Trader thoughts - the long and short of it

It was certainly positive to see the ASX 200 convincingly hold and close above the 10 November and year-to-date highs and while Aussie SPI futures indicate that the ASX 200 will open just a touch weaker (our call sits at 6069), the trend in the index is higher and any pullbacks into 6055/50 should be supported today.

Market data
Source: Bloomberg

Keep an eye on the Nikkei 225 and China too. The Nikkei 225 is called to open a touch weaker at 22,856, but there is a ceiling open the market at 23,000 and a close through here would be significant, so hold tight and wait for any closing move through here as it could indicate higher levels are on the cards.

China requires attention as the government release its economic blueprint for 2018 today and the talk is looking quite positive for risk. The view is they place less emphasis on debt reduction and that debt levels will be tolerated in a bid for higher growth, notably, given creeping concerns about a softer property market and trade threats.

This could be a highlight of the session ahead.

With the ASX 200 at a nine-year high, we looked at valuations yesterday and one conversation I had with clients is the sort of index levels we can expect in the index in 2018. Of course, for a trader making longer-term predictions is often a negative exercise as it just creates a bias and a view that so many fall in love with and refuse to alter even if price or ‘the trade’ is going against them. The market is not wrong if you are making a loss and it’s the trader's job to admit that and move onto another idea where their capital is put to better use. So we need to consider that while we have seen earnings growth in 2017, however, with the 7% gain in the ASX 200 (13% total return) YTD, the ASX 200 commands a forward earnings multiple of 16.6x. There have really only been two brief occasions in the past decade that investors have been happy to buy the market above here, so the question for equity investors is where does the growth come from? Materials, banks, healthcare? Without a belief that we can see earning re-ratings then it’s very hard to see the index push through 6150 to 6200 anytime soon.

We also need to consider the macro backdrop, as this has an important role in determining if the market is happy to pay a lofty premium (relative to the long-run average) for the index and if investors felt equities had to wear a higher risk premium then perhaps 15.5x earnings would be a more fair multiple, which would result in the index close to 5700 to 5800. Of course, the central backdrop to this investment case is near-record implied volatility, not just in the ASX 200 or S&P 500, but in interest rate, Treasuries and FX markets too.

So while being long Bitcoin (and the numerous other crypto’s) has been easily the retail trader’s trade of 2017, selling volatility has been the institutional trade of the year and this has kept markets supported on any pullbacks as more and more cash made their way off the sidelines. This has been largely backed by global corporations themselves, who have been the biggest buyers of stocks over the years and we can see corporate buy-backs have had a huge role in suppressing volatility too. So as long as implied volatility stays low then investors will be happy paying a lofty multiple for these future cash flows and earnings.

I stand by the call that there is a good chance we see a repeat of January 2017, where the S&P 500 continued on its bullish trend from the get-go and just because it was a new calendar year nothing changed. That should, in theory, materialise this year too, with inspiring global growth still a dominant theme, back by earnings growth and central bank forward guidance, which makes life so much more predictable. Inflation and importantly inflation expectations is therefore key and if we are to see a sustained pick-up in volatility, which will promote an unwind of a sizeable short volatility structure, that in turn increases cash levels within portfolios and causes traders to ramp up expectations of tighter policy from the Fed, ECB and BoJ then it has to come from inflation expectations moving higher. Central banks have created the conditions by which we live today, so they will ultimately be the driver of moves in credit, equities and fixed income. The question is of course, whether the market is guided to tighter financial conditions by the central bankers themselves, or they front run the idea of more aggressive tightening and try to get ahead of the curve?

One could say this is now actually happening in Europe right now where we just have to look at the interest market. So despite the ECB being openly dovish, with its QE and liquidity forever message, the market is starting to question this. We can see the spread or difference between December 2018 and 2019 Euribor futures contracts now at the widest in a year and about to break higher through 29bp, which would be key. This requires close attention, especially if one trade the DAX or EUR.

Back to the here and now and tax reform has been the central focus of late, but is discounted into equity markets here. We are hearing the vote is unsurprisingly passing through the House, followed by a vote in the Senate tomorrow. The market has heard the change of heart from the likes of Senators Collins and Corker and Marco Rubio has seen conditions change to vote for the plan, so we have come to a conclusion here.

So with tax priced in and in the absence of any new triggers, US equities have been modestly offered, with the S&P 500 currently -0.2%, driven by weakness in tech, REITs and utilities. That said, there have been some decent moves in bond markets and a steeper Treasury curve has been in play, where we can see small selling in the UK- and German 10-year, while the US-10 year Treasury has pushed up a sizeable 7bp into 2.46% and breaking out of the recent consolidation range. US banks have not warmed to this traditional driver, but we have seen an impact in FX, with USD/JPY the main beneficiary, with a move back into ¥113 which should support the Nikkei 225.

We can actually see EUR/USD not responding at all to higher US bond yields and has focused quite intently at the interesting workings taking place in the interest rate markets (Euribor) which I mentioned earlier. EUR/USD has gained of 0.5% on the day is in play and a test of last Thursdays high of $1.1862 takes the pair into $1.1900 perhaps $1.2000 in the early parts of January.

AUD/USD is unchanged on the day and the three-day consolidation continues here, with a pronounced ‘doji’ candle in play that needs to be reconciled and it will make interesting viewing as to the direction of the ensuing move.

In commodity markets, we can see buying in US and Brent crude (+0.4%), while gold is largely unchanged, as is copper and spot iron ore closed -0.3%, with a touch of weakness in iron ore futures too. Nothing here that will greatly inspire, although the ASX 200 materials space was hot yesterday and put in good points, so one suspects weakness will be bought today, although traders should keep an eye on any headlines around the China economic blueprint.

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