17-Feb-2020

1) Dollar pares recent gains on profit taking
2) Top three for the week ahead
3) Markets are Data-Driven, but which Data?

 

 

1) Dollar pares recent gains on profit taking

The greenback pared this week’s gain to a 4-month high as a slight downward revision in U.S. retail sales prompted profit taking in New York morning and the usd ended mixed against its G4 counterparts on Friday. The single currency rebounded from a 33-month low on short-covering ahead of weekend while sterling briefly fell across the board on renewed March budget concern.

 Reuters reported U.S. consumer spending appears to have slowed further in January, with sales at clothing stores declining by the most since 2009, which could raise concerns about the economy’s ability to continue expanding at a moderate pace.

The Commerce Department said on Friday retail sales excluding automobiles, gasoline, building materials and food services were unchanged last month. Data for December was revised down to show the so-called core retail sales rising 0.2% instead of jumping 0.5% as previously reported.

Core retail sales correspond most closely with the consumer spending component of gross domestic product.    Economists polled by Reuters had forecast core retail sales rising 0.3% last month.     University of Michigan surveys of consumer confidence index for preliminary Feb reading came in at 100.9 (consensus of 99.5) vs previous reading of 99.8.

 Versus the Japanese yen, dollar swung broadly sideways in lackluster Friday’s trading. The greenback rebounded from 109.74 in Australia to 109.90 in Asia before retreating to 109.71 in New York morning on pullback in U.S. Treasury yields and then moved narrowly in subdued New York afternoon.

 The single currency initially dipped to a fresh 33-month low at 1.0828 at Asian open on euro’s weakness before recovering to 1.0850 in Europe. Despite retreating to 1.0833 ahead of New York open on weak euro zone GDP data, the pair later gained to session highs at 1.0861 in New York morning on broad-based short-coveringin euro and later edged lower to 1.0830 near the close.

 Reuters reported euro zone economic growth slowed as expected in the last three months of 2019 as gross domestic product shrank in France and Italy against the previous quarter, but employment growth picked up more than expected, official estimates showed on Friday.

The European Union’s statistics office Eurostat said GDP in the 19 countries sharing the euro expanded 0.1% quarter-on-quarter in the October-December period, as announced on Jan 31, for a 0.9% year-on-year gain – a downward revision from the previously estimated 1.0% growth.

 Although the British pound moved sideways in Asia and rose in tandem with euro to 1.3063 in European morning, the pair erased its gains and quickly fell to 1.3020 on cross-selling in sterling, then to session lows of 1.3001 at New York open after U.K. Prime Minister Boris Johnson’s spokesman said Chancellor Sunak reminded Cabinet Ministers they need to find 5% budget savings as well as uncertainty if March budget would be delivered on time on the 11th before rebounding.

Reuters reported preparations for Britain’s next budget continue at pace and the government will have a clear fiscal framework, a spokesman for Prime Minister Boris Johnson said on Friday when asked whether the budget would still be unveiled on March 11. “We will continue to have a clear fiscal framework and … that is confirmed at budget,” the spokesman told reporters. “Preparations for the budget continue at pace.” Doubts were raised over the timing of and framework for Britain’s budget when Sajid Javid resigned on Thursday, saying he could not accept the conditions Johnson put on his continued role as finance minister. Rishi Sunak has been announced as his replacement.

 

2) Top three for the week ahead

• Coronavirus, what coronavirus?

Stocks may have had a subdued end of the week, but European and US stocks hit record highs last week even though coronavirus fears went into overdrive. When Chinese officials revised higher recent cases of the virus on Thursday, stocks took a tumble, however, they remain relatively unaffected by the pandemic that is gripping headlines around the world, and which has claimed its first victim outside of China after someone died in France. The situation remains fluid, the impact on growth in China, where thousands of cities remain in lockdown and where millions of people are in quarantine or strict curfew situations, is unclear. Although Asian stocks have taken the brunt of the sell-off, Chinese shares are down 6% since the first reports of the coronavirus, while in Hong Kong shares are down 4%, this is still fairly mild considering everything that is going on. The problem is that we don’t know what the impact on Chinese growth will be, the coronavirus is expected to have a larger impact on the economy than the Sars virus in 2003, but this is because China’s share of global trade is much larger now, at almost 11% of global trade. However, the impact on global supply chains is still unknown. China remains the world’s production powerhouse, where key global products are made, as well as consumed. Take Apple products, they have major production facilities in China, operated by Foxconn, which have only just opened after an extended break since Chinese New Year. This would normally cause investors to fret, not so this time, Apple’s share price is currently 4 cents below its all-time high. The same pattern is occurring across the world, even Toyota, based closer to the epicentre of the coronavirus, has seen its share price fall, but not by as much as expected, and it remains within its 6-month range. Some shares have struggled, for example luxury goods makers including Burberry, but they remain the exception rather than the rule.

So, do investors not care about the coronavirus? Investors do care about the coronavirus, as evinced by the increase in volatility this year, however, they have the ultimate card up their sleeve – the support of central banks. Traders across the world feel confident that if the virus gets any worse, or the economic impact deepens, then central bankers will come to the rescue. Weak growth and low inflation caused the ECB to re-start its QE program at the end of last year, the US cut interest rates in 2019 and remain ready to loosen monetary policy further if low inflation persists, Japan is also pumping liquidity into the global economy. This global tide of liquidity is propping up global stocks and protecting them from the worst of the coronavirus. Interestingly, the one central bank that may not come to the rescue is China’s PBOC. It implemented a one-off liquidity measure at the start of the crisis, but its hands may be tied as inflation for January rose above 5%. Thus, we may need to see a sharp slowdown in economic growth reports in the coming weeks before we see China loosen its monetary policy further.

Due to the market’s reliance on central banks, we believe that the Fed minutes released on Wednesday, are worth watching closely. The market will want to know if other members of the FOMC remain as dovish as Chair of the Federal Reserve Jerome Powell did when he testified to the US Congress last week.

• Economic updates

We will have to wait until Friday, but PMI reports for February for the Eurozone, UK and the US are critical economic reports for traders in the FX and stock markets. Economists are predicting a small decrease in reports for February, after a general upbeat tone to January’s PMI surveys. These reports are important because they are likely to give us a better view of the global economic impact of the coronavirus. As we mention above, the markets have been incredibly tolerant of the coronavirus to date, but will signs of a larger than expected slowdown send shock waves through previously buoyant markets, in particular, the major stock indices?

We believe that weaker than expected PMIs could cause a sell-off in major stock indices at the end of next week, particularly if reports are worse than expected. On the FX front, the impact could be large on the euro. EUR/USD fell below the $1.0850 level, a 3-year low, at the end of last week, which is a key sell signal from a technical perspective. Momentum is to the downside for EUR/USD, as the euro remains the funding currency of choice ever since the ECB restarted its bond-buying programme at the end of last year. The dollar is also in demand, partly because US Treasuries are the safe haven asset of choice in Asia, and also because the coronavirus has reinstated the US dollar’s dominance as the world’s reserve currency, with the euro and the Chinese renminbi unlikely to overtake the dollar’s influence any time soon. Weak European PMIs could send EUR/USD below $1.08, with $1.06, the low from March 2017, a key support level in the medium-term.

• Earnings season – the next big challenge

Earnings season for Q4 2019 is drawing to a close, so how worried are corporations about the coronavirus? According to FactSet, who trawled through transcripts of 364 S&P 500 companies who have reported Q4 earnings between January 1- February 13, 138 mentioned the coronavirus during their calls. The industrial, Information Technology and healthcare sectors were the sectors who referenced the coronavirus the most. Of the companies that mentioned the coronavirus, the average revenue exposure to China is 7.2%, for all S&P 500 companies the average revenue exposure to China is 4.8%.

Of these companies, 25% modified their forward guidance based on the coronavirus, although a majority said that it was still too early to quantify what the effect would be. So far, companies that have issued forward guidance have been less negative than normal, but the fact that 75% of companies that sound concerned about coronavirus had not changed their forward guidance, is worrying. If the economic impact from the virus looks like it has impacted Chinese consumption or that it is causing prolonged production delays for US companies who base some or all of their manufacturing in China, then we may see a rush of companies update their forward guidance in the coming weeks.

Thus, the coronavirus remains an ongoing concern for US stock markets, and even though they reached record highs last week, if they update their forward guidance due to fears about the virus, and if they sound more negative than they did during Q4 earnings season, then investors and traders could easily lose confidence, triggering a sharp pull back in US stocks. Thus, US stock market bulls should remember to protect themselves, this rally could be vulnerable.

 

3) Markets are Data-Driven, but which Data?

Like a Newtonian law of motion, market participants will continue to rely on a particular trading style or system until it stops working. Betting that volatility stays low is a cash register for many, and there appears to be what Soros called “reflexivity” here, like a self-fulfilling prophecy.  Why is volatility low?  Because it is being sold in various ways besides directly selling options.  Buying equity pullbacks and selling euro bounces, for example, also seem to be expressions of short volatility.

There is little on next week’s calendar that threatens to pull the plug on this cash register.  In other circumstances, the eurozone’s preliminary February PMI could have potential.  It is to be reported at the end of the week ahead.  The composite had not fallen since last September when it reached 50.1.  In January, it was at 51.3, little above where it finished 2018 (51.1).  However, one of the most important reasons market participants pay attention to sentiment data, of which this purchasing manager survey is an example, is that it ought to shed light on real sector developments.

Yet the market was shocked by the magnitude of the decline in the December industrial figures.  The December manufacturing PMI for EMU eased to 46.3 from 46.6, having bottomed in September at 45.7.  The 2.1% decline reported last week was tipped by the national figures, but the aggregate decline was the largest since February 2016 (-2.2%), which itself was the biggest drop since early 2009.  While the flash PMI may pose headline risk, it is most unlikely to turn the market.

The ECB’s course also appears set.  Lagarde has not “cleaned house” as Georgieva has at the IMF, and continues on the path set out by Draghi.   However, her presence has already been evident in the lack of sniping and media leaks. This represents an improvement in communication.  There have been reports in the media claiming a backlash against negative interest rates. Yet, Lagarde has given a spirited defense. Last week so did Germany’s Executive Board member, Schnabel, who may be the first in her position to defend it (and vigorously).  The ECB’s chief economist Lane also endorsed its efficacy.

China’s economic data for January and February was always going to be distorted by the Lunar New Year holiday.  This year, because of the new coronavirus  (Covid-19), the data is, particularly, of little value.  In addition to monitoring the progress of the virus in China, where the cases and mortality are the highest, the setting of the Loan Prime Rate will be an important signal.

Recall the one-year Loan Prime Rate has become the new benchmark, and it is set by a survey of the leading banks.  In this sense, it is a more market-driven metric than previously administered attempts.  It is set on the 20th of every month and currently stands at 4.15%.  The median forecast in the Bloomberg survey looks for a 10 bp cut.  If it is wrong, it is likely because rates have fallen faster.  The PBOC granted banks this week funds that can be re-lent to businesses struggling to cope with the effects of the Covid-19 for 100 bp below the one-year Loan Prime Rate.

The signal from Beijing is to go for growth. Yet, the inclusion of CAT scan diagnosis (rather than the nucleic acid test) saw a jump in confirmed cases, and nearly doubling of fatalities. This raises new questions and prompts an extension of closures and disruptions.  While the initial reaction is this was a one-off adjustment, it is not immediately clear.  There are problems outside of China too, with some observers, for example, seeing that Indonesia’s claim of having no cases, is a bit unlikely.  Also, there is concern in some quarters that the incubation period may be longer than initially estimated.

The political consequences are already materializing.  The death of Li Wenliang, a young doctor who was among the first to detect the virus and was harassed by local officials for doing so, and ended up being infected himself, is an unexpected catalyst for change.  It seems clear that public health requires clear and forthright communication, and yet in China (like several other places), this does not exist.  In fact, the lack of open and honest communication costs lives.  It is in this way that this experience is similar to the Soviet Union’s Chernobyl tragedy in 1986.  A campaign pushing for open communication has begun on social media.

Another political fallout is the replacement of the Communist Party heads in Hubei and Wuhan.  However, the replacement of the Director of Hong Kong and Macau Affairs suggests that Xi may be using Covid-19 as cover to pursue a broader agenda.  It may not be so dissimilar from using the anti-corruption campaign to also punish rivals and secure greater power.   A common understanding is that there is a social contract between the Chinese people and the Communist Party.  The latter delivers the goods, literally: rising living standards, and the people defer to the Party.  However, the lack of trust that was simmering below the surface is becoming manifest.  This is another window of opportunity for a change, a concession to people, a civil liberty,  but the greater probability is the opposite.  Push hard for a quick resumption of economic activity and repress dissent.

At the start of the week, investors will learn just how bad last year ended for Japan with the first official look at Q4 19 GDP.  The tax hike and typhoons are expected to have led to a 1% quarter-over-quarter contraction and risk is on the downside.  The reason the market will not act much is that the data is historical, and there are no new policy implications.  More important is how the economy is doing in Q1. There are concerns about the disruption of trade due to Covid-19  and the sluggishness of consumption after the sales tax increase. This may translate into an economic contraction here in the first quarter.

Japan’s January trade figures will be released.  The interest lies not in the balance itself but the components.  Exports were off 6.3% year-over-year in December, which of course, was before the public knew about China’s new virus.  Recall that in December, Japan’s exports of semiconductor fabrication equipment to China jumped by 60%. This is important too because semiconductor chips (design and manufacturing) are seen to be a bottleneck for China.

Japan reports CPI and the preliminary February PMI.  The composite PMI was at 50.1 in January.  Any decline would fan recession (two quarters of contraction) fears.  While much has been done in the name of the core inflation (excluding fresh food), it tends not to elicit much of a market reaction.  The headline may ease from 0.8% to 0.6%, while the core rate is likely steady at 0.7%.

The UK reports employment CPI, retail sales, and the flash PMI.  A couple of weeks ago, the market was particularly sensitive to speculation that Bank of England Governor Carney would cut rates at his last meeting.  Not only wasn’t it delivered but now the data might not be so important either.  The two dissenters at the BOE have been unable to convince any colleagues to join them, and the new governor is unlikely to start his tenure with a rate cut.  The market is fully pricing in a 25 bp rate cut around the middle of Q3.  Meanwhile, the fiscal rules were already relaxed before Chancellor Javid unexpectedly resigned as a consequence of the cabinet and staff shuffle.  The market anticipates an expansionary budget when it is presented in less than a month.

Last week, the Reserve Bank of New Zealand flagged that its easing cycle was over, and the markets believed it.  The currency rallied, and yields rose.  The Reserve Bank of Australia and the Bank of Canada are in somewhat different positions.  The Bank of Canada withstood three Fed cuts last year and stuck to its neutrality.  It has since softened its tone, and the January employment data was sufficient to refute any sense of urgency.  The January CPI report, due in the middle of next week, is expected to reinforce this message.   After finishing last year at 2.2% (November and December), it is forecast to rise to 2.4%, which would match last May’s pace, which itself was the strongest since the 2.8% rate in August 2018.  The core measures are expected to remain broadly steady 2.0%-2.2%.

The Reserve Bank of Australia’s cautious optimism rests on the labor market, which naturally draws attention to the January employment report.  The market is expecting the RBA will cut the cash rate by 25 bp in June or July.  Australia created an average of almost 22k net new jobs a month last year after nearly 21k a month in 2018.  The median forecast in the Bloomberg survey calls for a 10k increase last month.  Full-time positions grew by an average of 12.7k month in 2019 and 13.5k in 2018.  This may overstate the recent trend.  Full-time jobs fell in Q4 19 for the first time since Q1 18.  If the Australian dollar sells off on a strong report, it would be revealing about psychology and positioning.  It has depreciated by 4.4% so far this year to multiyear lows.  According to the OECD’s measure of Purchasing Power Parity, the Aussie is less than 1% undervalued (~$0.6720).

The key to the dollar’s outlook and to Fed policy does not hinge on the high-frequency data that will be reported in the week ahead.  The market continues to discount one rate cut fully and is roughly half-way toward factoring a second cut.  The logic is the same as last year.  The PCE deflator measure of inflation, which the Fed targets, is at 1.6%.  The target is 2%.  Officials continue to see mostly international risks and continued weakness in the industrial sector (contraction four of the past five months), indicating that some risks are, in fact, materializing.  The economy, they assure us, is in a good place, but that does not preclude taking further insurance out, possibly in Q2, extending the business cycle further and pushing the envelope of full employment.

Last week’s retail sales and industrial production reports for January told investors and policymakers that the new year has begun pretty much the way 2019 ended.  The consumer continues to shop but at a more subdued pace.  It should not be surprising as investors also learned last week that real weekly pay is flat year-over-year even though average hourly pay has increased (higher hourly is offset by working a few hours).  Revolving debt (credit cards) has increased to pick up some of the slack.

The production cuts at Boeing are being felt.  Aerospace and parts output fell 9.4% in January, and without it, manufacturing output may have gained 0.3% instead of contracting by 0.1%.  On the other hand, auto production picked up, and without it, manufacturing output would have fallen by 0.3%.  Manufacturing accounts for around three-quarters of industrial output (which includes mining/drilling and utilities).  The output of utilities also fell in January due to unseasonably warm weather that helped other sectors.  More troubling is the continued decline in capacity utilization.  At 76.8%, it is the lowest in nearly 2.5 years.  The low usage rates are associated with weaker profitability and deter new capital expenditure.

The Empire State and Philadelphia manufacturing surveys may draw attention because, outside of weekly jobless claims, they will offer the first insight into economic activity in February.  The Fed’s term repo will also attract interest.  Despite the last three repos being oversubscribed, the Fed announced it would reduce the amount it would make available, and taper further next month.  The Fed is implicitly assuming that it is the cheapness of the funds it makes available that attracts the strong demand and not a shortage of reserves.