US Equity Markets, USD Strength, GBP and China
US equity markets have reached new cycle highs overnight with inward looking and cyclical stocks such as financials leading the rally. The VIX index has declined towards its lowest level since August helped further by US real yields no longer rising. Markets have undergone a significant change with many correlations, which were ‘alive and kicking’ in August, either no longer in place or completely reversed. For instance, the higher USD has not prevented US inflation expectations or commodity prices from rising. Today the UK government will release its Autumn Statement. The GBP reaction should be positive if the tone of the government is to help UK businesses.
Investors are trying to get a handle on the growth and inflation effect of President elect Trump’s economic program. Some see these measures in the context of what has been claimed by Neo-Keynesians for a long time, i.e. to use fiscal expansion to overcome US investment weakness and hoping these fiscal measures may increase the effectiveness of accommodative monetary policies tools. A second group expects higher inflation, but growth staying subdued as the supply side of the economy may fall behind the demand expansion fuelled by increasing the money multiplier coming on the back of banks growing their balance sheets fast from here. The third group of investors expects the economy to maintain its low growth/low inflation profile citing substantial capacity reserves provided by the US’s main trading partners.
Confusingly, these three potential outcomes offer very different investment conclusions reaching from risk seeking towards risk aversion. What investors often overlook is that strong September and October US data releases currently hitting screens were achieved when markets were under a working assumption that Hillary Clinton was winning the Presidential election. It seems that something happened to the US economy over the summer months pushing it towards acceleration. Fading global headwinds with China’s growth rates stabilising and non-China EM growth accelerating had a supportive impact, but it may not fully explain the magnitude of the improvement. However, should the US have finally closed its output gap at a time when its household sector has completed balance sheet restructuring seems to provide the better explanation. Importantly, this explanation finds support in the way markets have changed trading from late summer onwards. In August, it was all about a liquidity imposed risk rally with the ‘hunt for yield and dividend’ driving markets. The USD was inversely correlated to US inflation expectations and commodity prices. Nowadays, we see the USD staying bid even when commodity prices move sharply higher. Overnight saw an 8% jump in iron ore prices. This new market regime makes sense should the US economy have closed its output gap.
The USD has entered a regime similar to what we saw in 1984 and 1999. In both cases, the US economy ran beyond its optimal capacity use, pushing its return expectations higher allowing the USD to gain exponentially. Only a few months ago, better non-US data would have weakened the USD. This is no longer the case as today’s release of the European November flash PMI’s may prove. Overnight, China’s Business Sentiment Indicator rose to 53.1 in November from 52.2in October. Both production and new orders picked up strongly in November, with the production indicator rising to a thirteen-month high of 58.0. Nonetheless, USDCNY has reached a new high at 6.8925 gaining 2% since the US election day.
CNY put option premiums have doubled over the past couple of weeks reaching their highest levels since 30th June. There are increasing voices in China warning about the impact of USD strength. Today it was Economic Information Daily warning about potential capital outflows from other countries should the USD become too strong. Meanwhile, Chinese reallocation efforts out of RMB deposits into alternative investments seem to have rediscovered the equity market. Outstanding margin trading on China’s domestic equity exchanges rose to RMB950 bln ($138 billion) on Monday, the highest in 10 months, while the Shanghai Composite Indexhas rebounded 22 percent from its January low.