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Buy the dip?

By David Morrison  |  12/10/2018 15:10
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This week saw a dramatic sell-off across global equity markets. But US equities were bouncing sharply going into the last trading session of the week. Does that sound the ‘all-clear’?

T
here was a dramatic equity market sell-off this week which was variously blamed on the threat of higher US interest rates, the possibility of a slowdown in global growth, the simmering US/China trade war, the Italian government’s deficit-busting budget plans, rising bond yields, high oil prices, emerging market woes, German state elections and the beginning of the third quarter earnings season. Have I missed out anything?

Friday bounce

But US stock indices bounced sharply going into Friday’s open, suggesting to many that the worst may now be over and that once again, the correct response to this week’s sell-off was hold your nose and just “buy the dip”.

Nerves of steel

It certainly does require nerves of steel to pile in on the long side following the kind of market rout we saw this week. But those with the strongest stomachs will simply point back to other occasions over the past ten years as evidence to show why this has been a successful strategy. Will it prove to be so this time?
Maybe. But it’s also fair to point out that there are some serious issues currently being dealt with and more on the horizon. Bulls will say that there’s no secret that concerns exist, but all factors are out in the open and therefore priced in.

Goldilocks scenario?

But it can also be argued that what the bulls are really pricing in is a successful outcome to each of these issues.  It may be reasonable to assume that the Italian coalition government and the European commission will find some mutually face-saving fudge to their showdown over Italy’s budget proposals, but what if they can’t? And will Presidents Trump and Xi finally meet up and come to an agreement over trade, or will the current situation deteriorate first? The sell-off in the Chinese yuan has taken the USDCNY rate dangerously close to the 7.00 threshold (currently 6.92) giving Trump the excuse to accuse China of deliberately devaluing her currency to offset the effects of recent tariffs. This kind of escalation only raises the prospect of US tariffs being hiked to 25% from 10% currently. But the 10% sell-off in the yuan since April is as much a function of the ongoing slowdown in Chinese growth, something that is given expression not just in the weakness of the Shanghai Composite, but also the German DAX as Germany’s exporters feel the pinch. The ongoing trade war could easily escalate from here.

Bond yields 

As for bond yields, we’ve seen a pull-back in the US 10-year Treasury note bringing it back from 3.26% (a seven-year high) to 3.16% earlier today. This represented a ‘flight-to-quality’ as investors rushed to buy bonds as equity markets sold off. But yields remain elevated as investors reprice the path of monetary tightening (and possibility of slower GDP growth) from the Fed. And if the 10-year holds above 3.05% there is a danger that yields may head higher again as this level marks a technical upside breakout. This may not matter too much if it happens at a steady pace, but another sudden jump in yields will once again panic holders of equities.

Fundamental perspective

So, from a fundamental perspective it boils down to this: if investors continue to believe that the US/China trade war is not only positive for the US (as is suggested by the confidence in US equities) but will be resolved without significant escalation, and if the Fed’s proposed rate hikes are a function of solid economic growth and a gradual pick-up in inflation, and if we don’t have another bond market tantrum which sees the 10-year yield rapidly shoot up to a fresh 7-year high, then all should be fine.
But if US economic growth has peaked, or if inflation (as measured by CPI and Core PCE, as opposed to the obvious inflation we see in equity, bond and property prices) takes off, or if US/China tariff wars escalate along with raised tensions between Italy and the European Commission, or we get another sharp spike higher in bond yields, or if US third quarter earnings disappoint, then this week’s sell-off could prove to be the precursor of a more substantial correction.

What about the charts?

From a charting perspective, there’s a disconnect between the US and Europe. So far, the sell-off in the US majors hasn’t done any significant technical damage. The key moving averages (50, 100 and 200-day) are all stacked up in ascending order suggesting that the trend is still to the upside. Only in the Russell 2000 is there a danger of the 50-day crossing below the 100-day, something which, should it happen over the next few weeks would presage a rush to cut long positions.

”sp500

But the technical outlook for European stock indices is less bullish. The German DAX is proving particularly vulnerable to selling with the key moving averages indicating the path of least resistance is to the downside. This week’s sell-off saw the DAX break below 11,700 - roughly the low hit back at the beginning of this year. And as of Friday afternoon, the early rebound had reversed with 11,700 now acting as resistance. Certainly, worries persist, but it remains unclear if US optimism will continue to trump the gloomier European outlook.


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Any information, analysis, opinion, commentary or research-based material on this page is for information purposes only and is not, in any circumstances, intended to be an offer of, or solicitation for, a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. Any person acting on it does so entirely at their own risk and GKFX accepts no responsibility for any adverse trading decisions. You should seek independent advice if you do not understand the associated risks.
 

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