Trader thoughts - the long and short of it

The global equity sell-off continued during Wall Street's final trading session for the week, putting an end to a horrid five days for markets.

Market data
Source: Bloomberg

Global price action: True to form, it was the Nasdaq that led the losses in US trade, clocking a loss of 2.07%, while the S&P 500 shed 1.73% itself. Volatility remained elevated and underscored the intense selling, maintaining a 24 reading throughout the session, prompting a flight to safety from investors. The dynamic pushed the yield on US 10 Year Treasuries to 3.07% – their lowest rate in close to a month – driving the DXY temporarily above 96.80, the risk-off USD/JPY below trend line support, and gold prices briefly beyond resistance at $US1240.

The action followed on from a European and Asian session in which equity markets fared little better. Chinese equities wallowed once more, exacerbated by fears of financial instability in the face of a depreciating Yuan, after the PBOC’s currency fix pushed the USD/CNH above 6.97 for the first time in several years. The AUD/USD fell in sympathy with the Yuan, breaking through support at 0.7040, only to drift higher into the European session. The GBP and EUR came under pressure due to the US Dollar's strength, but stayed within the 1.28 and 1.13 handle. However, European stocks crept towards their worst month in three years.

Bearish sentiment: The bears appear to well and truly have control of this market, spooked by the prospect of higher US rates and "peak earnings" amongst American corporates. Concerns around the latter were driven home on Friday, shortly before the beginning of the Asian session, when earnings updates from (Google parent-company) Alphabet and Amazon disappointed market participants. The reasons behind each company's relatively poor performance were unique, but hammered home the view that despite most of earnings reports beating expectations this reporting season, the market is reaching, or has already reached, peak earnings in this cycle.

Wall Street versus US economy: This question throws up interesting and contentious debates: one, whether share market performance is a leading or lagging indicator of economic health; another, to what extent a share market's fortunes are tied to the "real" economy. Friday's North American session cast an interesting light on the issue, perhaps providing evidence for the view that that the overall share market is a weak, lagging indicator of the economy's health: the US's GDP release beat forecasts (3.5% vs. 3.2%) and reaffirmed the view that the US economy is still roaring. The data suggests that while many investors are certainly suffering, the activity in US equity markets could be possibly better explained as a necessary correction in asset prices, which have been artificially inflated for many years by cheap money.

Market correction, not economic recession: A common fear in which the market is experiencing (an apparent) correction, is to assume that it reflects the state of the underlying economy. While that is sometimes true, history suggests that this need not always be the case. It's understandable as to why conventional wisdom suggests this is so: the monumental disaster that was the GFC has suffused the zeitgeist, conceiving the erroneous idea that every period of stock market disquiet portends a potential financial or economic calamity. It's always impossible to predict whether market volatility is indeed something indicative of underlying problems attached to the real economy, but the balance of evidence – supported by US GDP figures – suggests that this time around, the likelihood is very low.

Stronger economy, weaker share market? In fact, the more likely scenario is that the fundamental strength in the US economy is indirectly bringing about their share market’s sell-off. As is well known and widely discussed, the major structural factor behind Wall Street's tumble is the US Federal Reserve's insistence it will continue to raise interest rates to lean on a booming US economy. Of course, the effects of the trade war on global growth and corporate earnings, coupled with regional concerns as diverse as Chinese growth, Brexit, and Italy's fiscal crisis play a part; however, the primary driver in financial market activity, as it almost always is, is the decision making of the US Federal Reserve. Ironically, the stronger than expected growth figures out of the US supports the need for higher interest rates, probably enervating the strength in US shares.

Here's the rub: Given this, herein lies the problem going forward: a flight safety into bond markets the past week has pushed US Treasury yields down, allaying some of the pressure on equity markets. By necessity though, in the long-run, bond yields must increase as interest rates climb: a situation that will need to occur as strong growth, like that conveyed in Friday's US GDP numbers, leads to upward pressure on prices. Hence, the bad news and fundamental conundrum is this: the better the US economy, the higher US interest will go, and the greater the downside risk and volatility in share markets. Ultimately, this all means that there is a strong possibility that, at worst, this sell-off has further to run, or at best, perhaps periods of snap-and-sharp market down turns will become the new norm.

ASX today: Bringing it closer to home, SPI futures are pointing to a 17-point drop for the ASX 200, following a Friday in which the index managed to close flat. It was a see-sawing day for Australian shares, which gained in early trade, tumbled for the lion's share of the day, and then inexplicably recovered in the final 15 minutes of the session to end the day a dead-rubber. The bounce came courtesy of strong buying for the index's major large caps in the financial, mining and healthcare sectors, keeping the market out of technical correction. Despite late run, the ASX still appears exposed to and poised for further downside, ahead of a week high on local and international event risk.

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