Close Call – markets show their teeth

May 24, 2011

FOREX, Global Macro

Yesterday we asked if risk is going off and we’d have to argue that if it’s not off it is a little ripe. Yesterday’s price action in Asia kicked off a rout in equities, currencies, commodities and rally in interest rates. But, as is often the case the Asian lead faltered once it hit the shores of the United States. So, in truth the price action overnight was not as bad as it could have been. Certainly markets got pummeled at some points with the AUD trading down to 1.0480, the S&P down to 1312 and the SPI futures 4609. But there was not the wholesale rout we could have seen – rather the uncomfortable feeling that the last 24 hours has been portenous

So in context of what could have been a very poor night’s trade all we got was a volatile bad night’s trade. However, regardless of the fact that markets came back from their lows the economic underpinnings of this rally are eroding almost faster than the psychological ones. Look at last night’s data for example, specifically the PMI results in Europe covered left.

But first, some background. When faced with the biggest synchronous downturn in the global economy since the Great Depression, Central Banks and Governments around the world went ‘all in’ in an attempt to keep economies afloat until the consumers retrenchment passed and the credit/consumption dynamic of the past quarter of a century got back underway. Purchasing Manager Indices, given they represent the views of the “real” economy were both the bellwether and beneficiary of the central bank and government largesse. It was the engine of the recovery, the coal face of where we were headed and it gave succour to businesses as it told them thing in the economy were on the improve and it gave equity analysts justification for earnings estimates which have subsequently proven correct in many cases. We won’t argue about composition of earnings, thats for another day.

Here is the chart of the JP Morgan Global PMI

Clearly we can see the bounce from the lows but the stalling for the last 18 months and now pullback is also clearly in evidence. So, what we see here is that the engine of better economic growth over the past couple of years is slowing again. While consumers have been retrenching and rebuilding balance sheets business has been doing relatively well but the European PMI results out overnight were pretty poor and came on the same day the Chinese Flash PMI showed that it too was falling.

It is easy for markets to forget the embedded flaw in the reflation trade when manufacturing and service sectors of the economy are doing ok. They can wrap themselves in a blanket that says that all will be well consumers will come along soon. But, like retailers in Australia still wondering where all the income the RBA keeps talking about from the mining boom has gone, market players must confront the reality that the global growth profile is deteriorating. This means a re-jigging of earnings assumptions at corporations leading to lower valuations.

It means that the demand for commodities must be reworked and takes hot air from the speculative froth that is commodity markets at the moment. We can see this in the next chart from Bloomberg which is the AUD/USD, EUR/USD, S&P 500 and the CRB Commodity Index.

This chart is saved on my Bloomy screen as “Risk On/Off” (there are many different ways to represent this and many different assets – these are just my choices) and to me it is indicative of where the market is heading at the moment.  This is particulalry the case when we get further news from Europe of Belgian ratings down grade, Spanish regional elections results and street protests, UK Banks not lending their agreed amount and Home Builders suffering again.

If we trusted the message that PMI’s were telling us on the way up then we must listen to what is being said now. Crucially at a time when we are heading toward summer holidays and a seasonal de-risking this economic fact must, by definition, cause a recalibration of the risks metrics that traders and investors are working with. As we say often, when uncertainty rises planning is harder, fear grows and chips are taken off the table. So while last night’s trade was nowhere near as bad as it could have been it does signal that the rally of the last few months looks like it is headed on a summer holiday.

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