Markets appear to be at important cross-roads

Besides the clearly negative performance of assets related to Dubai or Greece, the past weeks have essentially seen range-trading in important markets. However, this range-trading seems to mask some interesting breaks or tests of the medium-term trends, highlighting that the risk of a fundamental change in market sentiment has grown larger again.
First, it was widely reported over the past weeks that the trade-weighted USD has broken through its downward trend (see chart below) late October. However, despite this trend-break, the USD continued to make new lows.

Trade-weighted USD broke through medium-term downward trend in October

Source: Bloomberg

One reason why the USD continued to weaken is that this technical signal (the trend break) was not confirmed by the major crosses and the USD remained in its downward trend vs. for example the EUR and the JPY. However, at the end of last week EUR-USD has broken through its upward trendline (see chart below). This to me is the first confirmation that a trend reversal in the fate of the USD is indeed in store.

First confirmation of a USD trend-reversal: EUR-USD has broken through its upward trend

Source: Bloomberg

In the commodities space, the bullish trends have so far remained intact. However, the index as well as some important sub-components are just trading at the trend line. First, the CRB index has almost exactly closed at its medium-term upward trendline (in place since early March) yesterday. The trend was running at 267.55 vs. a close in the index of 267.75. With a slope in the trend of 0.34, the CRB index needs to move slightly higher today in order to remain above this trend.

CRB index is testing its medium-term upward trend

Source: Bloomberg

Within the commodities space, the sub-indices for Livestock and Agriculture remain in a longer term sideways trading pattern whereas industrial metals continue to trade higher. Precious metals technically also remain in a longer-term upward trend despite the latest correction. However, the energy sub-index has closed below this year's upward trend just yesterday.

Diverging behaviour of commodity sub-indices

Source: Bloomberg, Research Ahead

Looking into the energy sub-component, we find that while the roll-adjusted ICE Brent crude future has closed just slightly above its medium-term upward trend yesterday (exactly as the overall commodity index), the ICE WTI crude oil future has broken below this trend on Tuesday and the Nymex WTI crude oil future yesterday.

ICE WTI crude oil future broke through upward trend on Tuesday

Source: Bloomberg

In the equity space, the S&P index is trading just above its upward trendline and also other major equity indices so far remain above the trends. However, the DJ Euro Stoxx 50 index has also broken below its upward trend on a closing basis yesterday.

DJ Euro Stoxx 50 has closed below its upward trendline

Source: Bloomberg

As stated several times previously, in the rates space, 10y Bund and 10y US Treasury futures remain guided by their upward trends.

Overall, markets appear to be at interesting cross-roads and especially the commodity complex looks weak. I think that especially energy commodities trade too high amid a lack of end-demand which should result in lower prices. Therefore, I also look for a break lower in the overall commodity index. Moreover, I still remain convinced that the subdued growth environment will act as a significant headwind for risky assets in general which should become more apparent again once the wave of central bank liquidity ebbs.

Strengthening headwinds for commodities

I frequently highlighted the connection between the BDI and commodities as well as between commodities and government bond yields (see for example: Commodities and related markets to fall first? dated August 26). Following a sideways trading pattern between mid August and mid September, the BDI has fallen by another 12% over the past 10 days. I still think that a great part of the surge in the BDI during H1 this year and the subsequent rally in commodity prices was down to stockpiling, most notably by China. When this stockpiling faded, the BDI collapsed and in turn commodity indexes moved into a sideways trading behaviour. The latest fall in the BDI suggests that further downward pressure in commodity markets is upcoming - in line with my fundamental view.

Latest fall in BDI as a precursor for the fate of the commodity prices?

Source: Bloomberg, Research Ahead

On an individual commodity price level there area also some interesting developments. For example, oil prices have broken through an upward trend following the release of US inventories earlier this week which have increased significantly. Technically, it is too early to tell whether oil prices are at the start of a new downward trend or whether the sideways trading pattern of the past months continues. However, fundamentally I continue to look for lower prices as the rise in inventories seems to confirm my view that indeed end-demand remains subdued while spare capacity remains relatively high.

Oil prices have broken through their upward trend

Source: Bloomberg

Moreover, also copper shows signs of exhaustion following the doubling in prices up to end August and has since retreated by 10%. This is fairly important as industrial metals are the sub-component of the commodity index which have shown the largest performance since the start of the year. The chart below shows the various sub-components indexed at 100 at the start of the year. Agriculture and Livestock have both not contributed much to the general commodity price performance this year and a break-down in energy and industrial metals prices could bring a significant correction in the overall commodity indexes.

Industrial metals and energy products have been a key driver of overall commodity performance

Source: Bloomberg, Research Ahead

As suggested several times, commodities and government bond yields show a high co-movement at present and a significantly different picture than the development of equity markets. This should not be that surprising given that lower commodity prices would go hand in hand with low headline inflation and therefore low nominal growth. Nominal growth, however, is the key driver for the longer term development of nominal government bond yields.

Ongoing co-movement of commodities and government bond yields

Source: Bloomberg, Research Ahead

Overall, fundamental headwinds for commodity prices remain substantial and the technical situation for energy products as well as industrial metals is weakening. I stick to my view from late August where I stated that timing wise we should see commodity markets to start falling which will spill over into commodity economies' equity markets and be followed by developed equity markets moving lower as well.
On the other side, the fundamental environment for government bonds remains supportive and I continue to expect a break lower in government bond yields over the next days/weeks.

UK: New data, same problem

I remain convinced that most developed markets' economies exhibit much less inflation pressures than is generally believed. Core inflation rates will fall further and nominal growth rates will remain muted for a prolonged period of time. However, I am seriously worried about the developments in the UK. I previously argued that I see the most pronounced risk of an inflationary outcome for the UK (see for example: Revisiting the UK: Not much good news dated August 18) and highlighted the disappointing development of UK inflation relative to the US and the Eurozone. Today, the August CPI data were published. Unfortunately, they did nothing to change my downbeat assessment as inflation once again overshot consensus and core inflation failed to moderate.
True, yoy inflation fell further, to 1.6% from 1.8% in July. However, this was once again above consensus expectations (which were looking for a 1.4% reading). Furthermore, compared to the US and the Eurozone, the UK's inflation moderation during the current year remains much more muted (last US and Eurozone numbers are for July):

Source: Bloomberg, Research Ahead

Moreover, as mentioned above, inflation has continued to overshoot expectations. As the chart below shows, this is unfortunately the rule rather than the exception. The chart adds the difference between actual inflation (mom value) minus the forecasted value (Bloomberg consensus). While during 2007, US inflation tended to overshoot vs. expectations, since mid 2008 this has been the reverse. In the Eurozone (I have used German inflation as it is been released relatively early), inflation tended to be more or less in line with expectations. In the UK, however, since early 2008, the consensus has consistently underestimated inflation (be it on the way up during early 2008 as well as on the way down over the past months). This was evident again today where actual mom CPI came in at 0.4% vs. expectations of 0.3%:

Source: Bloomberg, Research Ahead

Finally, core CPI in the US and the Eurozone has been falling (albeit slowly) on a trend basis since late 2008. However, UK core CPI has been increasing over the course of this year! This trend has been confirmed today with yoy core CPI remaining unchanged at 1.8% vs. expectations for a fall to 1.6%.

Source: Bloomberg, Research Ahead

Therefore, I can only repeat my conclusion reached in mid-August:
"I remain seriously worried about an inflationary outcome in the UK (in contrast to the US and the Eurozone) and suggest to underweight the UK from an asset allocation perspective. UK Gilts risk underperforming significantly vs. the US and Eurozone counterparts over the medium term and yields are likely to rise over the next quarters."

Market Update: Beware of the inflationistas

I highlighted several times the discrepancy between commodities and bond yields on the one side (sideways to lower) and equities on the other (up). As written in Commodities and related markets to fall first? I expect more downside in commodity prices in general amid a lack of end-demand which will subsequently spill-over into equities whereas government bonds should remain well supported. However, given that gold has traded higher recently and amid a falling USD, several market commentators have suggested that inflation pressures are resurfacing. This would clearly have vast implications from an asset-allocation perspective and run completely against my proposed stance.
However, I disagree with this inflationary view. I have frequently made the fundamental case for ongoing disinflation (amid a very high level of unused capacity and low credit creation). Furthermore, I also think that it would provide an inconsistent picture about what is currently happening in global markets. If inflation fears were indeed rising, then why are commodities in general not rising and why are government bond yields falling (with US yields at the short and long end outperforming their international counterparts)? Rather, I think, markets are not sending any signal about rising inflation fears:
First, last week I suggested that the price action in Gold might well be down to Barrick Gold buying back their gold hedges (which increases demand for gold now but also increases future net-supply). This would explain the surge in gold prices but would not send any inflationary signals.
Second, if inflation fears would be rising, it would be the ultra-long bonds which should send the least bullish/most bearish signal from the government bond market. On Friday, I suggested that 30y UST yields were sending an encouraging signal for the entire US Treasury market as they trade in a downward trend and try to overcome a strong support area in between 4.10-4.20%. Furthermore, and in contrast to its 10y counterpart, it has already traded through its former July yield-low and sends a bullish technical signal. So again, no inflation signal from this part of the market.
Third, the fall in the trade-weighted USD might well be down to USD Libor rates for the first time falling below their Japanese counterparts and rendering the USD the new funding currency of choice for carry trades, or at least reducing its appeal as an investment target. Both, make it more difficult to finance the current account deficit. However, as the experience of the Swiss and the Japanese economies have shown, a carry trade currency does not need to be mirrored by rising inflation rates. Therefore, the weakening USD - rather than signalling rising inflation expectations which would go hand-in-hand with rising yields - might well be down to USD rates dropping more than elesewhere amid low inflation pressures.

USDJPY: pressured downwards by falling USD yield advantage

Source: Bloomberg, Research Ahead

Fourth, within the commodities space it is so far mostly gold (and silver) which move higher, whereas the broader commodity complex continues to trade in a sideways to lower fashion. Frequently, gold shows a different behaviour than most of the other commodities. The chart below compares gold with the CRB index and shows that expecially during the past 12 months, there has been a significant discrepancy.

Gold and the CRB-index: not much co-movement

Source: Bloomberg, Research Ahead

On the other side, oil is much closer correlated with the CRB-Index (yes, energy has a larger weight in the index than gold but it is also true for other commodity indeces):

Source: Bloomberg, Research Ahead

Energy (as well as several base metals and agricultural commodities) are continuing to trade in a sideways to lower fashion and are not sending any inflationary signal which would confirm the rise in gold prices.

Overall, I would warn of any inflationary explanation of the recent rise in gold prices and the fall in the USD as it is inconsistent with current market behaviour. Rather, I think that gold is rising due to a special factor (the buying back of former gold-hedges) and the USD is falling amid reduced yield pick-up (given a DROP in US yields on an absolute basis and relative to their international counterparts). Overall, the fundamental picture calls for ongoing disinflation amid exceptionally high unused capacity and limited credit creation and market developments do not stand in this way. I still maintain my view that inflation pressures are very low and commodities should suffer further in the weeks and months ahead, ultimatley being followed by equity markets trading significantly lower again whereas government bonds remain supported.

Commodities and related markets to fall first?

Equities continuing to roar ahead while government bonds are trading supported has a goldilocks taste to it. As mentioned on Monday (see Rates Strategy Update: Sticking to longs), I think that equities rally on the back of the improving growth outlook whereas bonds trade supported amid a lack of inflation pressures. On the other side, the development of commodities on average remains relatively muted with several important commodities seemingly going nowhere over the past weeks (for example oil and gold). While I still continue to look for the equities rally to falter, it could well be that commodities and related (emerging) equity markets will lead the way.

Earlier this year it was the emerging markets world (most notably China) which led the risky asset rally and in conjunction with ultra-low central bank policy rates and the quantitative/credit easing measures were fuelling the fear of rapidly rising inflation rates, especially via a liquidity-induced commodities rally. If anything, long commodities seemed to become a consensus trade. Furthermore within equities money was flowing towards the emerging markets world. However, as the chart below shows, commodities have significantly lagged the upswing in equities. I have set the S&P500, the DJ EStoxx and the CRB-Index at 100 for March 6 (the day of the equity low). Since then, the S&P and the EStoxx have traded almost exactly in line with the same performance. However, the CRB Index has trailed the substantial equity performance by a significant margin. Furthermore, especially over the past month, there is a discrepancy with commodities trading sideways to lower and equities rallying further.

Commodities lag equities

Source: Bloomberg

Bringing government bonds into the picture as the chart below does via 10y Bund yields suggests that bond yields are currently moving more in line with commodities than with equities and as a result show the same discrepancy in terms of performance.

Bonds trade in line with commodities and less with equities

Source: Bloomberg

The lacklustre performance of commodities supports my notion that bonds have been moving higher/yields lower on the back of easing inflation fears. But why is it that commodities fail to rally in line with equities? Furthermore, is the performance of commodities a sign of things to come for equities (i.e. a lack of end demand as a precursor for renewed growth weakness) or another positive for equities (as it eases inflation worries and helps to keep rates low for longer)?
For one, I think a key reason why commodities seem to be going nowhere these days can be found in China. China seems to have gone on a commodities re-stocking spree (see for example The China Syndrome by MacroMan) and has injected a massive dose of credit into its economy earlier this year. However, both seem to have come to an end as the announcement of a stricter lending environment by Chinese officials suggests. This was also mirrored by the Shanghai equity index which is down some 15% since the start of this month. The end of the commodities restocking cycle would also explain the easing in the Baltic Dry Index which already topped in early June but is down another 25% this month:

Source: Bloomberg

Clearly, easing commodity prices are a positive for net commodity-consuming economies such as the US or the Eurozone and constitute a positive terms of trade shock via lower imported inflation. Furthermore, as it eases still persisting inflation worries it allows central banks to keep ultra-low policy rates for longer. Thereby, this would come a long way in explaining the recent co-movement of government bond prices and equities (both up).
Furthermore, I remain of the opinion that there is more downside for commodities in general amid relatively less demand and because any re-stocking can not go on forever (first, it is costly to hold physical commodities and second, there are no infinite storage capacities). Given that a lot of speculative money seems to have flown into commodites and related equity markets, it might well be that performance disappointment sets in which would lead to downward prices on such assets. In turn, I maintain my negative view for the commodities complex and the bullish outlook for government bonds.
From the data I have available, I cannot judge yet whether the developments in commodities is a sign of a broader weakness in end demand or just due to the end of the re-stocking cycle and less speculative flows. If purely the latter, then the positive impact on developed market equities might be sustained, however, if more from the former, then we should see the US and Europe be dragged lower as well via renewed weakness in exports. So far, my view remains that the equity rally will falter soon amid renewed growth disappointment.

Asset Allocation: Kissing the risk-recovery goodbye

Equity markets rallied sharply during the Q2 earnings season of the past weeks and surpassed their early June highs significantly. However, by now they look exhausted and burned-out. Strategically I have been recommending a defensive asset allocation (Asset Allocation: Defensive stance on June 22) but have proposed to lighten up all positions on a tactical basis on July 14 (Market Update: Temporary counter-movement) with the aim of getting back in on cheaper levels. Now, I realign my tactical outlook with the cautious strategic stance as the recovery in risky assets is ending:

Government bonds: Long duration
Equities: underweight, especially in cyclicals/consumer durables/financials&commodities
Currencies: overweight USD & JPY. Neutral on CHF. Underweight EUR, GBP and commodity-currencies.
Credit: Neutral to moderately underweight credit overall. Within credit overweight higher-rated non-cyclicals (for example utilities) across the curve vs. lower-rated cyclicals.
Commodities: Underweight, mainly energy and base metals but also Gold.
Cash: Overweight

The positive market developments during the Q2 earnings season of the past several weeks was largely down to the positive earnings surprises and the consensus shifting in favor of a marked brightening of the fundamental economic outlook. GDP expectations for Q309 as well as 2010 in general have seen a material upward shift. Additionally, as written here, sentiment towards equity markets has turned largely bullish. For example, according to the American Association of Individual Investors, most US retail investors have become bullish again, for the first time since May 2008. Furthermore, according to ChartCraft's Investors Intelligence, bullish institutional investors outnumber bearish ones by 2:1 and the percentage of bears is back to the lows prevailing in October 2007 (i.e. just when the S&P500 made its all-time high)!
This high level of investor enthusiasm lets me think that by now the positive news is more than adequately priced in. Yes, Q309 should show a markedly positive number in terms of US GDP growth, however, as I have written already previously (Q3 growth likely to surprise positively but not final sales) this should be mainly down to the reduction in the negative contributions from auto manufacturing and residential investment as well as a decline in the pace of inventory liquidation. Furthermore, net exports are likely to contribute positively. Final demand on the other side, does not promise to stage a significant rebound. For one, the positive development of net exports masks that both, imports and exports are falling (just imports are falling more). Furthermore, as US retail sales showed again last week, consumption remains weak. Finally, such weak developments of consumption coupled with the current extremely low level of capacity utilisation will keep business investment depressed.
Additionally, the positive earnings surprises evident for Q2 are more down to cost-cutting than a brighter fundamental backdrop given that revenue surprises painted a much less positive picture. Cost-cutting, however, will further depress future demand growth.

Oil: Upward trend broken, stochastics turn lower from overbought levels

Source: tradesignalonline.com

Finally, the market technical picture has been deteriorating over the past days. This is especially evident in some commodity markets as for example oil. The chart above shows that oil has broken through its former upward trend on Friday. Furthermore, stochastics are in overbought territory but have started to fall, also signalling that we are likely at the start of a more pronounced downward-movement.

Overall, I think that markets have discounted a too bright growth outlook, sentiment has become overly bullish and technically markets are starting to fall back from overbought levels. Therefore, I expect a longer-lasting and deeper downturn in risky assets which will also be mirrored by a widening of credit spreads as well as by a sharper downturn in commodity prices. I propose a defensive asset allocation from a strategic as well as a tactical horizon.

Market Update: Near-term risk-recovery not over yet

The recovery in risky assets remains in full swing whereas the correction in government bonds is ongoing even though in comparison it is relatively shallow. While I have been expecting this risk-recovery period to be over by the end of this month (see for example Market Update: Temporary countermovement), there is a clear risk that it might last a few days longer. However, in line with my near-term growth outlook, I still expect this period to be a temporary one with a deeper correction in risky assets into autumn and winter.

Equity and credit markets continue to be the driver of risk recovery. Broadly speaking, credit spreads have tightened back to their early June lows while equities are back to their early June highs. However, regionally there are some significant differences. For example, the US Nasdaq and Dow Jones as well as the Swiss SMI, the Spanish IBEX or the Swedish OMX have all surpassed their early June highs on a significant basis. Others, for example the DJ Euro STOXX50 and the UK FTSE are almost exactly at the highs of early June while a third group such as the Nikkei or the Brazil Bovespa fall short of the early June levels. Commodities on the other side remain lagging and for example the CRB-index has only recovered approx. half the losses it incurred since mid June, trading some 7.5% below the June highs.
Technically, most markets do not seem overbought yet and also the fact that a growing number of equity indices is making new highs suggests that the upward movement can continue in the short term. This would fit with apparently still high cash levels for a large part of institutional and private investors as well as improving near-term growth prospects and the news so far regarding Q2 earnings. According to Bloomberg, 76% of the companies out of the S&P500 which have reported earnings surprised positively vs. consensus expectations. As Bloomberg states: 'Despite a 6.4% drop in earnings for companies that have announced their results, firms in aggregate have exceeded expectations by 16.1%. Financials has beaten analyst projections by the widest margin.'
Credit spreads back at early June tights...
...Equity markets back to approx. early June highs...
...wheras commodity markets lag in performance...
...while correction in government bonds is ongoing but relatively shallow

Source: Bloomberg

However, despite the short-term risk recovery, my strategic asset allocation outlook remains cautious. As I laid down in Q3 growth likely to surprise positively but not final sales while near-term growth prospects look positive indeed, this is not the case for final demand and the growth rate should move lower again into autumn and winter, further aggravated by the rapidly rising risk of a swine flu pandemia in the Northern Hemisphere (see: Deflation due to swine flu?). Furthermore, I also see this subdued medium-term growth outlook being confirmed by the Q2 earnings season. To quote Bloomberg again: 'Revenue, excluding the Financials & Utilities sectors, is anticipated to be down 16.7% over the prior year. If the street consensus holds true, this will be the worst decline in the history of our database going back to 1994. Health Care is estimated to be the only sector to register an increase in sales.' If my impression is correct (sorry, but I could not find a hard statistic on this one), so far revenues vs. expectations has provided a mixed bag with several firms beating earnings expectations but falling short of revenue expectations. This to me suggests that more aggressive than anticipated cost-cutting exercises have been a key driver of earnings developments. It would also explain why the US unemployment rate has been increasing much faster than most anticipated even though Q1 (and most likely Q2) growth has not been much worse than expected. Furthermore, the divergence between earnings and revenue surprises explains as well the outperformance of credit and equity vs. commodities (i.e. still subdued growth in the demand for real assets).
Finally, as these cost-cutting exercises are performed on an economy-wide basis, they risk threatening the recovery as they lead to further weakness in final demand with a time lag. This is becausse the cost-cutting exercise of one firm is being mirrored by other firms' revenues or households' incomes being cut, leading to weaker future demand.

Overall, it seems that the near-term risk-recovery can run further which means that bond prices will also correct lower. While I previously expected this period to be over by the end of this month, there is a clear risk that it might last a bit longer. However, the medium term outlook remains subdued and a renewed period where risky assets and government bond yields move lower - most likely for a prolonged period with more pronounced losses - is likely to start sometimes during August. Therefore, I reiterate once again that I maintain my strategic defensive asset allocation stance but stick to a reduced risk taking on a tactical basis. The 120 area in the Bund future still looks as a good target to open/add to long duration positions.

Deflation due to swine flu?

The UK Telegraph ran a story on Monday Swine flue threatens deflation slump, Ernst & Yound ITEM Club report warns. To quote: "The group said a pandemic reaching 100,00 cases a day by August, and lasting six months, would lead to a 7.5pc fall in GDP this year. The lingering damage would cause a further fall of 1.2pc next year. 'With the western world still teetering on the brink of deflation it is not an exaggeration to say that a pandemic on this scale could tip it over the edge,'it said. The figures are based on projections made by Sir Liam Donaldson, the Government's chief medical officer. The report assumes that infections will ultimately reach 50pc, with a mortality rate of 0.4pc. Most of spread will occur before a vaccine is ready. 'Sir Liam is an expert on pandemics. We think his advice should be taken very seriously,' said the report. 'The main effect on the supply side will be that sick employees cannot go to work. On the demand side, spending on discretionary goods and services such as restaurants or tourism is likely to fall as people stay away from public places to avoid infection. Uncertainty about these developments is likely to make businesses further postpone investment projects,' it said."

It has been relatively calm in the Northern Hemisphere regarding the Swine Flu over the past months. However, in the Southern Hemisphere where it is currently winter, the virus has spread further. For the Northern Hemisphere, the situation will get worse when the usual flu season starts, i.e. around autumn.
As this article suggests (written in German by the Swiss daily NZZ), the swine flu might start to hit especially hard in September when most of the tourists are back from vacation and kids are back to school (as schools are a good reservoire for a virus). The expert quoted expects a vaccine to be ready during October. Effectively a vaccine will be produced by mid August but needs to be tested for effectiveness and security which will last into September. Thereafter national authorities will be informed and have to decide how to proceed. For Switzerland it is expected that between 1 and 2mln people will catch the swine flu (out of approx. 7.7mln).
So far the mortatility rate has been low. Nevertheless, if indeed infections reach such a high percentage of the population, it will have a significant impact on the economy. Both demand and supply will be negatively affected and therefore the impact on GDP growth is clearly negative. However, I have my doubts whether this will prove deflationary. First, it affects both supply and demand and it is not clear how the balance between the two will shift. Will we end up having more goods relative to demand than would otherwise be the case or is supply falling more than demand? Furthermore, at least part of the drop in demand will likely be temporary only and be reversed once the pandemic subsides (i.e. if I do not buy a car this week because I am sick, I am most likely still going to buy it once I recover).

Overall, there is a substantial risk that economic growth will be hit seriously during autumn and winter in the Northern Hemisphere amid a swine flu pandemic. The impact on inflation is less clear cut though. Moreover, following the Swine Flu scare earlier this year which did not leave an impact on the major economies, markets do not seem to price this risk adequately. It would clearly be a negative for risky assets as well as a positive for government bonds (due to lower growth and rising risk aversion). Within the government bonds universe, however, it is not clear whether inflation linkers or nominals will be the winner. The likely effect of a Swine Flue pandemic as well as its timing lend further support to my base case that the current recovery in risky assets will prove temporary.

Market Update: Impressed but not shocked

The correction in Bond markets as well as the recovery in risky assets is now well underway. Technicals have all turned relative to June's development as the upward trends in government bond futures have been broken to the downside and the downward trends in equity markets to the upside. Favorable Q2 earnings reports, the ongoing stabilisation in economic growth as well as firming expectations for positive growth during Q3 in the US provide the fundamental backdrop. I do not propose to stand in the way of this train. I maintain the view that 120 should provide a good support area - and entry area for potential longs - in the Bund future during this correction period which is likely to last another 1-2 weeks.
I have been looking for a consolidation in government bond prices since last week (see here) and also suggested that risky assets might recover again (see here) and the development in govies is so far playing out as expected. Also the recovery in commodity prices is in line with my expectations. As the chart shows, the CRB-Index has only moved moderately higher during the past days.

Source: Bloomberg

However, the speed of the equity market recovery has been impressive. The chart below shows the Euro Stoxx 50 index (but the same applies to a lot of the major equity indeces). The downward trend line which guided market movements during the past weeks has been broken to the upside on a closing basis. Furthermore, during a period of only four days, two-thirds of the previous downmove has been corrected again. The positive fundamental news (mostly from the US earnings season) has met with a market that was positioned for a break lower. For one, investors' cash levels still appear high. Furthermore, there has been a lot of talk about a bearish so-called Head & Shoulders chart pattern developing for example in the S&P which seems to have led some technical oriented accounts to set up shorts (see here: Head&Shoulder failure).

Source: Bloomberg

Clearly I see no reason to change my fundamental longer term macro-economic outlook where I expect muted growth and subdued inflation for the global economy and especially the large 'developed' countries (amid an ongoing deleveraging in the corporate and household sectors which will lead to weak demand growth). Essentially, growth on a quarter-over-quarter basis should oscillate around a low but slightly positive level (i.e. below trend) for the next several years. However, the ongoing economic stabilisation in the near term (amid a stop in the inventory correction and increasing effects of the enacted fiscal stimulus) is likely to fuel renewed hopes about a sustainable recovery and combined with still high levels of cash suggests that the current upward movement in equity markets risks surpassing the early June highs.
Therefore, I reiterate that I maintain my defensive asset allocation stance from a more medium-term strategic perspective but would reduce risk temporarily on all fronts.

Market Update: Temporary Counter-movement

Since I changed the tactical Bund market outlook to neutral last week and advised UST-Bund spread tighteners, i.e. long UST positions vs. Bunds (see: Rates Strategy - digging below the surface), the Bund bull market has started to stall and Bunds have underperformed significantly vs. USTs. Still, up to yesterday afternoon, the Bund future has moved in a tight trading range and speaking of a consolidation would have been exaggerated. However, since then a more pronounced setback seems to have started and this morning the Bund future dropped below its upward trendline which has directed trading over the past month (see chart).

Source: tradesignalonline.com

In combination with the current overbought stance this might indeed signal that the consolidation I am expecting to develop over the next 1-2 weeks has started. Furthermore, risky assets have been showing the opposite behaviour and I think especially the S&P500 is showing an interesting development. Over the past month, the S&P has lost almost 10% from its high (956 down to 869). On a closing basis, the support zone at 879 has held this week (even though on an intraday basis it was broken by approx. 1%). There has been a temporary recovery in late January which stalled at 878 and one in early February which stalled at 875. Furthermore, after the S&P broke through the 879 former resistance (after one failed attempt in April), this area served as a support and was tested several times in mid to late May. Therefore, from a technical perspective it is a strong signal that we could not move below 879 on a closing basis over the past days.

Source: tradesignalonline.com

In terms of newsflow, the start of US banks' earnings announcement is likely to provide some positive news (as was a key driver of yesterday's stock market gains). The former investment banks should have been able to profit from a recovery in risky assets during Q2 as well as high corporate bond issuance. As financial markets are ahead of the cycle, writedowns on risky assets tend to be ahead of the cycle as well. On the other side, loan losses tend to be more conincident but this affects more traditional banks than former investment banks.
Overall, the tactical outlook for government bonds has worsened whereas it has improved for risky assets. I maintain my defensive asset allocation stance from a more medium-term strategic perspective (see here: Asset allocation defensive stance) but would reduce risk temporarily on all fronts trying to get back in at cheaper levels. I expect the setback in government bonds to be relatively moderate and would look for the Bund future to trade down towards the 120 area. Tactically, I recommend a neutral stance for UST and Bunds. For investors wanting to get long duration in government bonds, the next 1-2 weeks are likely to offer the first opportunity to do so since the recent bull market started in early June.

Switzerland 2 - 0 UK

Last week I wrote about the UK (see: The UK: down and out?) arguing that even though UK's green shoots have been greener than elsewhere I remain worried about the medium term prospects: In short, I do not see how the UK can get back on a sustainable growth path already and think that the positive economic surprises are purely down to a more pronounced macro-economic stimulus (especially via a weaker GBP) and will prove temporary. Rather, the structural problems are very pronounced and will take a long time to be reduced with trend growth falling significantly in turn. In combination with the huge fiscal and current account deficits, the risk remains that foreign investors will take money out of the UK again.

On the other side, I am less worried about the medium term prospects of Switzerland despite the current severe recession with the SNB expecting growth this year around -3%. Yes, similar to Germany and Japan, Switzerland is one of those countries with limited domestic imbalances but a significant dependence on exports. In fact, Switzerland is even more dependent on foreign demand than Japan or Germany as exports account for almost 50% of GDP (with the current account deficit in 2008 close to 10%) and according to the latest data for May, exports are down 21% from a year ago. Clearly, there is much more downside ahead for exports given that 60% of Switzerland's exports go to the EU with Europe's fall in demand only finding its way into Switzerland with a delay. Furthermore, with UBS, the largest bank continues to struggle. Finally, the cracks in the banking secrecy for non-residents are becoming larger and might threaten the status of Switzerland as an offshore financial centre.
However, there are several positives. First, while house prices rose steadily during the current decade, there was no real boom and the housing market does not appear significantly overvalued. Consumers as well do not appear overly stretched (as the overindebted, undersaving and overconsuming US and UK consumers). With respect to the state of the banking sector, UBS appears to be rather the exception than the rule and for example the state-near cantonal banks (in contrary to the German Landesbanks) have not been hurt significantly. More importantly, I think that besides the current cyclical weakness, the structural story for Switzerland as a refuge for rich individuals and international corporations has become even better. Yes, the bank secrecy is becoming a bit weaker for non-residents. But this is not the case for residents. Furthermore, the Swiss tax system remains extremely competitive internationally and given that taxes are rising (as in the UK) or likely to rise (as in the US) for the high-income earners, stable and low taxes in Switzerland are becoming even more competitive. The combination of higher taxes and higher tax-evasion hurdles for non-residents renders moving to Switzerland more attractive. For corporations a similar logic applies (with some hedge funds moving to Swizterland amid a threat of tougher EU-wide regulation) and just today McDonalds announced to be moving its European headquarters to Geneva from London amid more preferntial intellectual property tax laws (see here: Swiss tax rules lure McDonalds from UK).
This erodes the tax base of the affected countries but increases the tax base of Switzerland, helping to keep fiscal deficits in check without having to resort to tax increases, a positive feedback loop for Switzerland. Furthermore, the movement of people and corporate headquarters is increasing demand for the already scare land and houses, supporting their prices. Overall, therefore, I think that despite the significant cyclical weakness of the export-dependent Swiss economy, the medium term outlook is superior compared to the rest of Western Europe. Especially, scarce land/houses should do well over the medium term amid an increase in demand for high-priced office space and high-end housing. Domestically focused high-end corporates should see rising demand for their services. Additionally, the SNB will continue to struggle to fight the inherent strength of the CHF. Selling GBP vs. CHF looks attractive on a longer term horizon. However, export-dependent companies will continue to face a mix of weaker demand and an increasingly uncompetitive exchange rate.

Market Update: Consolidation or Correction?

While risky asset markets are rather in a consolidation than correction mode, government bond yields have dropped markedly. Looking ahead, I maintain the government bond-bullish outlook which I adopted early June (see here: Have we seen the highs in UST and Bund yields?) as well as my defensive asset allocation (Asset allocation: defensive stance).
The underlying economic situation is improving only slowly and the output gap is increasing further, leading to an ongoing easing in inflationary pressures. Today's employment report confirmed this. While unemployment tends to lag the recovery, there are some forward looking elements within the report, such as temporary work and hours worked. Temporary workers are usually the first to be let go and the first to be hired. However, the number of temporary workers is still declining (-38k vs. May09) while average weekly hours declined slightly. I also look at what I call the index of aggregate weekly earnings. This is constructed by multiplying average weekly earnings with the index of aggregate weekly hours for the private sector (for more details see here: Consumer deleveraging spiral still getting worse). The chart shows the yoy change in this index. The sum of wages paid to private sector workers is declining at an unprecedented rate of 4.4% (after 3.8% in May) amid easing wage growth and sharply dropping aggregate hours worked.
Combined with the destruction in households' net worth, this is a strongly disinflationary development. Employment benefits and active fiscal easing by the federal government cushion the negative impact on households' income. However, the fiscal easing would need to increase further given the ongoing drop in income. Therefore, the outlook for consumption remains very bleak!
In the Eurozone, the situation remains even more fragile amid a less aggressive ECB than its US counterpart but a more substantial drop in growth across a host of Eurozone countries. Today's acknowledgement by the ECB that there might be more rate cuts if necessary is at least a positive sign and accepting the reality of falling inflation (and therefore potentially higher real yields) and further falls in domestic and external demand.
Overall, the outlook for nominal growth remains very subdued amid low/negative real growth and lower inflation. This will seriously constrain the ability of real assets to show positive returns! The risk remains that the current consolidation in commodities and equity markets (<=10% price fall) turns into a correction (>10% fall in prices). Government bonds on the other side should remain underpinned. Stay defensive in equities/commodities but stick to long duration positions in Bunds and USTs.

Outlook for macro-economic and financial markets volatility

The outlook for macro-economic and financial markets volatility is important for any asset allocation decision. A time period of low volatility (such as in the run-up to the financial crisis) sees investors moving into any sort of carry trades, depressing risk premia in turn. A period of high volatility such as ever since the onset of the crisis in 2007, destroys the rationale for carry trades, renders existing positions less desirable (just because of the higher volatility) and acts to increase any king of risk premia (be it the equity risk premia, risk premia for corporate bonds as well as the term premia incorporated into longer dated government bonds).
So where are we headed over the next few years in terms of volatility?
What we do know about macro-economic and financial markets volatility is that:
a) the so-called 'Great Moderation' has depressed the volatility of growth, inflation etc. in a statistically significant manner. However, macro-economic volatility spiked during the financial crisis
b) academic research gives several reasons for the 'Great Moderation', some of which should survive the financial crisis (increasing importance of industries which exhibit only limited cyclicality such as healthcare and education/reduced importance of cyclical industries such as manufacturing; better inventory management with lower inventory on average due to just-in-time production; empirically higher stability of inflation at low levels of inflation) and some of which have probably been only temporary (new financial instruments lead to a more efficient allocation of risk, especially credit risk) while for others it is too early to tell (improved macro-economic policy).
c) financial markets volatility is reduced during periods of increasing leverage in the financial sector and raised during periods of deleveraging. Financial markets volatility is also higher during recessions than during boom periods.

I think a lot of countries will exhibit relatively limited macro-economic volatility in the years ahead with the huge volatility of the past two years proving to be temporary. For one, as written frequently, my outlook remains that inflation will be low for an extended period of time in most of the so-called 'developed' economies. This per se should call for a relatively limited macro-economic volatility. Clearly not as low as in the run-up to 2007 but significantly below what we saw over the last quarters. Furthermore, I think that most of the financial sector deleveraging is behind us which should as well help to reduce volatility.
The key risk is that inflation shoots higher (again we will see that in some countries amid a currency crisis/sovereign default but not in the US or the Eurozone) which will bring with it a sharp rise in macro-economic volatility.

From this perspective, the carry trade is not dead over the medium term. (Higher-rated) corporate credit should profit and combined with a low growth outlook it suggests that developed economies' credit markets should hold a more attractive risk-return profile than equity markets.

Positive momentum is breaking down across the risky asset universe

In Breakdown in EURUSD and Gold signs of things to come? on June 8 I stated that the break of the upward trendline in EURUSD and Gold "might well signal the start of a much broader correction across risky assets and be followed by a breakdown in the positive momentum in equity markets as well." In the meantime risk appetite has indeed taken a hit and just yesterday, a number of assets have broken through their former upward trends.
a) Equities: the S&P has broken through its former upward trend and also through its 200 day moving average (it broke through the 200 day moving average to the upside at the start of the month). Also the German Dax index has broken through its upward trendline (which it touched several times since early March) and the 200 day moving average. It is currently sitting just on the trendline (at 4727) and the moving average (at 4729).
Source: Tradesignalonline.com

b) Commodities: yesterday Gold broke through a more longer-term upward trendline which was in place since late October. However, more commodities have been sharing into the downward movement. Oil for example is now down some 10% from its recent peak and also broke through its upward trendline yesterday.


Source: Tradesignalonline.com
c) Credit: creditspreads have formed a bottom early this month and started to rewiden approx. a week ago. The 5y iTraxx Europe Index is approx. 25bp wider and the Xover index is a good 100bp wider than at its lows.

Overall, bearish technical signals are emitted by a host of risky assets (be it equities, credit or commodities) across the globe. With commodity prices receding as well, the latest inflation fears should calm down, helping break-even inflation rates incorporated into inflation linked bonds to moderate again. A key difference to the surge in risk aversion during Q408/Q109 is that this time gold is falling rather than increasing. I think this is due for one to receding inflation risks while at the same time - a key difference compared to Q408/Q109 - systemic risks in the financial sector promise to remain much more contained.

Asset Allocation: Defensive Stance

As mentioned before, I expect government bond yields to fall during summer whereas risky assets should correct lower. In turn I recommend a defensive asset allocation stance for the next weeks. Inflation fears should subside whereas default worries will increase again.

Government bonds: Long duration
Equities: underweight, especially in cyclicals/consumer durables/financials&commodities
Currencies: overweight USD & JPY. Neutral on CHF. Underweight EUR, GBP and commodity-currencies.
Credit: Neutral to moderately underweight credit overall. Within credit overweight higher-rated non-cyclicals (for example utilities) across the curve vs. lower-rated cyclicals.
Commodities: Underweight, mainly energy and base metals but also Gold.
Cash: Overweight

I do not expect new lows in the major equity indices but think that a 20% correction from the recent highs would be in order. Credit should also re-widen a bit (due to rating downgrades and rising defaults), but this should be more the case for lower-rated credit, i.e. increased differentiation.
I think that commodities have run a bit too far. With world economic growth being negative, end-demand for commodities should be lowered as well. I think that a lot of the run-up in prices has for one been due to speculative demand (especially in oil and gold) but apparently also down to stockpiling in China (especially in Iron Ore, Copper and Coal. See here). To me both look unsustainable and we therefore risk also a significant setback in commodities.
Gold is a bit a different animal as it is said to profit from both, inflationary expectations as well as (a deflationary) deepening financial crisis. However, in an environment where systemic risks should have been moderating a bit whereas nominal growth remains tame, I fail to see a significant upside for gold in the next weeks and would look for another drop in prices.

End of recovery in risk appetite?

A week ago in Breakdown in EURUSD and Gold signs of things to come? I wrote that "...the break of the upward trendlines (in EURUSD and Gold) might well signal the start of a much broader correction across risky assets and be followed by a breakdown in the positive momentum in equity markets as well. Risk appetite might well take a setback again in the days and potentially weeks ahead." By now also equities and commodities such as oil have started to correct while government bond yields are falling again. I do think that this correction has further to run in the weeks ahead.
Yes, things are less bad in the economy than they have been in Q408 and Q109. But it should become evident soon that less bad does not mean good. My personal base case is that growth in the quarters ahead will oscillate around 0%, i.e. we will have some quarters with positive growth interrupted by the odd quarter with negative growth. This would clearly not constitute a self-sustaining recovery. Households everywhere remain under severe stress from falling asset values (household net worth in the US decreased by another 2.5% in Q109 or USD1.3trn) and rising unemployment. Furthermore, the default cycle in the corporate sector is nowhere near its end as excess capacity across a host of industries will continue to rise. Rising excess capacity amid slowing demand means that supply needs to be cut as well which in turn implies further rises in unemployment.
With growth far from becoming self-sustainable and a scenario for oscillating growth below trend, financial markets should as well not show a sustained ongoing recovery across risky assets. I rather think that valuations in risky assets following the recent strong recovery seems to have gotten ahead of itself. Therefore, I think that we are only at the start of a more significant correction in risky asset markets including commodities. On the other side, government bonds and the USD should perform further in the weeks ahead.

Have we seen the highs in UST and Bund yields?

In the post "Recovery or just getting less bad" dated May 27, I stated that "while government bonds should face more headwinds in the short term, I expect that over the next 1-2 weeks government boned yields should stop rising, slowly followed by yields trending towards the 3% again for 10y Bunds and UST during summer." In addition, this Monday June 8 I stated that "I maintain the view that the yield highs are close and we should top out in the days ahead" (see: Breakdown in EURUSD and Gold signs of things to come?). So as two weeks have past since the former and four days since the latter post, have we now seen the yield highs for Bunds and UST?
First there are fundamental reasons for lower yields from current levels: Yes, the economic situation is getting less bad compared to Q408/Q109 but any positive growth momentum will remain dependent on macro-economic stimulus for a prolonged period of time. The most likely scenario is that following a move back into positive territory during H209, growth will oscillate around 0% for several more quarters. Furthermore, despite all the talk about inflation being around the corner, I remain unconvinced. The deflationary impetus of the private sector deleveraging is far from having run its course (see for example the previous post: consumer deleveraging spiral still getting worse). I am not yet concerned about the balance sheet lengthening of for example the US Fed as velocity of money is falling. Furthermore, most of the expansionary monetary policy measures can be reverted relatively easily (I am more concerned about the size of the budget deficit as history shows that it is much more difficult to reduce the cyclically adjusted fiscal deficit).
So overall, I expect nominal GDP (which shows a good long-term relationship with nominal yields, see chart) to remain subdued for a prolonged period of time. In turn, longer-dated UST yields should remain relatively low as well. 10y UST yields of close to 4% do not fit with the outlook for nominal GDP growth of below 4% for the next several quarters.

From a more shorter term perspective and as mentioned earlier, positioning by speculative accounts in US bond futures is heavily tilted in favour of shorts. Additionally, consensus has shifted to a bear-market base scenario for government bond yields. Furthermore, technicals are now oversold. In combination, this suggests that a lot of the negative news for government bonds is now factored into positioning and price.
Finally, I think that we have touched a major correction level in 10y Bunds this week, the 50% Fibonacci retracement of the Jul08-Mar09 upward move. This Fibonacci level is on the adjusted future chart at 117.44. The bund future traded down to 117.47 on Monday and to 117.52 today.
Overall, therefore, I see a larger than 50% probability that we have seen the highs in 10y UST and Bund yields this week and that we are now in a topping process for yields/bottoming for prices with no new significant yield highs. My basecase of yields falling during summer remains intact.

Breakdown in EURUSD and Gold signs of things to come?

Market developments following the release of the US (un)employment report have been very interesting. Even though as is frequently the case, the payroll numbers could be interpreted in a positive (below expectations drop in payrolls) and a negative way (fantasyland adjustments on the back of the birth-death model, lower average weekly hours), the markets chose to move significantly against recent trends. Especially the sell-off in EUR-USD and Gold seems noteworthy. The rising risk appetite (as well as rising inflation worries) have propelled Gold and EUR-USD higher over the past months in line with rising equity markets. While technicals for all three assets have been highlighting overbought conditions, short USD (vs EUR) and long Gold seem to have been the much more crowded trades than long equities. In turn, the break of the upward trendlines might well signal the start of a much broader correction across risky assets and be followed by a breakdown in the positive momentum in equity markets as well. Risk appetite might well take a setback again in the days and potentially weeks ahead.
Bond yields have continued their march higher. However, I maintain the view that the yield highs are close and we should top out in the days ahead.