Making sense of two very busy weeks for markets

This article first appeared in The Edge Financial Daily, on August 7, 2018.
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FOR at least two weeks now, traders and investors could be forgiven for feeling like they have been trying to drink from a fire hose, and a multi-flavour one at that. Virtually every day, they have been confronted by some combination of market-moving corporate earnings and economic news, supplemented by competing policy signals and volatile technical influences.

As confusing as this situation may seem, it speaks to a fundamental transition in markets that I have described before. 

It has two major characteristics: increasing divergence in economic and corporate performance, as well as policy; and increasing dispersion in asset valuations. 

Both are underpinned by macro themes that are playing out in real time.

This is best seen, and best monitored going forward, through a grouping of recent developments and market influences. 

They fit into three broad categories that speak to country and corporate fundamentals, policies, and technical influences on markets.

Economic and corporate fundamentals

Recent data releases confirm that the US economy is increasingly outpacing other advanced countries despite its duration. Currently, it is on track for the longest expansion on record.

US gross domestic product (GDP) grew at 4.1% in the second quarter of the year as the eurozone slowed to its weakest rate for two years. 

And while part of the surge in US growth was due to one-off factors, the underlying health of the economy was confirmed by last Friday’s employment data.
 
The three-month employment creation rate of just over 220,000 jobs a month is impressive, and is likely to result in strong economic performance as wage growth (at 2.7%) and, hopefully, labour force participation (62.9%) pick up. 

There is a real possibility that America’s economic outperformance may be reflected in an increase in both actual and potential growth.

The increasing divergence in advanced country economic performance has been accompanied by a similar phenomenon in emerging markets. 

Domestic economic and policy factors separating countries there (1) have been compounded by the impact of actual and feared sanctions, particularly for China and Turkey. 

In China’s case, it has already led policymakers to step up the implementation of monetary and fiscal stimulus in the past two weeks.

In the corporate world, the markets’ attention has extended well beyond the traditional headline numbers relating to profits and revenues, including in the tech sector. 

As a result, many investors have had to confront the obvious reality that not all “FANNGs” are the same. 

With that, engagement and other forward-looking metrics have been given a lot of attention, driving a wedge between the stock performance of Amazon and Apple (whose market capitalisation was the first to breach the US$1 trillion [RM4.08 trillion] milestone) and those of Twitter and Facebook (which suffered the largest one-day dollar loss in market capitalisation in the history of stock markets). 

Policy signals 

While divergent economic and corporate trends are not new, their increasing impact on asset prices is partly explained by what is happening on the policy side — both for central banking and trade.

Over the last two weeks, markets have received further confirmation of the growing gap not only in the normalisation of monetary policy, but also in the confidence that each of the systemically-important central banks have when it comes to maintaining orderly bond market behaviour.

On one hand, the US Federal Reserve confirmed its intention last week to continue to raise rates, reassured that “strong” domestic economic performance will enable the US to shrug off weakness abroad and uncertainty about the international trading regime. In the process, policymakers set aside concerns about high-interest rate differentials versus other advanced countries, a flat yield curve, a stronger dollar, increased volatility in fixed income markets, and pressure from US President Donald Trump’s tweets. 

On the other, the last two weeks of top-level meetings in Europe and Japan have highlighted a lot more policy hesitancy on the part of those central banks, as well as quite explicit keenness to reassure markets that their policies will remain stimulative.

In the case of the European Central Bank, this has included guiding markets to translate general calendar language for the first rate hike (“through the summer” of 2019) to a more specific and dovish point estimate (that of October). 

For the Bank of Japan (BoJ), and despite pressure from the banking system, policymakers firmly countered signals that they were considering the relaxation of the ceiling for yields on 10-year government bonds within their overall approach to yield curve management.

Trade policy has also been the subject of divergence after a period in which the US skewed to a rather generalised approach to tariffs — both in terms of words and action — targeting its major trading partners. 

Europe and the US have seemingly paused their trade war. 

While the agreement between Trump and European Commission President Jean Claude Juncker lacks sufficient detail, it potentially opens the door for a more coordinated European Union-US approach to common grievances relating to China’s approach to intellectual property rights, joint-venture requirements and other non-tariff issues. 

This, in turn, enhances the possible positive tail of a “Reagan Moment” for the international trade regime. 

On the other hand, there has been little relaxation during the last two weeks in the tough tariff rhetoric between China and the US. 

Each govt has threatened the other with additional measures

Instead, each government has threatened the other with additional measures that would take both countries closer to a full-blown trade war. 
And occasional signals of readiness on both sides to renew trade negotiations have not yielded much as yet, if anything.   

Technical influences

Not surprisingly, technical influences have amplified the impact both of global liquidity receding in a more differentiated rate and of the increasing divergence in economic and corporate fundamentals, as well as trade policy. 

This has been particularly evident in “crowded trades” where seemingly small surprises have led to apparently excessive moves in asset prices. 
Look no further than Facebook shares falling by some 20% following its quarterly earnings report.

In the fixed income space, traders seem more ready to test the policy commitment of some central banks. 

This is particularly the case in Japan, both in the run-up and the follow-up to the latest policy meeting. 

In just seven days, this forced three market interventions by the BoJ to cap bond yields.

Conclusion

After two extremely busy weeks, this three-pronged approach to understanding market influences can help both traders and investors separate signal from noise. 

And the signal is extremely powerful yet simple. It has already yielded attractive opportunities.

Clearly, there is now a lot more diversity in economic/corporate/policy performance and greater dispersion in asset price behaviour than was generally believed. 

Over the longer term, individual security selection will increasingly dominate overall market exposures. (2) The occasional phase of technically-driven overshoots will provide for interesting tactical openings. 

And all this results in a landscape that should prove a lot more appealing and remunerative for active versus passive investment management. — Bloomberg

(1) Contrast, for illustrative purposes, Argentina’s 5.8% and Venezuela’s 18% GDP contractions to Egypt’s 5.3% expansion, its highest in 10 years.
(2) Particularly emphasising balance sheet strength, cash buffers and agile business models.

Mohamed A El-Erian is chief economic adviser at Allianz SE.