October jobs numbers were higher than expected coming in at 250k vs an estimates of under 200k. This will keep the data dependent side of the US equation going strong into next week. Data had a larger influence in October as yields and trade wars rocked markets. As we have seen in just the past week, lackluster PMI numbers and the fear of bad jobs numbers took the dollar rally in reverse. Now with better than expected numbers coming out today it will be interesting to see if the decline continues. If all remains constant we should see a stabilization in the Dollar and the equity markets to a degree. An increase of volatility will have to come from another source in the near term (earnings for stocks and perhaps geopolitics for the Dollar) to see volatility tick back up.
The dollar is nearing the highs for the year once again. Rising interest rates in the US have bolstered the dollar this year as other major central banks are not near the same part of the cycle as the US. The BOJ came out last night lowering inflation forecasts in a sign that rates and asset purchases will still be a part of the picture in Japan. The Euro and Pound outlooks for rate increases look murky from the threat of a hard Brexit and political and fiscal divisions across Euro member countries.
The only shorter term catalysts that could substantially move the Dollar lower would be heightened trade war rhetoric or signs that the language is starting to affect the overall economy (through corporate earnings or otherwise). These factors seem to be longer term trends that will take time to develop which means in the mean time, expect the dollar to remain strong going into the 4th quarter.
Stocks are making a comeback this morning after Italy concerns wane, but the initial shock of the announcement that Angela Merkel will not seek reelection in 2020 pulled down the Euro. Since the announcement that too has recovered to trade about flat. This change in the Christian Democrats chair could be good for the country, where taking a stance on issues such as immigration and European integration need to be dealt with to stop the populist rise in the country. The silver lining of this transition is that Merkel will now be able to take decisive action without the need to tip toe around political sensitive issues.
Elections in Brazil were looked at approvingly by the markets too, boosting EM stocks in European trading. The country is looking at the newly elected president, Bolsonaro, as good for the economy by being pro business. These changes in themselves do not make much of an impact to the markets but will be important factors in managing the economy as markets start to wobble.
About a quarter into earnings season and the data is showing a very strong 3rd quarter. The markets took the news and dropped the S&P almost 9% this month. A lot of analysts are scratching their heads over this conundrum and why the data isn't raising as rosy of a picture as in the past. There are three major thoughts on why earnings don't matter, two of them justify the correction, while one of them leaves a lot more to worry about in the coming months.
The estimate cycle usually goes in its downward revising fashion as the estimate date comes near. This is a classic example of people overestimating near term future conditions. This year something different has happened, estimates went up as a result of the tax cuts that came into effect. This caused the markets to rally on the news and the optimistic estimates before the actual results came out. Therefore no stock prices are shocked or unprepared for these higher numbers.
In relation to the earnings story, a lot of companies forward guidance was a cause for concern. Admitting to the one time boost from these tax cuts and concerns over the tightening of the rate cycle, the markets could be pricing in modest earnings growth in the future. Companies have come out in their earnings calls mentioning the tougher climate that is ahead and headwinds to their industries, or the economy as a whole. While this is not good for companies' stock prices it is a factor that can be measured, as a result, so will the market correction.
This is the big question mark in terms of how much the market has to drop. Earnings and outlook stories will understandably see an adjustment in the markets to take into account the new realities. The big "if" factor is whether the trade wars with China escalate, sanctions on the middle east de-stabilize the region and the oil market, or Italy and the Euro countries come to a budget resolution. These issues are more frightening to the markets because there is no estimate to how bad they can get. As escalation in the trade war deepens, you can see earnings consistently erode beyond even the lowest estimates. Sharp spikes in oil prices can negate any wage growth Americans have seen, and curb spending. These are the concerns to watch in terms of how much the market may still have to go. As time goes on you will see these negative factors start to fade, or be priced into earnings forecasts. It will be in a couple quarters that the macro factors start to become an earnings story.
The Euro came off its lows after the news that Italy wanted to start discussions over their budget with the European Commission. While coming off the recent lows, many market participants are not sure this will be the end of the volatility in the Euro or any other currency in the near term. Taking a look at the bigger picture we can see that, while the headline news certainly does affect there markets, the increase in volatility is nothing new.
Since the start of the crisis, major central banks lowered their interest rates to historic lows to stem the crisis and stimulate the economy. After the initial shock of the market turmoil this brought volatility down since interest rate differentials were the only measures to use and no country looked ready to start a rate increase cycle any time soon (The ECB tried it to their detriment). With the announcement of QE across central banks, volatility increased as the balance sheets of the major central banks started to swell.
Now we are starting to see the volatility decrease as the US starts to shrink its balance sheet. Europe is expected to follow suit with the end of their QE program this year and the start of higher rates in the middle of 2019. Barring the current threats of Italy the removal of the ECB in open market operations will bring down the volatility of the Euro. At that point we will be back to pricing the Euro based on interest rate differentials and this is where the importance of the Eurozone unity will come in. The level at which the euro is set will be dependent on several interest rates as opposed to just the ECB rate. It will be at this time the that spreads concerning the markets today will truly have an impact on the currency.
As results come in from the Bavarian election in Germany, the Christian Social Union (CSU) is forecast to have taken a hit. The CSU is set to take about 39% of the seats, with the far right Alternative for Deutschland (AfD) projected around 11%. This will give the far right group seats in Bavaria for the first time.
Why this matters to the markets is in how it will shape the ability of Germany to play a role outside the country. With the need for deeper integration between European counties to stabilize the currency longer term having a inward, nationalistic, shift will make this more difficult. Macron of France came into office on the premise that he would be able to better integrate Euro countries in a tighter union. With his domestic policy running into problems his ability to influence other countries into this union is becoming more difficult.
Italian markets dropped and bond yields increased as the government created a budget outside the agreed upon fiscal policy measures. This will no doubt cause tensions between the EU and Italy in the coming month when they have to submit the finalized budget. How this gets resolved will be important to watch as a gauge of the political unity within the Eurozone.
Political concerns are creeping up all over Europe with Brexit and populism growing in traditionally stable countries like Germany. The immediate fallout from the Italian budget getting passed will not be severe, but it would show the willingness of other Euro countries to enforce agreed upon measures with a new government. Failure to do wo would empower far right groups elsewhere to push for more nationalistic economic measures. Should this happen the fiscal issues that are isolated to Italy could be factored into markets on a country by country basis.
The Euro countries see this and will most likely try to contain the measures that Italy is proposing. By rejecting their plan they will show there is a 'penalty' for not agreeing to historical agreements. This is bad news for Italy and expect more volatility in the month ahead.
The Bank of Japan didn't rock the currency or the markets with its policy. The bank stated that their stance on easing will be dependent on the 2% inflation target being hit. They are looking to have the range in which they allow bond yields to move (currently floored at 0%), this will give some insights into the Bank's willingness to let rates rise when they feel comfortable with the direction inflation is heading.
In Europe we saw the Pound increase against the dollar as CPI came out better than estimated. The Bank of England is more on the fence with where policy is headed, with bullish indicators pointing to policy moving towards tightening, while the members are concerned about the looming Brexit implications.
This is a good reflection of the data dependency and tightening bias the markets are placing on it. This s a small example of a larger trend playing out, where investors are looking for yield as concerns arise over signs of weakness globally. Any indicators of a strong economy or higher inflation will see those respective currencies increase on rate anticipation.
The Bank of Japan is having an interest rate meeting Tuesday morning Tokyo time. This is preceded by a press conference later on. There is no expectations of actions from this meeting but it will be worth taking note to determine the language of the central bank of how it is positioning along side other banks.
Currently the US is the only bank with a focus on tightening, but the ECB isn't too far behind the US. With strong economic indicators in the Eurozone, the ECB will be cutting their stimulus another 15 billion a month and ending the program all together by the end of the year. The bank of England is expecting to see growth pick up in the coming year. The bank is holding off on any rate increases until more is seen from the Brexit talks. A good scenario in Brexit will see the bank become more bullish and a bad scenario could see a drop in the pound and more inflation imported. These situations will both lead to the bank having a hawkish stance.
Japan is one of the last central banks to not shift towards a tightening policy, or make any indications they think they will have to soon. This will be important to watch to determine how the markets will react to a combination of tightening across major currencies. The general rise in interest rates across the globe could cause a re pricing in assets, especially in the US where capital flows have increased over the past couple of years on the back of a stronger Dollar, higher rates, and a strong (but not too strong) economy.
Many factors are going around for the cause of the Emerging Market selloff. Trade wars, high debt loads, or trade deficits. These factors are always a tinderbox for a financial or economic crisis but not the spark. In this case the main factor of the strain is not a tweet or a 'sudden' realization of poor economic fundamentals. It was the steady and consistent rise in the Dollar.
The rise in the Dollar starting in late 2014 has put a strain on emerging markets but interest rates in the US were still very low compared to local currencies. in 2017 we saw rates on the 2 year and other shorter dated securities start to rise as rate expectations took hold in the markets. It wasn't until Sept. of 2017 that markets started to believe in the FEDs message and rates went up aggressively on the short end of the curve. This is where the real pain came in for EM as higher rates and a stronger Dollar made it very difficult to get out of debt obligations as well as finance the existing ones.
With the Jackson Hole meeting coming up at the end of this week we may see another turning point this September as well. One where the Fed talks back some of the recent hawkishness in light of the global signs of a slowdown or the more likely scenario. The data in the US shows there to be more need for rate increases to keep inflation at bay. There is little evidence in the US that higher rates are affecting the economy so there is no reason for the FOMC to worry, and it would be prudent to have higher rates in the future so the US can better stimulate the economy if the slowdown does occur. This message does not bode well for Emerging markets. But in this lies opportunity, with the US market hitting a record high again today, it might be a good time to pull some money off to the sidelines and await a good buying opportunity in EM. After all you are getting a higher yield while you wait.