ’s English speaks, NZ 2Q Westpac Consumer Confidence, NZ May Business PMI, AU May New Motor Vehicle Sales, NZ 1Q Manufacturing Activity
- Friday – RBNZ Governor Bollard speaks
- Tuesday – May PPI, May CPI, May Retail Sales, May Industrial Production, May Fixed Assets Investment
- Thursday – April Leading Economic Index
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.