View: Market downplaying risks of a weak final quarter, Oct rally mature
Over the past few weeks US economic news flow has improved in tone, highlighted by the bounce in the October Philly Fed index (+8.7 compared with –9.4 median) and jobs data amongst others, which has helped steady equity markets after the rout of the summer. But it’s questionable whether this modest improvement in tone marks the start of a sustained recovery or is simply noise in what remains a hostile economic environment. There is as ever natual volatility in the data series. We’d also be tempted to ascribe a large chunk of the perceived improvement to economists catching up with reality, adding a pessimistic bias to their forecasting models, having failed to pick up on the slowdown in growth mid-year. Such tweaks increase the probability that volatility in the data will lead to a surprise on the upside vs. the median call. There has also been a significant positive contribution from expectations that politicians in Europe have now grasped what needs to be done to ring fence Greece and recapitalise the banks even if technicalities mean final negotiations are as protracted as ever.
But looking directly at the macro risks there is still plenty to concern, underlined by the October consumer confidence print which slumped to 39.8 vs. market estimates of 46.0, a level that fits well within the bounds of a recession. The principle headwinds of weak housing, high unemployment and creeping inflation further eating into incomes are unlikely to disappear anytime soon and additional steps by the Fed to inject some pace into the economy, via the ‘twist’ don’t really look to have got off the ground, underlined by chattering from several members - Fed Vice Chairman Janet Yellen and NY Fed President William Dudley included - that as more aggressive QE3 type programme could yet be implemented.
Thursday’s advance Q3 GDP print (+2.5% q/q) provided a supportive balance to Tuesday’s confidence number but as we move into November it’s questionable whether the rebound from the particularly weak August/September outcomes can really be sustained. There are a number of confidence indices due (including NAPM and Chicago PMI) which should evidence this, the most useful being the October ISM figures due ahead of the next Fed meeting on Nov 2nd. This measure has been the more stable survey over the past few months so weakness would be a worrying development for those expecting the year to end on a firmer note. The early expectations are for a modest gain in both the manufacturing and non-manufacturing components but after the run up in markets this month there is little upside to trading positions for such an outcome. Indeed, markets should become more sensitive to negative surprises now recession concerns have been pushed back to the fringes of debate.
While it doesn’t appear we’re quite yet on the edge of another sharp fall in stocks (10%+), the October rally is well advanced and is now reaching levels we consider more formidable resistance too, namely past the 61.8% Fib, 200-DMA and late June base around the 1,255 area. There is room for a swing back into the September ranges, 1,175 being a reasonable objective, on any broader reassessment of the macro picture. Another way to play this scenario is via USD which has given back the bulk of its gains in recent weeks. If you look at a DXY chart one could be forgiven for not wanting to pick the low but the 75.80/76.30 area is nonetheless strong support and consolidation here should begin to tempt buyers again. We think recent EUR strength is overdone given the underlying problems facing the Eurozone, deal or no deal, and while the economic story in the US is weak it is still far better than the euro block which should feed into dollar performance on a longer-term basis. We’d also pick up on renewed mutterings from Japan on the yen which has continued to firm despite improved risk appetite.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.