Head of Equity Strategy
Summary: Equities have been on a roller coaster move the last 24 hours with an initial sell-off sparked by an ugly ISM Manufacturing print for August. However, a positive China Services PMI figure and the news that Hong Kong leader Carrie Lam is formally withdrawing the extradition bill added fuel to the rally. We concentrate in today's equity update on DAX and Hang Seng futures, but we also discuss European banks as a potential big mover leading into and after the ECB rate decision on September 12.
Yesterday the leading gauge on the US manufacturing sector surprised to the downside dipping below 50 for the first time since early 2016. The decline in August was dramatic as the ISM Manufacturing PMI Index fell from 51.2 to 49.1 highlighting continued weakness. ISM New Orders fell to levels not seen since the Great Financial Crisis but in fairness it came off historical highs in December 2017. The situation facing the US manufacturing sector is elevated inventory which needs to be brought down before production can go up again. The initial reaction was a weaker USD and sell-off in US equities.
Adding to negative macro backdrop US President Trump warned that if he is re-elected his demands for a US-China trade deal would be tougher than current demands. China’s largest technology company Huawei gearing up for US court case said yesterday that the US had been launching cyber-attacks against the company’s systems. Once again, more escalation and lower probability for a trade deal this year.
Just as markets were shaping up for declines two major events hit during the Asia session. China’s Services PMI for August declined a bit but remained moderately strong suggesting that the global services economy is still not seeing contagious spill over effects from the manufacturing weakness. Equities were already on the move when the next event hit. The Hong Kong leader Carrie Lam announced that she would formally withdraw the extradition bill.
Hang Seng futures jumps 4% on extradition bill withdrawal
The mood was good with Hang Seng futures up 1.2% when the news hit that the extradition bill would be formally withdrawn. The news sparked massive bids pushing up Hang Seng futures by another 2.5%. This is a significant event as this could be interpreted as China blinking or at least postponing confrontation with Hong Kong. With the upcoming 70th Anniversary of the Chinese Communist Party (CCP) on October 1 the move makes sense. If the demonstrations decline meaningfully in size over the next couple of days and weeks, then we expect this to be a significant catalyst for Hong Kong equities. Short-term this is likely the biggest opportunity in global equity markets.
DAX blows real risk-on into the air
Today’s move in DAX futures is for once not supported by weaker EUR suggesting real price action. With DAX futures climbing firmer above the recent resistance level around 11,850 it looks like the market is positioning itself for further gains. Traders are likely betting on a momentum trade leading into the ECB rate decision next week on September 12. In general equities could see a short-term rally leading into the ECB, FOMC and BoJ rate decisions and then experience hangover as investors will realize that central banks are acknowledge the weakness and that central banks are running out of tools to fight the ongoing deflationary pressures and overhang from debt.
Watch European banks
European banks are up 1.6% on the general risk-on session as the industry is a high beta component of the market. We see major upside opportunity in European banks here as we believe ECB will throw a life line for European banks. Call options are a good way of expressing this view with expiry in December.
ECB policy maker Francois Villeroy said in a French interview that he does see the needs for additional bond buying but that there might be a need for “economic actors” to have lower short-term rates. ECB is opening the door for lower deposit rate, but the key thing for ECB’s move into deeper negative rate territory is package the policy move with some protection for the banks as Europe’s credit mechanism is highly dependent on bank lending.ECB policy makers have been discussing a tiered deposit rate for months which would effectively reprieve them from their current penalty on deposits with the ECB. This is sensible initial move for ECB and could either come at this month’s meeting or the next. So, first phase of the new ECB policy response is lower short-term rates coupled with a tiered deposit scheme to lift profitability of European Banks to backstop the credit mechanism. The second logical move with the upcoming new ECB President Lagarde is a Japanese style yield control allowing Europe’s governments to increase fiscal deficit spending without jolting the bond market. This obviously requires the Germans to rethink their position on fiscal policies in Europe but when the next recession hits Europe with the ECB in negative rate territory the fiscal need should be obvious for German politicians.