There was a palpable turnround in investor sentiment on Wednesday. Hong Kong’s withdrawal of its extradition bill bolstered emerging markets and in turn knocked the US dollar, while the UK parliament’s first steps toward stemming a hard Brexit was a positive development at the margins.
For the current quarter, Hong Kong equities remained well under water, with a loss of 7.1 per cent. A shown below, only Italian and Chinese equities have bucked a tough third quarter for shares to date, with the FTSE All-World index down some 2 per cent from the start of July. But both the S&P 500 and Euro Stoxx 600 indices were not far from entering positive territory for the quarter, so there’s plenty left to play for in September.
The protracted trade war has left its mark on share markets in the likes of Germany and Japan. The worry remains that easier monetary policy from here is not going to offset the damage inflicted by the trade dispute on business confidence and investment in those countries.
Northern Trust’s Katie Nixon says:
“A waning business confidence can result in lower capital spending and investing, leading eventually to slower earnings growth and ultimately to a slowdown in jobs creation.”
The release of US service sector data for August on Thursday is an important moment. If an expected reading of 54 is delivered, this will help allay some concerns that were flagged by contracting US manufacturing activity.
After that, policy meetings by the European Central Bank and Federal Reserve beckon over the next couple of weeks, with some observers hoping the expected easing will help nurture a recovery in risk sentiment.
The latest monthly outlook from DWS notes:
“From a portfolio perspective, we feel the massive reallocation of global funds from equities to bonds in August is of particular importance.”
This, the asset manager argues, creates a short-term buying opportunity easier central bank policy easing, a pause in the trade war and an ebbing pace in earnings being revised lower outside the US.
“Following the corrections in most stock markets in August, we have again raised their weighting a little. In the medium term, however, we would expect to reduce equity positions again after these rallies.”
One risk after this month’s central bank meetings is that expected easing measures disappoint investors and challenge would-be buyers of the dip in risk asset prices.
As shown below, while BlackRock’s Global Trade Tensions index remains shy of last summer’s record peak, the asset manager conveys a health warning:
“The protectionist push has been stronger than we expected, raising the risk of accidents. This has potential to challenge our modestly pro-risk stance.”
This leaves investors facing divergent paths during the coming weeks.
Longer term, a trade deal and an ensuing bounce in global economic activity, with a shot of fiscal stimulus, (a point being pushed by incoming ECB president Christine Lagarde) will extend the economic cycle and arrest the hefty decline seen in sovereign bond yields.
On the flip side, slumbering bond yields are vindicated by weaker economic activity that runs ahead of central banks' ability to react. While equities can absorb an earnings recession for a couple of quarters, they become a lot more vulnerable to a major correction when economies start to stall.
Under this scenario, the corporate credit market (which has enjoyed a grand time as government yields have dropped) looms as the most important barometer to watch for equity investors.
This is highlighted by Michael Hartnett and the global investment strategy team at Bank of America Merrill Lynch:
“The ‘glue’ that sustains the lower rates, higher stocks combo is the corporate bond spread. When government bond yields fall to levels that cause higher credit spreads, equity prices will decline. Until then we believe the ‘pain trade’ in stocks is up.”
Signs of policy easing by central banks failing to bolster risk sentiment will also manifest in wider credit risk premiums or spreads.
“Credit spreads are likely the #1 ‘tell’ of policy impotence: when central banks ease and credit spreads widen the bull market ends.”
Looking beyond September, Nicholas Colas at DataTrek sums up the current dilemma facing investors:
“The only thing we know (almost) for sure is that the 10-year Treasury will not yield 1.46% — its current payout — in 12 months’ time. A year from now we’ll look back on September 2019 and wonder how markets could have either been so fretful or so complacent about 2020’s economic conditions.”
Quick Hits — What’s on the markets radar
Long due a bounce, the Hang Seng index rallied 3.9 per cent on Wednesday, its best one-day rise since last November, and that may well be the best for now. A recent reading of private business activity for Hong Kong showed it plumbing a fresh decade low during August, leaving the economy flirting with recession. As for the protests that have convulsed the territory over the summer, the withdrawal of the controversial extradition bill has been joined by other elements spurring unrest among citizens.
As Brown Brothers Harriman note:
“This is a good first step but we suspect the protesters will not be placated so easily by something that should have been done much earlier.”
EM currencies and the pound are leading gains against the US dollar. The rally in EM is being led by the South African rand, Turkish lira and Mexican peso, helped in part by China maintaining a steady daily fix for the renminbi.
Brad Bechtel at Jefferies noted that the weaker dollar tone was “shaking out a lot of short term shorts in the EMFX space”. Looking ahead, he sticks to the view that EM currencies had room to fall versus the dollar, and more so than G10 currencies, where both the pound and euro have already seen big declines.
Sterling implied volatility has dipped below that of the Brazilian real, but still sits above the Mexican peso, via three-month at-the-money option measures for currencies. UK three-month volatility remains roughly double its level from July's low of 6.07, while options positioning shows sentiment leaning fairly heavily towards owning puts, or contracts that become profitable should the pound fall sharply from here. No shortage of action in currency trading for the pound as the House of Commons debates a bill seeking to prevent a no-deal Brexit on October 31.
A promised UK spending splurge from, Sajid Javid, the chancellor, (the day-to-day spending rise for government departments in 2020-21 is £13.8bn or 4.1 per cent) has sparked a jump of 10 basis points in UK 10-year real yields. This measure is back at minus 2.92 per cent, having blown out to 3.04 per cent on Tuesday, while the nominal 10-year gilt yield is back near 0.5 per cent, outpacing Wednesday's rise in rival benchmarks. There is plenty of bond market tolerance for greater government spending, but of course the real issue is whether such fiscal largesse will fundamentally improve the UK economy. Here’s the link to the UK government spending review.
Bank of Canada kept policy steady at Wednesday’s meeting, but the market expected rate cuts from its current overnight level of 1.75 per cent. BoC meeting came as the Canadian dollar has weakened more than 2 per cent since July versus the US currency, helping loosen financial conditions. That perhaps explains why the BoC held back from sending a stronger signal of more easing. That has helped the Loonie appreciate, but the currency remains within a narrow C$1.30 to C$1.35 range that has persisted since early January.
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