WORLD STOCK INDEXES
World Stock Indexes have continued to set the direction for global commodity and forex markets. So the biggest question coming into the week is: how likely are stocks to continue to rally, hold, or pullback?
Evidence for a pullback
- Stocks are at or near 2009 highs, having rallied in the past two weeks based on having beaten earnings estimates in the first weeks of US Q2 earnings reports. However, these results were mostly a case of bad results beating even worse earnings estimates.
- Most firms reported declining results from operations. Revenues and earnings are in an overall downtrend.
- The slope of that downtrend may be leveling off, however that does not mean growth is coming any time soon.
- The picture is arguable worse in the critical financial sector, which has been the source of every major decline and rally over the past two years. Not one major bank showed solid results from ongoing, sustainable operations. Instead, they beat estimates based on either risky trading operations or one-time asset sales. Meanwhile, continuing job losses steadily erode their loan portfolios and raise default rates for every kind of loan.
- Stock prices ultimately rise due to rising earnings expectations, not less contraction.
- Even the Federal Reserve does not see the continued loss of jobs ceasing any time soon. Consumer spending generates about 70% of GDP in the US, which remains the largest market for many exporting countries, and one of the largest for most of them. Without jobs growth, there will be no real recovery in the US, or elsewhere.
Evidence for continued rally
Not much, at least for those who insist that the evidence should point to a rational conclusion. In the short term, at least, markets are not necessarily rational. Thus the only argument seems to be that the markets have risen on little evidence so far, so they could continue to go further. I admit a bias against this kind of thinking, but those who followed it have profited over the past two weeks.
Evidence for stocks holding in a trading range
Given the range of gloom and hope seen since March, it will take some very strong new information about the state of global and regional economies to move them much beyond recent March-July ranges.
Conclusion for world equities and forex, and commodities
Given that risk assets are at the top of those ranges, and that markets revert to their means (middle area of their trading ranges over a given period) the odds favor a pullback.
Crude, gold, and most other easily transferable commodities (which excludes natural gas in many cases) have followed the overall direction in stocks as their indicator of future demand, thus comments above for stocks hold for commodities.
A reversal to the upside is likely to be just a matter of time. Trading it is a matter of timing.
Fundamental Outlook for US Dollar: Neutral
- US Gross Domestic Product numbers show worst drop in 27 years
- Dollar slipped on S&P rallies through earlier-week trading
- Months of consolidation could foreshadow US Dollar breakdown
- Near term overbought condition could bring USD rally
- This week's ISM Manufacturing, Service, Or NFP data could be the catalyst
The US Dollar finished the week lower against foreign counterparts, yet despite sharp S&P rallies and fairly disappointing domestic economic developments, it held above key trading range lows.
The past week's main event, US Gross Domestic Product, showed that the economy contracted less than expected in the second quarter of the year, but noteworthy downward revisions to earlier figures clearly dampened optimism on growth. Government data showed that the economy saw its worst quarter-on-quarter performance in 27 years in Q1. The slower rate of contraction in Q2 may have calmed some nerves, but truly dismal Personal Consumption figures emphasized consumer spending—the engine of earlier economic growth—remains weak.
The upcoming week's likely headline event is Friday's Non Farm Payrolls data. Last month, it disappointed and sent the global markets retreating until they were saved by a somewhat upbeat US Q2 earnings season. As was the case for the last report of July 2nd, markets are again near 2009 highs and are extended after the past two weeks' rally. They remain vulnerable to pullback on any disappointing news. As shown with this Friday's "good news-bad news" second quarter GDP report. Anything less than a strongly positive surprise could once again send risk assets into retreat, and safe haven currencies like the USD soaring. The fuel is already there, including:
- World stock indexes are again at or near 2009 highs, and other risk assets are nearing the top of their multi-month trading ranges. Without enough good news to further lift expectations, there won't be enough reason to continue selling the safe-haven dollar in order to buy higher yielding currencies.
- Forex futures and options data shows that traders remain extremely net-short the US Dollar. How short? Based upon last week's CFTC Commitment of Traders report, short dollar positions, particularly against the euro had reached the highest level since March 2008. With forex trading volumes down 25 percent from the previous year, the lack of participants and the one sided positioning are the perfect ingredients for profit taking.
A dour NFP report could be the next catalyst for a major USD move up. So could failure to meet expectations from this week's similarly market-moving ISM Manufacturing and Services results, which are also expected to show improvement.
Thus the USD is ripe for a move up, but as with so many things, timing is everything. Oversold conditions can persist for a while. Eventually, the Greenback should finally break above the Euro 1.4350 mark or below 1.3800. It will be critical to watch for signs of a sustained reversal. Those signs may well come from the S&P 500 and other key financial market risk barometers.
Because of its inverse relationship with the USD the Euro May gain most against it if risk appetite remains hearty
Fundamental Forecast for Euro: Bullish
- German unemployment falls for the first time, but only due to seasonal adjustments
- German consumer confidence rises for a third month
- Fundamentals remain mixed, key news from US, Euro Zone to be decisive
The dollar is plunging, and the biggest beneficiary could be the Euro.
- It's the world's second most liquid currency after the USD
- The GBP and AUD depend on unpredictable risk appetite
- Liquidity, a steady yield, bullish growth forecasts and a policy authority that is confident financial conditions are sound make for an appealing alternative for the most actively traded currency in the market.
- While the Euro Zone is far from healthy, it need only be in better shape, or be better at exceeding expectations, than the underlying economies of the UK, Australia, or other competing currencies, to gain demand at their expense.
Here's why not:
- The Euro Zone economy is not as solid as the strength of the EUR suggests. While we will not see the first round of the German and Euro Zone second quarter GDP figures until August 13th, the current picture is mixed at best.
- Surveys for consumer, business and economic sentiment all reported improvements in their July readings (though they were mostly still showed contraction). More worrying, German unemployment rate has held at its highest level since December of 2007. Consumers are the foundation for economic health and will determine whether the Euro Zone will struggle to recovery or truly return to growth. Retail sales, factory orders and industrial production will all factor in to this outlook.
- Moreover, while the US and UK are seen as less economically sound, many of the biggest risks to the broader markets going forward come from the Euro Zone. A premature draining of financial aid threatens to choke the economy, regional banks have yet to write off their losses (they will) and Eastern Europe threatens to default on its loans to the EZ in masse.
The ECB is likely to provide the big news for the EUR this week.
While each of these indicators will feed into the market’s unobserved and dynamic growth forecasting model; the true benchmarks for economic activity will come from the ECB.
The central bank is likely to leave benchmark interest unchanged at 1.00 percent. The real value from the event comes from the statement that accompanies the announcement and President Jean Claude Trichet’s forum with the press shortly after the official release. It may reveal the relative balance of power between pro vs. anti stimulus forces. On one hand, continued stimulus risks inflation. On the other, too little or too soon a cutoff of liquidity could choke off the recovery before real growth and job creation begins.
Japanese Yen remains captive to risk appetite
Fundamental Forecast for Japanese Yen: Neutral
Fundamentals are mixed. Key risk appetite data like US non-farms payroll are likely to be more influential
- Retail Sales fell 0.3% in June and 3.0% from a year ago, declining for the 10th straight month
- Japanese industrial production rose 2.4%, the fourth straight improvement, PMI Moves to expansion at 50.4
- Unemployment rose to a six year high of 5.4%in June
- Consumer Prices fell at a record pace in June to -1.8% from -1.1%
The Yen was mixed to end the week as it rallied against the dollar on the better than expected GDP figures and broad based greenback weakness. However, it fell against riskier currencies. Equity market rallies have show no signs of abating but they are near significant resistance levels and with the U.S. employment report scheduled next week a pull back is possible. Meanwhile, Japanese fundamental data continues to point toward a slow recovery.
Sounding like most central bankers, BoJ member Tadoa Noda stated this week that central bank shouldn’t end their emergency credit programs prematurely as it could limit the scope of a recovery. The upcoming economic docket is relatively light from Japan this week, so price action will most likely be dependent again on risk sentiment which could be limited with US NFP’s looming. The USD/JPY has been in a downward trending channel and which was kept intact with Friday’s sell off.
British Pound Volatility Ahead on BoE Rate Decision, Stock Markets Reversal
Fundamental Forecast for British Pound: Neutral
- Per Hometrack Survey, Buyers Returning to UK Housing Market
- GfK Says UK Consumer Confidence Unchanged in July
- UK Mortgage Approvals Rise to Highest in 14 Months
The British Pound is all but guaranteed a week of heavy volatility as the busy economic calendar headlined by a pivotal interest rate announcement from the Bank of England is compounded by hints of a drop in risk appetite.
Traders will be closely watching to see if policymakers choose to ramp up quantitative easing measures after promising to “review the scale” of the program for the August rate decision in conjunction with the release of their quarterly inflation report. Despite the BoE’s apparent optimism and signs of stabilization in some leading indicators, economic growth disappointed in the second quarter, bolstering dovish arguments from the likes of the British Chamber of Commerce and the Shadow Monetary Policy Committee (a group of independent economists that meet at the London-based Institute of Economic Affairs).
A timely GDP estimate tracking the pace of economic growth in the three months through July from the National Institute of Economic and Social Research (NIESR) will help set the tone for the monetary policy announcement: while usually quite good at estimating official economic growth figures, NIESR missed the mark in the second quarter having called for output to shrink just -0.4% only to be faced with a -0.8% result; this time around, the prestigious think tank will have likely identified the reason for their previously over-optimistic reading and may offer valuable insight on potentially overlooked weaknesses in the UK economy.
The remainder of the economic calendar is comparatively light considering the themes behind further marginal improvements in PMI and Industrial Production are likely to have already been priced into the exchange rate while signs of moderating turmoil in the property market expected to be reported by Halifax have been adequately telegraphed by the latest Hometrack Housing Survey and the Rightmove House Prices report.
Indeed, only a meaningful downside surprise in these metrics is likely to prove particularly market-moving, as the trajectory of stock prices and 12-month interest rate expectations (derived from trading in overnight index swaps) over recent months suggest traders are surely looking for the recession to begin to bottom.
Turning to risk sentiment, technical positioning is hinting that the equities rally that began in March is starting to run out of momentum and may be on track to putting in a double top at the October 2008 swing high, with volumes steadily declining since early May and clear negative divergence between rising prices and stalling relative strength studies.
A trade-weighted average of the Pound’s value against a basket of major currencies is now over 83% correlated with the MSCI World Stock Index, suggesting sterling will be dragged along if stock markets do indeed turn lower. That said, US news has been the key fundamental catalyst in setting the trajectory of risk-related assets, and expectations of modest improvements for nearly all of the scheduled releases on the US calendar suggest a steady week for equity markets, barring any significant downside surprises on key metrics or a particularly disappointing second-quarter earnings outcome from a major company. That is not just a remote possibility, however.
Traders should be focused on the news mentioned above that is most likely to move global stock indexes, especially the S&P, for clues to the overall direction of forex and commodities.
Disclosure and Disclaimer: The author may hold positions in the above mentioned instruments.