In Exaggerations Lie Investment Opportunities

In Exaggerations Lie Investment Opportunities

  • The key to stabilizing the markets may not lie with data; the most important missing piece is the intent of policy makers
  • That is why the more important event this week (August 29) may be the Fed Vice Chairman’s panel discussion at Jackson Hole on US inflation developments
  • Many argue that China’s move may preclude a Fed hike – we very much doubt it
  • News from Europe will likely reinforce the view that the best of the cyclical recovery may be behind the eurozone

Price action: The dollar is mixed on the day. The euro has rallied to $1.1500 but has not been able to break above. Sterling is trading at $1.5715. The yen is outperforming, with the dollar falling to ¥120.50, below the 200-day MA and the lowest level since mid-May. On the other end, the New Zealand and Australian dollars are underperforming, at $0.5680 and $0.7230, respectively. The list of EM currencies making new or cycle highs continues: RUB, ZAR, MYR, COP, CLP, MXN and TRY are some of the ones most in focus. It’s interesting to note that BRL has been relatively stable, with the dollar unable to close above the 3.50 level on Friday, though this level is likely to be breached today. The selloff in global equities continues with the Shanghai comp falling 8.5% and the Nikkei down 4.6%. EuroStoxx is down nearly 3% and US futures are down 2%. Oil continues to collapse with WTI futures at $39 dollars a barrel and brent just below $44, a roughly 3.5% decline overnight. Fixed income markets are mostly quiet with the exception of UK gilt yields, up 12 bp across the curve.

  • Markets are prone to exaggeration.   The now 3.1% decline in the yuan, more than any other factor, has been blamed for the huge moves in financial markets. Some have noted today’s break above the CNY 6.40 level overnight as an important indicator, even if the move was only 0.2%. Last week, as the stock market tumbled, the yuan traded sideways, and if anything, firmed slightly. It’s important to remember that magnitude of the yuan’s decline is too small to have much impact on Chinese exports.  This, of course, can change going forward, but there is no reason to think that it is likely.
  • Our analysis suggests that the market has exaggerated the risk of a global recession and the competitive implication of the depreciation of the Chinese yuan.  The sharp sell-off that has pushed the prices of almost 60% of the S&P 500 members more than 10% below their peaks will create new opportunities, but prudence dictates waiting for a technical sign that the momentum has exhausted itself.  In particular, be on the lookout for one of a number of reversal patterns which usually entail a sell-off followed by a strong close.
  • The same is true of the dollar.  The short-covering squeeze has lifted the euro and yen.  Given market positioning, there is room for additional gains.  However, these gains should be seen as counter to the underlying, fundamentally driven trend based on the divergence of monetary policy. This is the kind of pullback in the dollar than many investors had wanted to create a new opportunity to get with the trend and adjust hedges.  Such participants should await a sign from the price action itself that the short-squeeze is over.
  • The key to stabilizing the markets may not lie with data; the most important missing piece is the intent of policy makers.  What is China thinking?  Are officials panicking?  What is the Federal Reserve thinking?  Can it go against what the market is telling it via bond yields and break-evens?
  • That is why the more important event this week (August 29) may be the Fed’s Vice Chairman’s panel discussion at Jackson Hole on US inflation developments.  We would not look for Fischer to break new ground, but rather to explain how the Fed targets core inflation, and why the appreciation of the dollar, and drop in commodity prices, have a transitory impact on the general price level.   The Fed attempts to focus on the underlying signal of prices.  There are lag times between the change in monetary policy and impact on prices. This is true domestically as well as internationally: the price of money adjusts much faster than the price of goods and services.
  • Many argue that China’s move may preclude a Fed hike.   The Fed keeps its own counsel.  Policy is not necessarily set as the IMF wishes.  It is surely not set in Beijing.   While it is perfectly reasonable that financial conditions are broadly taken into account in the setting of monetary policy, monetary policy cannot be a slave to the VIX either.  Just like the Fed has noted that expectations for higher rates in the US have helped strengthen the dollar, it may have also left equity market vulnerable to a setback.  The fact that it was in such a tight range prevailed for so long. The duration of such a narrow range is rarer than the S&P 500 falling nearly four standard deviations away from its 20-day moving average.
  • Large surprises in data could still matter, of course, given how close we are to the first Fed hike. Markets expect an upward revision in Q2 GDP to 3.2% from 2.3%, according to the Bloomberg consensus.  A sharp drop is expected in the headline for durable orders, depressed by aircraft orders.  Personal consumption, a wider category than retail sales, is expected to rise 0.4%, which would match the three-month average.  And a 0.1% rise in the core PCE deflator may be sufficient to keep the year-over-year rate steady even if not strong at 1.2%.
  • While the media fanned ideas that the sharp drop in equity prices was a sign of fears of a global recession, the Atlanta Fed GDPNow estimate of Q3 GDP nearly doubled from 0.7% on August 13 to 1.3% on August 18.  As more economic data is reported, the Atlanta Fed’s GDPNow model is adjusted.  It is nowcasting not forecasting.  The challenge for the FOMC is not the full employment mandate but the price stability mandate.
  • In the UK, the 0.7% quarter-over-quarter GDP growth reported for Q2 is subject to revision.  It is expected to be unchanged, but there is a small risk it is downgraded slightly.  The details are expected to show that UK exports rose 2.0% in the quarter.  This is remarkable.  Many countries, including Japan and South Korea that have experienced weakening currencies, reported a decline in exports in Q2.  In Q2 sterling was the strongest of the major currencies gaining 6% against the dollar.
  • News from Europe will likely reinforce the view that the best of the cyclical recovery may be behind the eurozone.  The composite PMI has been going sideways since March.  Nearly every member reported weaker than expected growth in Q2.  Germany’s IFO is expected to have softened, dragged down by the weakness of the DAX, China’s stock market sell-off and yuan depreciation. Other EC confidence indicators for the region likely weakened as well. Money supply growth has stabilized though credit growth appears to be continuing to improve slowly.  German and Spain’s HICP measures of inflation are expected to have slipped lower.
  • Japan’s data cycle sees several important reports in the coming days.  These include household spending, unemployment, and inflation.  The general sense is that the contraction in Q2 will not be repeated, but despite the BOJ’s aggressive, unorthodox easing of monetary policy, deflation has not been defeated.   Investors should not focus on the headline CPI figures, or even the traditional core rate, which excludes fresh food.  Although this latter measure of inflation is what the BOJ targets, it is clear from public comments, and confirmed privately, that key officials may be more focused on the measure that excludes food and energy (and alcohol).  That measure is expected to be unchanged at 0.6%.
  • Some observers claim that Vietnam’s currency depreciation, and the decision to float (sink) Kazakhstan’s tenge, was a consequence of China’s currency move.  It is asserted as a fact, but there is no evidence.  The media does not quote officials from either country explaining such motivation.  Vietnam depreciated the dong twice before China’s move.  The only connection with China’s currency move is that it took place prior to the third move by Vietnam.  The larger concern for Vietnam may be the slowing of Chinese growth not the 2.8% decline in the yuan.  This more than the currency explains the decline in Chinese auto sales, cell phone purchases and luxury goods consumption. Kazakhstan is Asia’s largest oil exporter. The share of commodities of its exports is one of the highest in the world; nearly 90%.  Oil accounts for a little more of its Kazakhstan exports.  It had a rigid currency regime.  It has been under chronic pressure even before the collapse in oil prices.  It had devalued by nearly 20% in early 2014.
  • A more compelling narrative of Kazakhstan decision to float its currency links it to the rigidity of its regime in the face of incredibly powerful terms of trade shock.  The drop of oil cannot be directly attributed to China.  The most recent trade data show that the economic slowdown has not weakened China’s demand for oil.  Kazakhstan Prime Minister, Massimov, linked his decision to oil prices, not to China.  The terms of trade shock went more through Russia than China.  Most of the country’s imports come from Russia.  The depreciation of the ruble cheapens the price of such imports.  The ruble has depreciated 11% since China devalued.
  • Unlike Kazakhstan, China’s devaluation was self-imposed.  China chose to weaken the currency.  It was not forced upon it.  Many of the (currency) war camp focus on the depreciation.  Instead, the (potentially, if operationalized) more important aspect of its decision was in letting market forces steer the yuan.   Chinese officials have recognized the need for greater financial reforms.   The pressure is both internal and external.
  • The IMF’s recent staff paper recognized the immense progress that China has achieved over the past several years.  However, it argued that more efforts are needed if the yuan is going to be part of the SDR.   Investors learned last week that the IMF board accepted the staff recommendation to delay the implementation to 1 October 2016 on any decision that the board takes on the yuan later this year.   In addition to making the currency regime more flexible, at least on paper, it also can better generate a real market price that is operationally necessary for setting the SDR prices, which was not produced by the former regime.