Following a holiday-shortened week with a shortage of economic releases, this week's data docket is brimming with valuable information. Undeniably, Wednesday's FOMC meeting will also scare up significant attention, though the Fed is widely expected to remain on hold. However, don’t misjudge the pause as the presser could be eventful.
The FOMC should hold rates steady at the January meeting and reiterate that monetary policy is in the right place. As such, the current stance is likely to remain unchanged, barring a "material reassessment" to the outlook. Overall the market is expecting the meeting statement to be a mostly unaltered version of December's communiqué.
The focus will fall on the presser where it's expected to revolve around 4 major topics — the policy outlook; persistently low inflation; the Repo market; and implications of global risk events.
Bank of England
The sharp bounce in UK PMI data combined with other recent data (CBI, retail sales) infers that there has been a recovery in sentiment since the December 12 general election which reduces the prospects of a January Bank of England rate cut. But at this stage the decision on Jan. 30 remains a coin flip, as traders are still trying to figure out why four MPC members in quick succession basically tripped over themselves to deliver ultra dovish comments. Of course, this raises some concerns that the MPC has information about looming risks more so than the markets have priced.
The number of people who have contracted the novel coronavirus (2019-nCoV) rose sharply in the past few days. The market continues to use past experiences with the SARS like a lens to view the current outbreak. And, of course, the viruses spread is being complicated by billions of travel plans and the mass movement of people over the Chinese Lunar New Year.
Economically the focus will remain on travel and consumer spending. Compared to SARS, 17 years ago, online buying is more significant which somewhat reduces the economic impact of the virus, but travel remains the big elephant in the room for oil prices.
However, most economic damage from a virus comes from fear. Social media is far more widespread today and we know that it spreads fake news farther, faster and more fearfully than it covers the truth.
In that context, last week's measured response from the WHO was received well by the market, but the agency was careful to hedge their bet – and probably wise to given the fact the virus has spread to Singapore, one of the most heavily scrutinized customs entry points in the world. This does suggest that the ideal window for controlling the infection may have passed and that the situation does warrant close monitoring while at the same time raising a visible red flag.
As we open a new chapter on yet another major developing risk event so early in 2020, and after viewing the plethora of media reports from ground zero, Wuhan, it’s increasingly probable to market participants that China's government has failed to contain this viral outbreak.
So, traders are completely pivoting from the other wars, trade and Iran and into the "WARS" zone of another kind: the Wuhan Acute Respiratory Syndrome where the latest travel restrictions now confine nearly 60 million Chinese.
Traders who would typically be discussing the weekend’s football results are now sadly focusing on mortality scores this morning. In my experience no market professional likes making money off misery, but we all have a job to do to protect clients’ savings. So, risk profiles need to be adjusted as the Wuhan frenzy factor kicks in and risk markets enter the fear zone – a highly pandemic place in its own right.
Defensive strategies will be priced at a premium out of the gate this week as investors shed China and global risk proportionally to the mounting reports of confirmed Wu-flu cases worldwide, suggesting the market risk lights could start flickering between amber and red.
While much of the focus has been on the usual suspects of luxury, travel and tourism, just calculating the number of canceled tourist trips, declines in retail trade and similar factors are not sufficient to get a full picture of the impact of WARS. The structural changes to the global economy complicate the economic analysis of this because there are linkages within economies, across sectors and across international trade and international capital flows that need to be factored in.
The biggest threat to the global economy is not just that the disease spreads quickly across countries through networks related to global travel, but also because any economic shock to China's colossal industrial and consumption engines will spread rapidly to other countries through the increased trade and financial linkages associated with globalization.
Unlike 2003 where SARS was less impactful on the developed world market, the rest of the world could feel the pinch this time around. And if the virus stunts domestic economic growth in an echo of the SARS epidemic nearly 20 years ago, the falls could be even more precipitous than projected. There are two reasons for this: 1) consumption is now a more substantial part of China's GDP, and 2) China's overall growth trajectory – in 2002 retail sales accounted for 34% of nominal GDP; this share is now over 40%.
And since China has been at the forefront of the global recovery this year, mostly driven by consumption, there could be a massive knock-on effect globally as China's pivot from a brick and mortar economy to a services powerhouse means they import much more from abroad than they ever did.
There’s already been a significant markdown in China exposure and leisure stocks as positioning had been extremely consensus in both. But, not only could we see a multi-sector ASEAN equity market fire sale unfold, a massive chunk of the nascent great global growth trade of 2020 could unwind. A possible one percent haircut to China's GDP is not a trivial matter because when China sneezes, the world catches a cold.
And there’s nowhere China's economic influence is more on display than in Asia. A key driver of ASEAN's steady growth over the past decade has been the rapid growth in bilateral trade with China. China has been ASEAN's largest trading partner in the past ten years, with two-way trade reaching $292 billion in the first half of 2019, and is a growing source of foreign direct investment. This makes the rest of Asia extremely vulnerable to a China economic slowdown.
Global equity markets
Investors will continue to weigh the anticipated China growth fallout against the backdrop of the current global growth recovery. While the calculus is not coming up roses, it's far from a state of global market panic just yet. Still, if risk aversion starts to spread beyond China's borders and starts to affect more than the usual suspect's luxury, travel, and tourism, then we will likely see a more significant dive in the broader global indices.
On the data front this week, the releasees are expected to mainly reinforce the Fed narrative that consumer spending can carry the load and sustain the expansion through the ongoing soft patch in corporate America spending. So long as the labor market remains strong and consumer sentiment stays sturdy (released Tuesday) the Fed primary inflation gauge, the real PCE, should stay on track and notch above 2 % this year. So, the market will continue to focus on the US jobs market as much of the Feds rosy view hinges on the US employment data.
However, and what could be more harmful to US equities and credit in general is the increasingly collective view that risk is totally mispriced. But given the cushy cash environment there’s an impulse to stay invested but when the Fed pulls the plug it’s time to run to the hills. So, in other words, enjoy the party while it lasts but don’t celebrate too far from the fire exits.
There’s growing concern the Fed has boxed itself in again to a never-ending cycle of liquidity injections that continues to pour gas on the fire pushing valuations into the mesosphere. And when the Fed signals a slowing or stopping of the liquidity firehose it could trigger a mini taper tantrum and deflate the all aboard tech momentum trade.
Because of the US impeachment process and the Democrats dogged determination to air Presidents Trump dirty laundry on a daily basis there is some thought it could affect voting behavior, and this is why the US election risk is brought forward as investors set sights on Super Tuesday.
Moving along the curve , if President Trump doesn't win in November, it will deal markets a Smoking Joe knockout left hook – equities in particular, as they are at record highs so investors will most probably need to take some defensive measure as a hedge against their overweight positions. However, a recent Goldman Sachs institutional survey showed 87% of the buy-side thought Trump would be re-elected.
From a quantifiable perspective, a pullback of 3-5% in the S&P 500 has been typical every 2 to 3 months historically. The last knockdown occurred in early October. At over 3 1/2 months, the duration of the rally since then is already well above average. Is time being ripe for a significant decline?
ASEAN currency markets
Depending on how widespread the outbreak gets, we could see more shifts in the market long ASEAN axes with tourist-heavy THB and the global growth-sensitive TWD as most vulnerable in this case.
The THB remains the most exposed to the new coronavirus outbreak as Thailand is a top destination for Wuhan tourists. Analysis of seat capacity on flights by OAG shows that the two largest international markets are Thailand, with nearly 107,000 seats and Japan with 67,000 seats available.
Other analysts estimates suggest a 3% haircut to tourists during the Lunar New Year holiday week
But if the virus stunts economic growth in an echo of the SARS epidemic narrative and triggers a deeper slowdown in China and weakens the RMB, the jointly Yuan correlated basket of KRW, HKD and MYR have the most to lose
It was a problematic week for Yuan bulls as long RMB was turning into a consensus trade after the P1 trade deal singing. But when it comes to the market, there seldom a free lunch and what is comfortable is rarely profitable.
Risk is trading on the back foot again amid concerns regarding China's deadly coronavirus. And with the Shanghai Composite closing below the psychologic 3000 levels into the LNY, the first time since late December, investors were scrambling to cover downside risk in equities and topside risk in USDCNH.
But this week caution should be exercised given the low liquidity profile typically around LNY. And while the outlook still looks favorable for the Yuan, it could be wise to monitor the virus outbreak and waiting for liquidity to return post-LNY before stepping up to the plate
G-10 Currency Markets
G10 FX vols are holding in for now in though spot markets will be quiet in Asia due to the Lunar New Year holidays across the region. Implied levels are already low, and concerns regarding the new coronavirus outbreak continue, so market makers do not want to be short just in case fear escalation. If the virus outbreak expands, it could significantly impact the currency market where the safe-haven JPY and CHF should shine while the USD will attract its lion share of safe-haven flows.
Especially as the Euro continues to struggle even in the face of a moon shot on this week's ZEW data, and while hints of a move towards a symmetric inflation target are a small positive within the context of the ECB policy review. Still, without a more supportive fiscal policy input and a bounce in rates, the Euro could languish.
Despite the most significant move in near end interest rate pricing for two years as the market upgraded, the probability of an MPC cut the Pound barely blinked. As we suggested on the dovish fist rate cut node for the MPC, the monetary policy transmission to the Pound remains weak and has been the case since 2016. (See chart below) But the market could be getting that sense of déjà vu all over again that the opportunity of capital flows drifting back to the UK in 2020 is too big to ignore.
Monetary Policy Transmission into the Pound (Bloomberg)
Time for an oil change? A sell-off that started in cents is now getting scaled in multiple percentage increments.
Oil sold off aggressively last week on concerns about the impact on China's economy of the outbreak of a SARS-like virus. Brent is down close to 6% relative to previous week highs as fast money speculators are out for bear and were quick to price in worst-case scenarios.
However, oil prices could remain on a slippery slope as traders remain incredibly twitchy about the effects of the Coronavirus outbreak could have on Chinese GDP and air travel more broadly with current estimates implying 250-300kbd of demand at risk.
China remains the most significant driver of year-on-year oil demand growth, so it's fair to assume that the Oil markets will continue to bear the brunt of the China flu fall out. And if the virus stunts economic growth in an echo of the SARS epidemic nearly 20 years ago, the falls could be even more precipitous than projected. And there are two reasons why: 1) consumption is now a more substantial part of China's GDP, and 2) the overall growth trajectory. In 2002, retail sales accounted for 34% of nominal GDP. This share is now 40%.
But significantly for oil markets consumption of services, like transport (related to tourism), has also increased exponentially. Using the SARS epidemic as a lens: In 2002 from a sector perspective, the transport sector was the worst-hit, followed by accommodation and catering, and other services (culture, entertainment, education, social service, etc.)
There is an extremely tight linkage between Chinas economic growth and its appetite for oil.
Positions at risk, the market remains relatively long oil contracts are elevated in a six-month context and could be a factor if the market takes a deeper dive.
CFTC Crude Oil speculative net positions
Upping the defensive allocation in gold once more.
Gold prices ended last week above $1570/oz supported by defensive positioning due to the unknowns around the coronavirus. It’s the unknowns that warrant the market attention and the fear of the unknows probably contributed to the gold market bounce. Its been a pretty consistent theme for the last 2 years, when the market looks unstable, buy gold.
As for the virus breakouts, the patterns can look random. But some health experts have predicted, based on the SARS epidemic 17 years ago, that the coronavirus has now entered a more explosive phase of growth, which could potentially reach its peak in March, before tapering off in May. The upcoming Chinese New Year holiday looks to be a sure-fire catalyst. In 2019, an estimated 3 billion trips were made during this national holiday. And despite China-wide multiple city lockdowns, the fact the virus has spread to Singapore, an overly scrutinized customs entry point, suggests the best window for controlling the infection may have passed.
If the virus continues to spread, and at a faster pace in the coming months, it will represent another significant headwind to growth. Given how early we are in the newfound growth cycle, more policy easing will be needed to support growth, which could be viewed as bullish for gold. A policy response from the PBoC is a given, but the big question is if the Feds need to react.
But the virus in itself is not the primary reason to keep your percentage allocation in gold more elevated than usual.
With the FOMC next week, all eyes and ears will be honed on Chair Powell's presser. Still, more specifically, Chairman Powell will be grilled about the financial stability risks created via the Fed's liquidity injection due to balance sheet expansion. There's no blueprint for unwinding the balance sheet without some element of risk. But the fear heading into the next week's meeting is a communication misstep as he will need to communicate a temporary pause in the Fed's repo activities. Still, a misstatement could easily trigger a huge adverse market reaction. This in itself demands some protection either via long gold or downside JPY structures.
Gold investors appear willing to increase gold allocation on dips ahead of "Super Tuesday "US election risk. And as a hedge against trade tensions reigniting, but broadly speaking, they haven't brought out the big guns just yet.
But overall, it remains a very comfortable environment to own gold with US yields drifting lower and 10-year TIPS lingering around the lower end of the range. The more prolonged low yield environment continues to add to golds allure as a must-have hedge against the backdrop of a plethora of market uncertainties.
But these strategies along with the January seasonality support might be worth reassessing on a clean break of $ 1540/oz
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Ongoing rate curve repricing and risk asset reaction perfectly illustrate how worryingly reliant investors have become on easy money policies