If
the third quarter was about the reduction of tail-risk by official
actions, then Q4 will be about the limitations of the policy response.
It will pose a challenging investment climate after what turned out to
be a favorable performance in Q3.
Equities
generally did well. The US S&P 500 rose 5.75% in Q3. The Dow
Jones Stoxx 600 rose 6.9%, led by a 12.5% rally in Germany's DAX. The
MSCI Asia-Pacific Index rose also 12.5%, which is all the more
impressive given that the Nikkei and the Shanghai Composite both fell
(-1.2% and -6.3% respectively).
Bond
markets also did well, even though the benchmark 10-year US and UK
yields did rise by a few basis points. The anticipation of new
supportive measures that were ultimately outlined in early September
helped spark a sharp rally in Spanish and Italian debt markets. Spanish
10-year yields fell 98 bp over the quarter, while Italy's 10-year yield
fell 110 bp. Two-year yields fell 196 and 191 bp respectively. Gold
too rallied; appreciating 14.2% on the quarter. The low and stable
volatility was also an important feature of the global capital markets.
There
simply are too many brinkmanship games being played in the major
financial centers to expect this to persist. If Q3 was about
positioning for the risk-on advance, then Q4 may be about protecting
those gains.
In
Q3, many fund managers that were underweight Europe, and speculative
shorts, were forced to cover. This theme is clearly evident in the
futures market with the gross short euro contracts were slashed from
250k in early June to about 100k as of Sept 25. However, as Q3 wound
down, the tone in the market had already begun changing.
Over the last two weeks (here and here),
we have been observing a deterioration in the tone of the major foreign
currencies against the dollar. This has continued over the past week
and looks set to continue, as we discuss below.
The
fourth quarter begins with a bang. In the days ahead, four G10 central
banks meet (RBA, BOE, RBA and BOJ) Japan releases its quarterly Tankan
survey (early Monday), the US holds its first presidential debate and
reports it employment figures at the end of the week.
The
backdrop and context that these events include the deterioration of the
global economic outlook. US economic data mostly has surprised to the
downside. The euro zone is contracting. This in turn is weighing on
industrial output in Japan, China, South Korea and Taiwan, for example.
Japan's economy may also be contracting. The UK may be one of the few
countries that growth likely improved in recent months. After three
quarters of contraction, it may have grown again, albeit slightly.
The
political backdrop may arguably be even worse. The odds-on most likely
scenario in the US is that Obama is re-elected and the Republicans hold
the House of Representatives. While most observers appear to believe
the fiscal cliff will be avoided, the uncertainty related to the tax
outlook, the debt ceiling already appears to be having a cooling effect
on employment and business investment. In addition, many businesses and
investors are skeptical of the risk-reward of QE+. Given this
skepticism, the program that was meant to improve risk taking may result
in its opposite, further driving the animal spirits into comatose
state.
In
Europe, the Spanish and French 2013 budgets were greeted with a yawn.
Optimistic assumptions about growth, for example, allow officials to
square the circle, and project meeting EU targets. Overshoots are more
the rule than the exception. There is no closure yet on Greece and
there may not be until November. Spain's three-prong debt crisis
(sovereign, regions, and banks) is also morphing into a constitutional
crisis. Prime Minister Rajoy meets with the regional heads on Tuesday
in an attempt ease the dispute with Catalonia.
A
major surprise of last week was the selection by Japan's Liberal
Democrat Party (LDP) of former Prime Minister Shinzo Abe as its leader,
putting him position to becoming prime minister again after the
elections. No date has yet been set, but pressure is mounting on the
government as the LDP is blocking issuing any more bonds to finance the
current spending.
During
his first term, Abe is credited with improving relations with China,
after it deteriorated under his predecessor Koizumi. However, he has
taken on a more nationalistic mantle, but it is not clear whether he is
leading the party or the party is leading him,
In
either case, it is unlikely to help resolve the present tensions over
disputed territory. Politics, as is said, makes strange bedfellows.
China is warned Japan that it will defend the Taiwanese fishing boats
that harass Japanese ships near the disputed territory, which it also
claims.
Euro: The
attempt to rally in the second half of last week failed and the euro
finished the week near the recent multi-week lows. The technical tone
is poor, with momentum indicators pointing down. In the coming days,
the 5-day moving average will most likely cross below the 20-day moving
average, confirmed the downtrend. A break now of the $1.2775-$1.2800
area signals another 1-2% decline. It requires a move above the
$1.3000-50 area to signal a new leg higher, which we had previously
thought possible.
Yen: The
dollar recorded a big outside up day on Friday. The yen's weakness was
also notable because it seemed to be more a risk-off day.
Nevertheless, it is unlikely to mark the start of a significant decline
in the yen. Initial resistance is seen in the JPY78.20 area and a
break could see the dollar retest the JPY79.00 area. Many technical
tools get chopped up in the relatively narrow trading ranges that
continue to prevail. The low volatility, near the lowest since the
crisis began, is one of the conditions that draw players to carry trade
trades, but the fear of adverse impulses emanating from the US or
Europe, is an important deterrent.
Sterling: The
technical tone deteriorated further in the past week. Bears seem to be
gathering an upper hand as selling rallies seems more successful than
buying dips. Momentum indicators are pointing lower and, like the
euro, the 5-day moving average will likely cross below the 20-day
average in the days ahead. A break of $1.6115 would signal a move
toward support in the $1.6000-$1.6050 initially, but would suggest
potential toward $1.5900.
Swiss franc:
For all practical purposes, the franc is pegged to the euro. Consider
that the Hong Kong dollar, which is pegged to the US dollar, has moved
0.13% over the past 6 months. The Swiss franc has moved 0.25% against
the euro. The technical condition is therefore similar to the euro and
it has similarly deteriorated in recent days. A dollar move through the
CHF0.9420 area would spur a new leg up for the greenback.
Canadian dollar: The Canadian dollar's technical tone was the first we saw deteriorating two weeks ago.
The technical condition continues to deteriorate. The attempt to
recover failed in the second half of last week. If the US dollar
overcomes resistance near CAD0.9860, there is scope for a move toward
into the CAD0.9950-CAD1.000 area in the near-term, and would suggest a
more important bottom may have been carved out on a medium term basis.
We note that the greenback's 5-day moving average crossed above the
20-day moving average.
Australian dollar: The
Australian dollar's technical tone has also deteriorated. The attempt
on the upside was rebuffed before the weekend and additional losses are
likely. The 5- and 20-day moving averages will likely cross next week.
Trend line support near $1.03 is likely to be tested on a break of
$1.0360, but the more important target is the lows from the start of
September near $1.0175.
