Risk May Be on the Brink

by: Brian Dolan
Markets received fresh signals this past week that global growth is moderating further, suggesting potential for further declines in risk assets (stocks and commodities) in the weeks ahead. Stocks in the US did not lose much ground, but attempts to rebound were rejected, highlighting our view that sellers remain dominant. Commodities, using the CRB index as the proxy, posted much sharper declines and look to have broken down in many key respects (see below). Major FX mostly consolidated in a choppy fashion, but US Treasury yields finished the week at new lows for the current decline, suggesting risk aversion remains high.
What was behind the slump in risky assets? Apart from the ongoing Greek drama, which we earlier cautioned has been obscuring the bigger picture of slowing global outlooks, incoming data and forecasts continue to point to a weaker 2H of 2011. Just this past week, sharper than expected declines in June euro zone flash PMIs and ZEW surveys point to a slowdown on the continent. In the US, the FOMC lowered its 2011 GDP forecasts from 3.0-3.3% to 2.7-2.9%, while some market forecasters are penciling in an even weaker number around 2.0-2.5%. In the UK, June CBI reported sales plunged from +18 to -2, suggesting the bump from the Royal Wedding was short-lived indeed. And in China, the privately issued HSBC flash June China Manufacturing PMI slipped from 51.6 to 50.1, while the MNI June Business Conditions Survey (also privately issued) fell from 61.22 to 57.76.
While the debate continues over whether the current slowdown is temporary or something more daunting, we’re inclined to view it as a more substantial slowdown due to the inability of major economies’ governments and central banks to provide fresh stimulus. The Fed continues to view the slowdown as temporary and indicated additional asset purchases (QE3) was not even discussed. The ECB continues to insist on austerity and is poised to hike rates again in July to fend off headline inflation above its target.
The RBA seems to have gotten the picture, as the most recent minutes indicated rates are to remain on hold due to global backsliding and risk from the euro zone debt crisis. And the BOE also appears to have seen a subtle shift, with some MPC members discussing a return to asset purchases. While the recent commodity price declines may potentially lead to a pick-up in consumption and limit the extent of the downturn, we think deleveraging households and employment-challenged consumers in major economies are most likely to show continued spending restraint, preventing any rapid improvement. We think this will bias risk assets further to the downside, and below we highlight key break-down levels we are monitoring.
All eyes on Greece, again
The Greek debt drama is nearing its next critical phase, with the Greek government needing to secure passage of its new deficit-reduction plan, where a vote is now scheduled for June 30. The EU/IMF has made it clear: No package, no more bailout funds. While the governing PASOK party has a five-vote majority in the Greek parliament, recent defections by several PASOK MPs threaten to derail adoption of the new measures. Should the measure fail to pass, we would expect a spike in risk aversion as markets quickly price in a likely Greek default within weeks.
Assuming the measure does pass, the EUR may experience another relief rally, but we would expect it to be limited to the 1.4450/4500 area due to lingering concerns. The so-called voluntary rollovers of maturing Greek debt, due in the week of July 17-23, may cause the leading credit rating agencies to cut Greek ratings to default levels. If so, that would make Greek government debt ineligible as ECB collateral, effectively cutting off the Greek banking system from further ECB funding and likely rendering it insolvent within days. There is no shortage of risk out there and markets will likely continue to be headline driven.
IEA emergency reserve release: Transitory or permanent influence on crude oil prices?
On Thursday, the International Energy Agency surprised markets by announcing a coordinated 60m barrel crude oil output release from emergency reserves to be implemented in increments of 2m b/d over 30 days commencing next Friday. Both WTI (US) and Brent (UK) crude oil experienced sharp declines to end the week near pre-Libya supply disruption levels around $91.00/bl and $105.00/bl, respectively. While Thursday’s plunge lower in crude clearly asserted immediate downside oil price implications, longer term oil price downside is likely to be transitory.
While an additional +2m b/d may very well offset lost Libyan production (estimated to be around 1.3m b/d) for the duration of the program, it fails to confront existing total output imbalances that have accrued since the onset of Libyan unrest; IEA estimates total Libyan production losses to total about -132m barrels. There is also the risk that the IEA’s proposed 60m barrel output injection may not be fully absorbed into the gross crude oil supply stream, especially when considering a global backdrop of moderating growth and its detrimental impact on global demand. Additionally, the IEA’s goal to buoy global growth prospects via supply induced oil price reductions may actually backfire -- exaggerated downside crude oil fluctuations could boost EM demand resulting in higher oil prices.
Ultimately, future chapters in the ongoing growth saga are likely to be the wild cards to longer term oil price determination. Any abatement in growth risks would support both WTI and Brent, while amplification or compounding growth risks would weigh on crude oil prices. Accordingly, we think near term crude oil prices may see further downside corrections towards $101/bbl in Brent and $85.00/bbl in WTI on the back of the IEA's surprise output decision alongside oil demand risks stemming from the ongoing Greek debt debate and the recent stream of negative US data surprises. However, we think a still firm underlying fundamental oil market structure may see both crude oil benchmarks resume their primary uptrends upon completion of the IEA’s release schedule.
UK data releases evidence a stagnant economic recovery
The sterling declined against the greenback for the fourth straight week as UK economic data releases continued its recent trend of softening. CBI reported sales sharply reversed to -2 in June from +18 in May, confirming negative implications from the -1.6% May retail sales reading, which evidenced weakening domestic consumption.
However, the catalyst of sterling underperformance stemmed from the more dovish tone in the June MPC minutes. To start, newest member Ben Broadbent sided with the majority to keep rates steady, leaving Weale and Dale on the short end of the 7:2 vote. Adding dovish color to the minutes was the admittance from minority voting members that growth outlooks were softening. This doesn’t bode well for a sustained UK economic recovery as even more hawkish members seem to be second guessing the current environment.
The stream of negative data seems to be spilling over. May jobless claims rose 19.6 and April average weekly earnings evidenced stagnant income growth of 1.8%. With wage growth considered by many MPC members as being a key determinant in shifting policy direction, it seems accommodative BoE policy may be here to stay for a while longer.
Further denting prospects for a healthy recovery in the UK economy and its currency is its sensitivity to negative risk events. While risk sentiment has been supported in anticipation of Papandreou’s successful confidence vote, the Greek debt drama is likely to drag on a while longer. Total UK bank exposure to Greek debt is approximated to be around $8B as of Q4 ’10 (according to BIS estimates), trailing just Germany and France and almost double that of total US exposure. So while recent Greece developments are encouraging, any future hiccups in the EZ periphery are likely to have negative ripple effects on the UK economy and subsequently GBP.
The technical outlook in GBP/USD is consistent with recent UK data deterioration and suggests medium term sterling weakness may be in store. GBP/USD posted multiple daily closes below primary uptrend support (from the 2010 lows) as well as below the neckline of a H&S top formation, which projects a measured move objective towards the key 1.5350 horizontal pivot.
Important technical levels to watch in the week ahead
Over the past week, the greenback has seen gains versus other G10 counterparties with exception to the Swiss franc and Norwegian krone. The USD’s rise was sparked by risk aversion flows seen in equity, treasury and commodity markets. This can be attributed to two primary factors that occurred: Ben Bernanke’s FOMC testimony on Wednesday, wherein he stated the US economy is recovering at a “moderate pace, though somewhat more slowly,” and Thursday's announcement by the International Energy Agency that it would release 2 million barrels of oil from the strategic petroleum reserve a day for the next 30 days. Together, the slowdown in the economy and lower oil prices eased inflationary fears and thus was seen as boon for the buck.
USD Index: Technical developments last week suggest the greenback’s gains may continue. Currently, it is bumping up against long-term trendline resistance, drawn from the June 2010 highs, as well as the 100-day SMA – both of which come in around 75.60/65. Should this level be surpassed next week, the dollar may see further gains towards the 23.6% retracement near 76.45/50 ahead of the 200-day SMA around 77.20/25. However, if a setback occurs look for the 55-day SMA by 74.65/70 and then trendline support, drawn from the May 2011 lows, near 74.00 to be supportive.
EUR/USD: The technical outlook has decidedly shifted to the downside after failing up against the 55-day SMA earlier in the week around 1.4400. Even today’s gains on the back of the much better than expected German IFO numbers proved unsustainable. Now the Euro looks poised to retest the 1.40 handle prior to the end of the month. Fundamentally, the EU peripheral debt problem is likely to persist as long as Europe is unable to find a suitable funding source. Thus, technicals could take center stage next week. We are watching for a potential break of trendline support around 1.4110/20 (drawn from May 2011 lows) to spark further declines. The next credible levels to watch are the psychologically significant 1.40 level and then the 200-day SMA around 1.3860/65.
GBP/USD: Cable has posted multiple daily closes below primary uptrend support from the 2010 lows and while doing so formed a head and shoulders top. Earlier last week, it failed up against a multitude of key technical levels converging between 1.6245/65 – retest of broken long-term trendline support, 100-day SMA, 200-hour SMA and 38.2% retracement (1.6545/50 to 1.6075/80 decline), which ultimately proved to be the nail in the coffin. The daily close below the H&S neckline support projects a measured move objective of about 750 pips towards the key 1.53-5400 horizontal pivot (Sept. and Dec. 2010 prior lows). Going forward, also look for the 200-day SMA to prove resistance around 1.6030/35 in the near-term.
XAU/USD broke below long-term trendline support around $1527 earlier in the week (connect January, March, May and June 2011 lows) and then retested this level over the past 24 hours and failed. There were a few signs the impending sell-off in fold was about to occur as we spotted an Evening Doji Star formation, which is one of the strongest bearish reversal signals in the market; this formation is characterized by the continuation of a bullish trend, which is then followed by a Doji (reflecting uncertainty in the market) and then the trend reversal is confirmed with a sell-off. Typically, the larger a move down is on day three, the stronger the reversal signal.
Furthermore, coinciding this bearish candlestick formation was a negative divergence between gold and RSI on the daily chart, whereby gold made a higher high and RSI made a lower high. Today’s decline decisively took out the 50-day SMA around $1521 – a level we have not been below since mid-February, and the daily/weekly close below may lead others to take action next week. Since reaffirming its trend higher at the beginning of 2009, gold’s 150-day SMA has limited the downside on multiple attempts and currently resides around $1438 and could be a reasonable longer-term objective should the psychologically significant $1500 level give way.
S&P500 appears to be running out of upward momentum as the U.S. economic recovery struggles in a soft-patch. This week the S&P formed a Bearish Harami followed by a Hanging Man candlestick pattern – both of which portray a rough road ahead. Furthermore, the 200-day SMA has provided support on the last two attempts over the past week and a half; however, it may be vulnerable next week as it rises to 1264 on Monday. Should this level give way, the 2011 lows near 1250 could come under pressure. Typically, the minimum correction technicians target is the 38.2% retracement – this is currently located at 1233 (drawn from July 2010 low to May 2011 high), which ultimately seems reasonable should risk aversion flows continue to pick up over the coming weeks (keep your eye on $90 in WTI next week as a potential trigger).
Key data and events to watch in the week ahead
United States: Monday – May Personal Income & Spending, PCE Deflator, Jun. Dallas Fed Manf. Activity, Fed’s Kocherlakota Speaks Tuesday – Apr. S&P/CaseShiller Home Price Index, Jun. Consumer Confidence, Jun. Richmond Fed Manf. Index, Fed’s Fisher Speaks Wednesday – May Pending Home Sales, Fed’s Raskin Speaks Thursday – Weekly Jobless Claims, Jun. Chicago PMI Friday – Jun. Final U. of Michigan Confidence, May Construction Spending, Jun. ISM Manufacturing, Jun. Vehicle Sales.
Eurozone: Tuesday – German July GfK Consumer Confidence Survey, May Import Price Index, German Jun. Prelim CPI, ECB’s Trichet Speaks Wednesday – EZ Jun. Business Climate, EZ June Confidence Surveys Thursday – German May Retail Sales, ECB’s Trichet Speaks, German Jun. Unemployment Change & Rate, EZ May CPI, ECB’s Coeve Speaks Friday – EZ May Unemployment Rate, German & EZ Jun. Final Manufacturing PMI.
United Kingdom: Tuesday – 1Q Final GDP, Current Account, Total Business Investment, BOE's King, Tucker, Dale, Posen, Miles speak in London Wednesday – Apr. Index of Services, May Net Lending on Dwellings Thursday – Jun. GfK Consumer Confidence Survey Friday – Jun. Manufacturing PMI.
Japan: Tuesday – May Retail Trade Wednesday – May Prelim Industrial Production Thursday – May Vehicle Production, Construction Orders, Housing Starts Friday – May Jobless Rate, Jun Tokyo CPI, May National CPI, 2Q Tankan Survey.
Canada: Wednesday – May CPI, Apr. Teranet/National Bank HPI Thursday – Apr. GDP.
Australia & New Zealand: Monday – NZ May Trade Balance Tuesday – RBA’s Debelle Speaks Thursday – NZ May Building Permits, AU May Job Vacancies, Jun. NBNZ Activity Outlook & Business Confidence, AU May Private Sector Credit Friday – AU Jun. RBA Commodity Price Index, May HIA New Home Sales.
China: Monday – May Industrial Profits Friday –Jun. Manufacturing PMI.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.