Goldmans' Dominic Wilson,director of global macro & markets research, is out with a note which indicates a material shift in the firm's sentiment on risk. In a nutshell, the firm, unwilling to fight the macro double dip headwinds is prepared to concede that the American stimulus/reflation experiment has failed, and that investors should instead focus on underperforming markets (O'Neill's N-11 comes to mind): "Our own forecasts point to one other emerging theme. We see more risks of slowing in the economy where people have seemed most comfortable (US) and expect less slowing in places where people are more worried (Europe, China). If our forecasts are right, US domestic outperformance could ultimately reverse more." Also amusing is the attempt to reconcile a slightly bullish residual view on risk assets with the firm's 1.15 target on the EURUSD which would imply an S&P in the triple digit range. In summary - get out of America if you are a Goldman client, or, using the whole re-reverse psychology trick, now is the time to short the BRICs and Europe (even more), and buy the US. As usual with a Goldman report, more questions than answers, none more so than the original one - has recent market performance been a product of an actual rally, or nothing but massive squeeze?
Markets have moved well off the lows of a couple of weeks ago, though on low volumes. European policymakers have been shifting towards stress tests and the Chinese authorities are showing some signs of flexibility on the CNY. Our central case for the global outlook is still benign and our recommended trades have a pro-risk feel again (long DAX; long MXN, CNY, PHP and KRW; short UK real rates and short protection in dislocated EM CDS). But with global momentum past its peak and a forecast for a slower US H2, the macro backdrop is more nuanced. We think what will now be needed for this squeeze to become a sustained rally is clearer evidence that the growth cycle is not deteriorating as rapidly as markets have begun to price. The next two weeks are packed with key data and events and will be important to whether we maintain our course.
Our core view is that the transmission of sovereign and financial worries into a growth slowdown is less likely than in 2008 and 2009 (including in Europe itself). But we have argued that this recent pullback is more complicated than anything since the recovery began. First, sovereign worries and the reemergence of funding strains create genuine (if sometimes exaggerated) downside risks. Second, global momentum, while still solid, appears to have peaked on many measures and we continue to forecast a significantly slower US growth picture for H2 than consensus. Both tend to mean a more modest (though positive) trajectory for risk assets. So what the market is grappling with is more about whether slowing is over-priced than whether it is real, a judgment which is more subtle. We have seen both stabilization in sovereign credit and positive data surprises as likely conditions for a sustained recovery. There are tentative signs of the first. The question is whether they continue and are matched by supporting macro data.
The most recent development has been the shift towards renewed CNY flexibility from the PBOC. We have written about the weekend’s announcements in several places across ECS. The extent of flexibility is still not clear and the announcement is clearly aimed at diffusing pressure at the upcoming G20 meeting. But resumption of moderate appreciation is likely, consistent with the ‘risk-based tightening’ framework that Mike Buchanan has laid out. The economic impact of the kinds of movement we anticipate is not large. So the main significance is more in reducing emerging tensions and the risk of stronger domestic-focused tightening. Thomas Stolper and team anticipated the rising pressure a couple of weeks ago, taking us short 12-month USD/CNY forwards at good levels and have since added longs in KRW and PHP, which have lagged the recovery and should benefit from further CNY moves.
Markets had made significant but varied progress before the weekend’s events. Even with the disappointing price action this week, US equities are around 40% back from the recent correction, while several markets where FX depreciation was the release valve (DAX – our preferred long – and KOSPI, most notably) are close to old highs. The battered AUD has rebounded proportionately more, as have several EM currencies including USD/MXN, where we have been short. The EUR has bounced too of course (temporarily defying our new lower forecasts). But progress has been comparatively modest and several EUR crosses have made new lows or are close. As with the sell-off, the rebound been quite varied. Copper and to a degree cyclical equities now look like laggards, as do CEE3 assets. Volatility – realized and implied – is also well off the highs, something that not just reflects but has helped reinforce the relaxation, as Themos Fiotakis recently described.
The bounce has caught many by surprise, in part because a good part of it occurred while Spanish sovereign spreads were widening sharply. Reality however, has been somewhat better than this single barometer of pressure would reveal. As yesterday’s daily discusses, the Bank of Spain has announced that it will publish a stress test, as will the ECB, and there are signs that others in Europe may follow. Having argued for ongoing Spanish underperformance, Francesco Garzarelli noted last week that we now see a good chance that Spanish spreads have peaked (they have come in sharply in the last few days). Spanish equities have in fact been climbing steadily for a couple of weeks. And the brief pressure on French sovereign spreads has eased back for now. We are a long way from a resolution, and there is plenty of room for error and renewed stress, but some of the news flow has been more encouraging than the skeptics have admitted.
Unfortunately, the pop in risk assets complicates the trading picture. In many ways, it would have been easier to enter the heavy macro data calendar of the next couple of weeks and move into Q2 earnings with the market still heavily skeptical, particularly given our bias that the global macro picture is still quite benign. But with an initial squeeze behind us, the bar has already moved higher in terms of what is needed to turn this into a more sustained rally. What we are likely to need now – more than was true two weeks ago – is confirmation that the transmission to the real economy from the sovereign crisis is proving smaller than feared. That is our own clear bias. But the reality is that we have not had enough information to provide much clarity in either direction yet. And while we continue to have a constructive bias, the risks are more symmetric than they were at 1050 on the SPX. On one rebound, we are clearer: our revised forecasts look for the EUR/$ bounce to reverse (to 1.15), a process that has started – though we do not think that means that risk assets must fall too, despite recent correlations.
The next two weeks may begin to provide some clues. We are now in the macro-heavy part of the month and Europe’s crisis has been in full swing long enough that the more forward-looking data should be somewhat reflective of its impact. The (mostly second-tier US) survey data so far has been inconclusive, with rising consumer sentiment and a decent Empire survey matched by a weaker Philly Fed survey, not altogether reflective of its ‘guts’. European surveys out today have shown only modest slowing, so while things appear to be softening a little there is certainly no indication of a large shock to confidence at this point. Next week we move into the US survey season and Friday’s payrolls, which could calm or confirm the fears from the previous month. Having extended our new GS-MAP framework for assessing data to a much wider group of countries, we are even better placed to track incoming news.
The heavy calendar is not confined to the macro releases. Alongside the evolving shift in Chinese policy, today’s UK budget may be digested as a broader signal for the chances of fiscal adjustment and the risks of sovereign contagion. The G-20 summit is pending and continued announcements on European bank stress tests seem likely. The deadline for Spanish banks to apply to the FROB for recapitalization funds is June 30th. The US financial reform bill is heading into its – still uncertain – final stages. And of course quarter end – with its funding issues and asset allocation shifts – will be upon us shortly. There are times when we feel strongly about positioning heavily into events. But while we clearly have a pro-risk bias to our trades, we are open-minded enough that we can imagine changing course. And it would be comforting to see EMU periphery spreads and key measures of funding pressure come in further before relaxing too much.
As we look at where to take risk, we continue to focus most on areas where either a) policy has eased in response to the emerging crisis; b) underlying economic resilience or distance from sovereign issues are greatest and c) market reactions look most extreme. The two longer-standing pro-risk trades that we have recommended (DAX and MXN) tick one or more of these boxes. And we added a recommendation to sell protection on a basket of EM CDS recently in areas that looked most extreme versus our models (Korea, China, Poland and Czech), which alongside our long KRW and PHP recommendations have much of this flavour too. In looking across assets, some striking differences emerge. Significant FX depreciation has in places (Germany, Korea) helped to cushion local equity markets or credits (Mexico), but in others (most notably the CEE-3), currencies and local assets were hit together. And the fact that European equities are not underperforming the US, even in common currency, in a supposedly European crisis is also an oddity. So there are plenty of anomalies to work through.
Amongst the areas that look most vulnerable to signs that the global cycle is holding up are parts of the rate markets. As Francesco and team have argued over the last week or two, for the first time in many months rßßisk premia look too thin in major bond markets (Germany especially) for us to want to pursue our long-standing bullish bias and in fact our overall stance is somewhat short (through UK real rates). The market may also have to shift its views of short-term rates if slowing is limited. While the RBA’s decision to pause was widely interpreted as a sign that policymakers were taking fright at European developments (and many have cited European problems), at least as striking since then have been the central banks that have either begun tightening (NZ, Canada, Chile), continued it (Brazil, Peru) or mused over it (India, Switzerland and now one vote on the UK MPC). As per Thomas Stolper’s latest FX Views, the Swiss are a particularly interesting case with the unsustainably large reserve accumulation increasingly at odds with somewhat more hawkish SNB policy rhetoric. Switzerland and Sweden both stand out as areas where central banks could join the ‘hikers’ more quickly if their own local data remains as strong as it has. And it is no accident that both currencies have seen fresh lows against the EUR. [TD: lows or highs?]
Our own forecasts point to one other emerging theme. We see more risks of slowing in the economy where people have seemed most comfortable (US) and expect less slowing in places where people are more worried (Europe, China). While there are no smoking guns for the degree of US slowing in our forecasts yet (1.5% annualized H2 growth), housing data has been undeniably weak again consumer data overall has softened. Interestingly, after a long period where US domestic outperformance was one of the strongest market themes, equity markets appear to be taking note, as Noah Weisberger discussed in last night’s Tradewinds. We have long argued that US housing-related stocks (as captured by our Wavefront Housing basket) had run too far ahead of the data but lost patience with a short here ahead of what is now a very clear decline. But consumer cyclicals, which were at the heart of the early 2010 rally and which we favoured then, are also now lagging (watch our Wavefront Consumer Growth basket). For the first time all year, China-related cyclicals are now outperforming consumer-related areas in the US (and H-shares may be starting to outperform the SPX). We expect sequential slowing in China too – and have been seeing it more clearly – so the relative story is still muddy. But if our forecasts are right, US domestic outperformance could ultimately reverse more.