With the S&P500, seemingly unable to break decisively above 2090, investors are wondering what are the main catalysts that can push the market higher, and are asking questions. To help with the confusion, Deutsche Bank has laid out the top five recurring questions asked by investors who are trying to figure out what will push stocks higher. Among these are whether European (and global) equities will rally as Brexit fears are being priced out; is there scope for earnings upgrades and will value stocks finally start outperforming.
However, the two most important questions by far, those whose answer will determine not only the near term return of the S&P, but also global equity markets as well as that all-important commodity, oil, are the following:
- Can the oil price hold up even as the dollar rises?
and
- Can the CNY depreciate without hurting asset prices?
Let’s take a look at these in sequence; first: will the recent disconnect between rising oil and a rising dollar persist? This is Deutsche Bank’s answer:
Can the oil price hold up even as the dollar rises? The oil price has risen above $50/bbl this week, despite a number of negative catalysts: a) the broad dollar TWI is up 3% since the start of May on increased market expectations for a Fed rate hike – consistent with oil below $40/bbl, according to historical correlations; b) iron ore has already dropped by 30% from its late April peak as the China rebound has faded (historically the correlation with the oil price has been very strong at around 60%); and c) the oil price has rallied far ahead of what sluggish global economic momentum would have suggested. Oil remains crucial, given that it has been the key driver of US high-yield credit spreads in this cycle, with the risk premium for European equities in turn moving in line with credit spreads.
- The benign scenario: the positive price impact of the tightening in the oil market continues to outweigh the negative catalysts – pushing the oil price higher or keeping it at least stable. This allows US high-yield credit spreads to remain at current tight levels, thus preventing a renewed outbreak of credit stress.
- The risk scenario: the oil price drops again as the USD rises further and the slowdown in China becomes more pronounced, putting renewed upward pressure on credit spreads and hurting equity performance.
Adding some literal color to the answer, DB then goes on to layout some of the key considerations, including the 74% probability of a rate hike by December, the rise in WTI above $50 despite the 3% rise in the USD TWI in the past month and the resulting 25% overvaluation of oil relative to its regression to the US Dollar, all of this in light of the strong correlation between the USD and crude.
DB then points out the recent weakness in China-supported commodities and asks if oil can maintain its levitation even as the latest Chinese bubble has burst, while at the same time not only has oil overshot recovery expectations but spec positioning is at two-year highs, suggesting there is a risk for a sharp selloff should the momentum reverse:
DB does point out that US crude oil production appears to have peaked for now, and that according to the IEA the market should be in balance in H2, but it also notes that historically this particular fundamental relationship has been irrelevant for the price of oil.
And then, if oil does correct, what will it impact: most likely HY bond spreads.
That covers DB’s thought on oil; what about that other critical factor, the Chinese Yuan, namely “Can the CNY depreciate without hurting equities?” DB’s response:
Can the CNY depreciate without hurting equities? The Chinese currency has depreciated by 1.6% against the dollar since mid-April, against the backdrop of a broad dollar rebound. CNY weakness is a function of Fed tightening expectations, and is therefore likely to intensify as Fed hikes become more likely. Chinese authorities face difficulty in supporting their currency through higher rates given high private sector debt and weakening growth momentum. DB forecasts a weakening of over 6% in CNY by the end of the year (to USD/CNY 7.0). This points to downside to European equities, which have tracked USD/CNY closely since the middle of last year.
- The benign scenario: the fact that the PBoC’s CNY basket is already below the target level of 100 and that authorities have managed to stop capital outflows suggests both, that depreciation risk is lower than it was in mid-2015 and early-2016 (when the CNY basket was clearly above 100) and that a depreciation against the dollar could be less problematic for global risk assets this time round (if it does not translate into renewed capital outflows). Furthermore, the upcoming G20 Summit in September hosted by China means they are unlikely to rock the boat in the near-term.
- The risk scenario: the PBoC’s basket is merely a reference rate rather than a hard peg, as our China economist argues, and CNY weakness driven by Fed tightening triggers more capital flight since leakage through trade channels in particular have not been fixed. This sparks concerns of a) renewed capital outflows and FX reserve draw-downs, leading to tighter global financial conditions; b) weaker commodity prices, as a lower CNY depresses Chinese commodity imports; c) the renewed risk of a sharp one-off devaluation in China to stem reserve losses
As we have documented here before, the biggest reason why the market is focused on the Chinese currency is because CNY weakness is a function of Fed tightening expectations, and therefore likely to continue as Fed hikes become more likely; needless to say, the natural response to a stronger currency (due to its USD peg) would be to raise rates, however as a result of an unprecedented debt load, China can not afford to do this.
Here, DB anticipates further Yuan weakness, and forecasts that the year-end value of the USDCNY will be 7.00; It also points out that so far equities have not reacted to the CNY weakness over the past month – unlike during the depreciation episodes in August and January.
Why is this the case? One possible explanation is that capital outflows have been stopped and that the PBoC’s RMB basket is already below its target level – this would explain the lack of selling of various US-denominated assets. However, DB adds, “capital still has the potential to escape through trade and our China economist argues that the index is used as a reference rather than a hard peg”
* * *
What are DB’s conclusions? In one word: skeptical.
First, on the question of whether oil can continue rising alongside the dollar, DB says that its commodity analysts expect Brent crude to finish the year close to current levels, at $50/bbl, but chief strategist Sebastian Raedler notes that he is worried about downside risks relative to this scenario, given that the USD, a potentially negative catalyst, has been a more reliable determinant of the oil price over the past ten years (R2 of 80%) than the balance in the oil market, the potentially positive catalyst (R2 of 40%). He adds that “any weakness in the oil price would likely have a negative impact on credit and equity markets.”
As for whether the recent devaluation in the onshore Yuan to levels not seen since February 2011 will impact equities, DB is “not convinced by the argument that Chinese FX vulnerability has been reduced significantly. 6% downside to our FX strategists USD/CNY target of 7.0 by year-end would weigh significantly on the European equity market.” Also, on the US and global stock markets.
For now, it remains to be seen if these pessimistic forecasts play out: oil continues to trade around $50 with the USD rising, which in turn is pressuring the Yuan lower, however so far risk assets have not felt the brunt of it.
Ultimately, the answer is in the hands of none other than Janet Yellen: perhaps a main reason why the stocks and crude have not reacted forcefully to the recent rise in the dollar is because there is little conviction that Yellen will actually follow through with her warning of a June or July rate hike. However, the closer we get to these important dates, should the Fed not relent as it did in March, it is very possible that those who are betting Yellen will chicken out will do so themselves, and the reaction that was observed in August and again in December will recur.
Which is why for anyone seeking answers to these two most important for the market questions, should just ask Yellen. We can only hope that she knows the answers.
via http://ift.tt/1Vtn3Bc Tyler Durden