Larger risk retreat underway in markets

What to look for in the week ahead

  • Larger risk retreat now looks to be underway
  • The UK leads the “soft patch” in global growth
  • The euro gets hit as sovereign crisis enters its second act
  • Asian growth outlook subdued
  • Is gold about to lose its luster?
  • Key data and events to watch in the week ahead

Larger risk retreat now looks to be underway

After last week’s rout in risk assets (commodities, stocks and JPY-crosses)/rebound in the USD, we were largely constructive on the move, viewing it as only a positioning-driven correction within a larger uptrend. Price movements in the past week, however, have now convinced us that a larger trend reversal lower is likely taking place. While there are plenty of individual stories and themes playing out, we prefer to focus on the strength of the global recovery as the primary driver. And here, we think recent data points to moderating global growth, as Asia shows signs of decelerating (see below) and major developed economies appear set to languish as austerity measures increasingly take hold. German factory orders and Eurozone industrial production both declined MoM in March, suggesting that the strong 1Q growth in the Eurozone is unlikely to be sustained. Anecdotally, we continue to hear market talk of sizeable leveraged names (hedge funds) exiting long risk/growth trades and turning more bearish. Additionally, a quarterly Bloomberg News survey also revealed a decidedly bearish shift in sentiment among global investors for the months ahead. Lastly, the impending wind-down of the Fed’s QE2 asset purchase program is cited by many as feeding in to expectations that US rates may rise and stocks may fall, though we don’t ascribe recent risk asset strength to QE2 at all. We will continue to look to incoming data for what it suggests about the strength of the global recovery and to inform our view of risk sentiment.

We think positioning is still a factor, but recent sharp declines in major currencies and commodities suggest that a potentially significant portion of the excess has been worked off, meaning the pace of declines may moderate in the week ahead. Still, we don’t think positioning is anywhere yet near short “risk” assets, so we will look to use rebounds in any consolidation periods as an opportunity to re-sell key commodities, and major currencies/ buy USD on dips. Please note, this is a reversal of the view we suggested in last week’s update. Technically, we are getting trend reversal signals in many major markets: The CRB commodity index has dropped below the daily Ichimoku cloud; WTI crude oil and silver have both dropped into the cloud, but so far are holding above the base (hopefully offering room for a rebound); Gold is lagging and holding well above the 1435/36 cloud top, possibly signalling it will play catch-up (see below); EUR/USD has dropped into the cloud; and the USD index has tested the bottom of the cloud from below. These developments suggest that there may still be some bounce left in certain commodities and currencies/pullback in the USD, but that another week like the last two would trigger unambiguous signals of an even larger reversal lower in risk assets/higher for the USD in the weeks ahead.

The UK leads the “soft patch” in global growth

Last week’s Inflation Report delivered what many had expected– a downgrade to the UK ’s growth forecast for 2011. The Bank of England’s central projection for growth this year is between 1.8 per cent and 3.5 per cent. This is below the Bank of England’s February forecast of 2 – 4 per cent.

Inflation was revised higher, which was also expected. But the Bank surprised the market with its interest rate forecast. Its projections were based on interest rates rising to 1 per cent by the end of the year. This surprised the market since investors had been pricing out the prospect of any rate hikes this year after a spate of weaker data including first quarter GDP that was below the growth rate of Greece .

The Bank’s signal last week suggests that rates may be increased as early as August and then again at the end of the year. But with growth essentially flat since the third quarter of 2010 and PMI survey data for April pointing to the slowdown extending into Q2, we think that rates may remain on hold for some time yet.

Interestingly, in the aftermath of the Inflation Report Short Sterling futures, which measure interest rate expectations, have not had a significant move, suggesting that the market is not convinced the Bank will raise rates at all this year.

There are two reasons for this. Firstly, the outlook for growth has deteriorated. Austerity measures have just started to take hold and household incomes are likely to remain constrained for some time yet. That is bad news for the UK economy as it relies heavily on consumption and services to grow.

Secondly, the fall in commodity prices has the potential to affect UK inflation rates more so than in the US because the Bank of England looks at headline inflation, which includes energy and food prices. So if oil prices continue to come off then we could see CPI rates decline in the coming months. There is a caveat to this: processed food prices. They have risen strongly in recent weeks and have the potential to keep upward pressure on inflation for some time to come.

Putting that concern to one side, weak growth and the potential that inflation has peaked do not support higher rates. While the UK economy faces strong headwinds in the medium-term, if the Bank holds off on raising rates that may boost growth as we move into 2012. So there is a chance that this soft-patch is a temporary bump in the UK ’s economic profile.

Sterling had a volatile week falling back from 1.6500 – the high post the Inflation Report - and closing the week below 1.6200, the lowest level since the start of April. The economic outlook is particularly cloudy, which makes it hard to predict the direction of sterling. We think the risk is for another down-move, with 1.6500 the high for now. Below 1.6180 – the top of the Ichimoku cloud, GBPUSD is no longer in a technical uptrend and we may see down to 1.6000.

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