August Monthly Forecast: Setting up for the Fall
With a modicum of risk appetite returning and the VIX volatility index registering the lowest level of fear since the credit market crisis began, equities have rebounded significantly in the past five months. Equity markets took another leg higher in the last month, confounding some bears, moving major indices into positive territory for the year. The Dow garnered a lot of headlines when it broke above 9000, and the S&P500 is streaking toward the 1000 mark as July posted its best result in 20 years, prompting PIMCO CEO Mohamed El-Erian to warn that the July rally in equities appears to be a "sugar rush." Meanwhile, treasury yields have crept higher in the face of relentless new supply and as central banks have remained silent about extending asset purchase plans. Commodities ground sideways through July but maintained an underlying bullish tone as the greenback demonstrated further weakness. As the climb up the wall of worry continues, August may prove to be an inflection point, as events this month may rekindle worries about the nascent recovery as we head into the fall.
Too Far, Too Fast?
Earnings season powered stocks higher in July, bearing out the bulls' case that firms could exceed expectations for the quarter as a set up for a return to growth in the second half of the year. The bears counter that corporate performance was skewed to the upside by one-time events like cost cutting measures, and with earnings season over, there will be fewer company specific stories to drive stocks higher. Among the handful of company reports that might affect the market this month are Cisco Systems (reports 8/5) and Hewlett-Packard (8/18) in the tech space, and big box retailers Home Depot (8/18) and Target (8/18).
Autumn is known as the season during which the stock market has its greatest struggles, with September the worst performing month for stocks and October the historical host of market crashes. Notably, however, in the last two decades the S&P500 has fared worse in August than in September, so an equity market pullback can't be ruled out this month. It's likely that a true fundamental catalyst will be necessary to push the S&P500 beyond the 1,000 mark, rather than just the absence of bad news.
Uncertainty in Japan, Stagnation in Europe
As the global equity markets signaled the worst appears to be over for now, the rising risk appetite seen the later part of July seemed to assume that the potential global economic recovery would be evenly spread. However, cyclical recovery in the euro-zone (led by Germany and France) will lag the recovery in the U.S., the BRIC nations and non-Central and Eastern Europe (CEE) emerging markets. The German IFO data on August 26 will likely serve as a reminder of this uneven global recovery. The IFO data has improved over the last four months, but a stumble or leveling out of the number this month could betray the weakness of the euro zone economies.
Central bankers at the ECB and BOE will meet again on August 6. With interest rates expected to stay at record low levels, the central bankers now only have their words to guide markets. The ECB tends to hold the course in August as Europe vacations, but the BOE will have a significant decision on its plate: whether to raise its quantitative easing program another £25B to the full £150B that has been authorized by the Chancellor of the Exchequer. The BOE surprised some pundits by not taking this step at its July meeting, and may continue to hold off this month on the hopes that the recent improvements seen in home price and mortgage data are signaling a bottom in the battered UK housing market.
The recent firming up of economic data has prompted a softer USD on rising risk appetite, but the Yen may be the key currency in August as Japan faces a sea change in the form of national elections. Japan opposition's leader Katsuya Okada is expected to lead the Democratic Party of Japan (DPJ) to a resounding victory against the ruling Liberal Democratic Party coalition in the Lower House election on August 30, as foreshadowed by the strong gains the DPJ made in local elections in July. The party also just issued a manifesto promising ¥16.8T in new annual spending over half of which supposedly come from eliminating wasteful spending, despite its perennial opposition to issuance of deficit financing bonds. Officials of the DPJ, have already admitted this spending plan may mean they will have to issue such bonds, with Okada acknowledging additional economic stimulus might be needed in the second half of 2009 which would "have to be [funded by] some kind of borrowing." New leadership in Japan may also raise concerns about the DPJ's foreign reserve strategy: last week Okada had to play down comments from his shadow finance minister Nakagawa that Japan must consider diversifying away from US Treasuries to avoid foreign exchange risk. Okada pledged that his administration has no plans to shift Japan's foreign reserves away from the US dollar, but questions may linger about whether Okada's promise on foreign reserve policy is as mutable as his platform on deficit bonds issuance
More Supply... But Who Will Buy?
Treasury markets are likely to remain at the forefront of market action in August. Out of the gate, markets will be forced to respond to what is likely to be nearly $400B in government financing needs for both the third and fourth quarter. Investors of all asset classes will also continue to thoroughly dissect the steady stream of coupon auctions. With as much as $180B or more in supply slated for August alone, it will be crucial to see if creditors of the US government will demand ever higher yields and price concessions similar to those seen in the July 2-year and 5-year auctions. Foreign participation will remain a key component as well especially in the wake of speculation that the Chinese were purposely throttling back at the late July note sales as Chinese officials met with their counterparts in Washington.
Despite all the handwringing over the aforementioned auction results, yields actually begin August at or below where they came into July. Chairman Bernanke's semiannual testimony to Congress emphasized that unemployment would likely remain high into 2011, potentially undermining what is already expected to be a gradual recovery, and for that reason the Fed will only consider tightening fiscal policy once the job market shows signs of recovery. The August 7th payroll and unemployment numbers could provide some color on this front, but generally it appears inflation pressures are offering little if any upward pressure on rates. At some point this month the Fed will have to address the future of its asset purchasing program. By early September, the Fed is projected to have used up the entire $300B already allotted and very little has been communicated about what the next step might be. San Francisco Fed President Yellen recently called the continuance of Treasury purchases an "open question" while the Fed's Fisher stated outright that he is against extending or expanding the program. Bernanke avoided the topic entirely at his semi-annual testimony in July, but it is unlikely that the FOMC can continue to remain mum on the topic as it meets again on August 12, as a lack of a clear path forward would risk injecting a new cloud of uncertainty into markets that remain historically volatile.
Beware the Bear Market Bubble
With earnings season winding down, the equity rally may be running out of logs to throw on the fire. Yet, in this climate where a 1% GDP drop counts as good news, the economic data this month will not have to clear high hurdles to evoke positive sentiment. It may be tempting to breathe a sigh of relief, content to know that the financial markets dodged a complete meltdown (ironically thanks largely to the stimulus efforts of a US government with record low approval ratings), but the global economy is still fragile, still going through its worst convulsions since WWII, and is setting up for a "jobless recovery" with slower growth than in the past (the "new normal"). With markets still trying to shake off the excesses of the last decade, and the unwinding of massive stimulus programs still to come in the years ahead, market participants must be watchful for the formation of fresh bubbles which could be a set up for a fall.
Key dates in August:
- Aug 6: ECB and BOE rate decisions
- Aug 7: July US Nonfarm Payrolls and Unemployment
- Aug 12: FOMC rate decision
- Aug 26: German IFO survey
- Aug 27: US Preliminary Q2 GDP (2nd reading)
- Aug 30: Japanese Elections
Trade The News Staff
Trade The News, Inc.
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