Weekly Outlook

By David Morrison  |  09/02/2018 16:35

This article considers the stock market sell-off, bond yields, FX, gold and crude oil

Summary

Friday was a rollercoaster session to round off a tumultuous week. Once again, global stock indices swung about wildly as investors tried to position themselves ahead of the weekend. At the beginning of last week there were a few scenarios which could play out:

1: We get a bounce-back in US stock indices as markets were technically oversold on a short-term basis. Indices make new highs and rally continues. This didn’t happen.
2: US indices rally but fail to take out January highs. Indecisive move which could leave markets range-bound for a while and in a consolidation phase. This didn’t happen either.
3: Indices continue to sell-off and end below prior week’s lows. This happened and is potentially a game-changer. It suggests that we’re likely to experience a longer correction before equities find a base from which to rally. This means that traders will look to sell the rips rather than buy the dips.

It’s important to keep a close eye on US Treasury yields, particularly the 10-year note. Equities sold off sharply when the yield broke above 2.8% but then bounced back as the initial sell-off saw investors rush back into US government debt for safety, driving yields back down below 2.7%. If the 10-year heads back up towards 2.9% (2.85% going into Friday’s European close) then expect equities to sell off again. But watch for sharp reversals if investors pile into bonds again driving yields back down.
 
Key events

Monday -             Chinese M2 Money Supply, New Loans; US Federal Budget Balance
Tuesday -             Australian NAB Business Confidence; UK CPI and RPI; US Speech from FOMC-voting member Loretta Mester; Japanese Preliminary GDP
Wednesday -     German Preliminary GDP, Final CPI and speech from Bundesbank President Jens Weidmann; Euro zone Flash GDP and Industrial Production; US CPI, Retail     Sales and crude Oil Inventories
Thursday -           Chinese Spring Festival; Australian Employment data; US PPI, Empire State/Philly Fed Manufacturing Indices, Weekly Jobless Claims, Capacity Utilisation, Industrial Production
Friday -                 Chinese Spring Festival; UK Retail Sales; US Building Permits, Housing Starts, Import Prices, Consumer Sentiment, Inflation Expectations.   
US corporate earnings include Baidu, Cisco, Coca-Cola, Interpublic, Loews Corp, Marathon Oil, Marriott, Occidental Petroleum, PepsiCo,

Stock indices

The sell-off in global equities continued last week. At their worst levels, all the US and European majors had fallen into “correction territory” having lost over 10% since hitting record highs in January. The 10% fall may be considered a somewhat arbitrary measure of what constitutes a correction and of limited predictive use. But nevertheless, it serves to shake up those investors who have been fully invested or holders of leveraged positions who have enjoyed the near- uninterrupted rally since the Brexit vote in June 2016. The big question for everyone is obviously “what next?”

The honest answer is that no one can know with any certainty. The best one can do is to look back at occasions and look for parallels. In the case of the “dot com” bust in 2000 we had the equivalent of a mania as investors rushed blindly into companies and start-ups without really understanding why. Without doubt, there was a strong story behind the boom as more and more people and businesses went online and the way we interact and transact was changed forever. But not all companies were going to benefit in the same way and most of the late-stage buying was driven by the fear of missing out. Back then a start-up with “.com” attached to its name would be overwhelmed by investors desperately chucking money at it. We’re seeing the same thing now with digital currencies – the insanity of most Initial Coin Offerings and the share prices of companies skyrocketing overnight just by adding the suffix “coin” to their name. But the ongoing cryptocurrency bust hasn’t rolled out to the wider market appreciably, and as with the tech cash, no doubt there will be some digital currencies which will stand the test of time.

But the current situation is different to “dot.com”. In much the same way that World War 2 was really a continuation of the Great War, the problems that we currently encounter have their roots in the fall-out of the financial crisis of 2008/2009. It’s unfinished business, and the current move we’re experiencing is the markets adjusting to tighter monetary conditions as the world’s major central banks remove stimulus and look to raise rates. Add in loose fiscal policy from the US at a time when there’s a synchronised pick-up in global economic growth and suddenly everyone is panicking that inflation is about to surge. This in turn could lead the Federal Reserve to raise rates faster than previously expected – a possibility brought into even starker relief by the Bank of England’s unexpectedly hawkish statement last week. The prospect of higher inflation raises concerns of higher interest rates. Obviously, this is bad for leveraged investors. But higher yields also increase the attractiveness of fixed income over equities which means rebalancing portfolios away from the latter.
 
FX

The US dollar has put in a strong countertrend rally since the beginning of this month. It is up 2% against the euro with the EURUSD approaching support around 1.2200 after topping 1.2500 less than a fortnight ago. The major part of this move occurred last week following on from January’s Non-Farm Payroll release. Traders reacted to the sharp rise in Average Hourly Earnings which were up 2.9% when compared to the same month last year. This was well above the +2.6% reading anticipated and the fastest rate of increase since 2009. The news saw US Treasury yields spike higher taking the 10-year note up to 2.88% - its highest level in almost four years. Investors worried that wage growth was set to feed through to inflation and that the Federal Reserve would look to raise rates more aggressively this year than previously forecast. US Treasury yields have been climbing steadily since September this year. The dollar rallied with them initially as one would expect. However, the greenback then resumed the downtrend which began in early 2017 until yields broke through some key levels which suggested that the 35-year bull market in bonds may be coming to an end.

So, US Treasury yields are key going forward. We can expect the dollar to be supported if yields continue to rise. However, it looks as if investors get spooked whenever the 10-year yield approaches 2.9%. When this happens, equities fall sharply and investors head back into the safety of US government debt, driving yields (and the dollar) back down. It’s also worth keeping a very close eye on the USDJPY. This has fallen back towards significant support around 108.00 and we should expect this to weaken further if the equity market sell-off continues. The Japanese yen is typically another haven in times of market turmoil.
 
Crude oil

Oil has also been caught up in the general “risk off” move over the past fortnight. WTI broke below support (previously resistance) around $61/$62.50. On Friday it went on to plunge below $60 to hit its lowest level since Christmas. According to the Energy Information Administration US production hit a record of 10.25 million barrels per day. The US Department of Energy also reported an increase in crude inventories for the second successive week. Given that speculative long-side positioning stood at record levels going into last week, this was pretty much all that was needed to trigger a sell-off which quickly accelerated into a rout. But the slump in global equity markets also fed into the change in sentiment from positive to negative.
 
Precious Metals

Gold hit a 17-month high at the end of January, just as the major US stock indices reached fresh record levels. Since then, stock indices have slumped by around 10% with some truly scary daily moves. The Dow closed more than 1,000 points (4%) lower twice last week (and this was written ahead of Friday’s open). Yet there’s been no evidence of a “safe haven” move into gold which it would be reasonable to expect if there was a full-blown panic going on. Instead, traders have paid far more attention to the dollar which is undergoing a countertrend rally and finally responding to higher US Treasury yields. However, it’s worth noting that while gold has dropped around 3.5% in dollar terms since the end of January, it is down 2% in euros and unchanged in sterling.

The Dollar Index bounced off a 3-year low at the end of last month after briefly dipping towards 88.00. It now appears to have found support around 88.30 which marks the 161.8% Fibonacci extension of the September-November 2017 rally. The basket is now hovering around 90.00 – an area which acted as support in January. If it breaks above here then we can expect gold to struggle. But a failure could lead to a resumption of the dollar down-trend which should prove supportive for gold and silver. Last week both precious metals slumped below a number of significant support levels. The next line of support for gold comes in $1,300. But a break below here raises the risk of a move to $1,280/85 which roughly marks the 200-day moving average and the 38.2% Fibonacci Retracement of the September-December 2017 sell-off.
Silver looks considerably more vulnerable as the chart gets rather messy at current levels. There’s mild support around $16, $15.80 and $15.60. But one can’t rule out the possibility of a sharper fall taking prices back down below $14 to retest the December 2015 lows. 


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