The models are broken
The market is trying to get back to the pre-Covid and pre-war times, but that model is broken. A new dawn is here and the financial world needs to adapt.
Chief Investment Officer
Summary: Russia has recognized the two self-proclaimed republics formerly of eastern Ukraine and is sending in Russian forces. The moves were widely condemned by Western leaders and one that entirely severs diplomatic options for now in dealing with the unfolding situation. The US is set to announce sanctions on Russia later today. Equity markets are breaking down through important support levels, gold and crude oil prices have surged anew and yields as these developments push widespread deleveraging.
What is our trading focus?
Nasdaq 100 (USNAS100.I) and S&P 500 (US500.I) - Nasdaq 100 futures are trading around the 13,680 level, which is below the lows from January, as Russia’s decision to deploy troops in Ukraine’s breakaway regions in the east has ignited risk to higher levels. We expect volatility to remain elevated and downside risks to equities will persist as inflationary pressures will remain high for longer as also seen in Germany’s PPI y/y figures yesterday showing highest levels since the late 1940s. Russian companies and Western companies with high exposure to Russia are the most vulnerable over the coming weeks as risk premiums will be adjusted to reflect the risks of various sanctions.
Hong Kong Stocks & China A Shares. With escalation of tension in Ukraine, Hang Seng Index and Hang Seng Tech Index both fell 3%. CSI 300 was down 1.6%. As worries about the tightening of regulatory grip over Chinese technology companies linger, tech stocks were pressured. Meituan came off 6%, Alibaba -4%, Weimob -8%, and Tencent -2%. In A shares, materials and computing outperformed while healthcare and online entertainment traded weaker.
EURUSD and EURCHF – the euro weakened due to the proximity of the geopolitical tensions unfolding in Ukraine and the impact of higher energy and power prices triggered by Russia’s actions this year, with EURCHF trading sharply lower, now only some half a percent from the cycle low of 1.0300 on a whiplash move after it recently pulled all the way up to the 1.0600 level on the anticipation that the ECB is set to revise its stance on inflation at upcoming meetings. The CHF is proving a more compelling safe haven than the US dollar here, but EURUSD is approaching a pivot low near 1.1280.
AUDUSD – unlikely almost any episode in modern memory, the widespread deleveraging in asset markets is not weakening a traditional currency proxy for global risk sentiment like the Australian dollar. This may be due to the regional nature (Europe) of the geopolitical concerns as the focus is mostly on the economic and market impact there. Australian stocks have only dropped about two percent from the highest recent closes as regional confidence is higher on the recent opening up of the Australian economy and of the country’s borders.
Crude oil (OILUSMAR22 & OILUKAPR22) trades at a fresh seven-year high on worries sanctions against Russia could trigger reduced supplies, thereby tightening the global oil market even further amid a strong a post-pandemic recovery in global growth and demand. Adding to those, concerns over Iran nuclear talks which have stalled and the inability of several OPEC+ members to reach their production targets. Trading above $97, the market is now more focused on when and no longer if Brent will reach the psychological 100-barrel level. The annual International Energy Week in London kicks off today, and over the next three days we can expect plenty of headlines from the event.
Gold (XAUUSD) closed above $1900 for the first time since June yesterday supported by a fresh geopolitical bid and tumbling global stock markets. Gold has so far this year shown its credential as a haven asset and a diversifier amid political tensions and turmoil across other asset classes. In addition, the technical breakout earlier this month has triggered fresh momentum buying with total holdings in ETFs rising while large money managers more than doubled their futures net long during a two-week period to February 15. Several previous highs, starting with $1916 are, however, likely to prevent a runaway market with the pace of central bank rate hikes also a continued focus.
US Treasuries (IEF, TLT). Uncertainty in the bond market is extremely elevated. As tensions in Ukraine escalate, yields continue to fall, and the market pares back on interest rate hikes. The market is expecting the Federal Reserve to front-load interest rate hikes due to elevated inflationary pressures, and it is already pricing a rate cut by 2024. This week’s focus remains on the PCE Index, a favorite inflation indicator for the central bank, and Fed’s speakers. We believe the Central Bank finds itself in a difficult position in which it's extremely easy to spur either inflation or taper tantrum.
European Sovereigns (VGEA, IGLT). The PMI data for Europe and the UK show that the economy is recovering after the winter period of lockdowns. That allows the BOE and the ECB to be more aggressive in tightening the economy, hence explaining yesterday’s rise in yields. However, things might change today as the tensions in Ukraine escalate. European long-term sovereign might serve as a safe haven, but the market will need to take into consideration higher energy prices in case of sanctions, which could force central banks’ hands to be more aggressive, lifting short-term yields. Central bank officials’ speeches are in the spotlight as the bond markets seek clues regarding forward monetary policy.
Junk Bonds (HYG, JNK). It’s time to reconsider credit risk. Junk credits have overperformed investment-grade bonds since the beginning of the year. However, there are signs that credit risk might start to crumble. It has been more than a week that high yield bonds have not been priced in the primary market nor in the US, or in Europe. Leverage loan indexes are falling on both sides of the Atlantic and real rates continue to rise. At this point, it’s going to be challenging for the Federal Reserve not to spark a selloff in markets as it could be seen as too aggressive if it hikes by 50bps or not serious enough about inflation if it hikes only by 25bps.
What is going on?
Russian President Putin recognizes separatist republics formerly of east Ukraine, sends in “peacekeeping” forces. The move triggered a powerful slide in markets already on edge and trading in thin US holiday conditions yesterday. The US and EU countries condemned Russia’s moves and the White House will announce sanctions on Russia today. Ukrainian president Zelenskiy said that Russia is simply making legal the Russian troops that were already on the ground in the breakaway regions of Lugansk and Donetsk. The move completely severs any diplomatic options for now, as the market will watch whether this new situation becomes that status quo or whether Putin has greater ambitions in Ukraine.
Eurozone preliminary PMI for February indicates the economic activity is accelerating. The winter economic dip was short-lived. All the European countries are dealing much better with the current wave of the pandemic than with the previous ones (Services PMI at 57.4 in France, at 56.6 in Germany and 55.8 in the eurozone, for instance). Demand is on the rise for both services and manufacturing, with significant improvements from foreign buyers especially. This will push unemployment lower in the short term in an already tight labor market. There is clear evidence of second-round price effects – high producer prices are passed on to consumers, leading to much higher consumer goods inflation. In another note, Germany January PPI continues to increase, at 25 % year-over-year versus prior 24.2 %. All of this is likely to bring support to hawkish calls ahead of the ECB March meeting.
HSBC Q4 earnings disappoint. On the conference call the CFO said that the bank had increased its provisions on Chinese real estate loans and that the Chinese housing market worsened in Q4 compared to Q3. The bank is also seeing significant wage pressures. Q4 adjusted pretax income was $4bn vs est. $4.1bn.
What are we watching next?
The path of the situation in Ukraine is paramount for now – especially if further escalation of the situation aggravates the rise in energy prices in Europe and globally, as this leaves a backdrop of higher input costs that central banks cannot realistically address with policy tightening, as the only way to ameliorate the rising prices is via reduced demand and weaker real GDP growth. Primary headline focus on the severity of the sanctions from the EU, UK and US today.
Reserve Bank of New Zealand to alter guidance tonight? The RBNZ is expected to hike 25 basis points tonight to bring the Official Cash Rate to 1.00%, but it could be interesting to watch the guidance from one of the more forward leaning central banks in this tightening cycle in developed markets as to how they see the risks shaping up for New Zealand from a possible spike in energy costs - the country does have a diversified primary energy generation, but is reliant on imported fossil fuels for well over half of its energy production.
Earnings Watch. The Q4 earnings season is cementing itself as the second straight quarter of profit margin pressure suggesting inflationary pressures are real headwinds now for companies. Overall, the earnings season has been good in terms of revenue growth, but the outlooks provided are generally mixed and many companies have low visibility over global supply chains. This week more Q4 earnings releases will hit the market with Thursday being the big day. Today, earnings releases from Home Depot, MercadoLibre and Palo Alto Networks are key to watch.
Economic calendar highlights for today (times GMT)
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