As if the third quarter of 2015 wasn’t enough with its mini market crash in August dragging stocks, commodities and the Aussie dollar to their lowest levels in years, it looks like Q4 could be just as fraught for global markets.
That’s the view of Richard Franulovich, Westpac’s New York-based strategist, who says that even though the fourth quarter contains “long term seasonal patterns (which) strongly favour risk-on trade” and there is a strong chance China will be once again easing policy in “coming weeks” danger lurks.
Franulovich implies traders have become a little complacent and are underpricing the risk that lurks, highlighting that “implied volatility has drifted lower across a number of asset classes in recent weeks and seems to understate a bunch of risks”.
He’s highlighted six key events he’s watching closely.
1 – US Debt Ceiling
Franulovich says the key dates are “3 Nov US debt ceiling limit and 11 Dec expiry of US government funding. A short term continuing resolution to fund US government operations expires 11 Dec.”
The US Treasury itself has nominated November 3 as the key date, and Franulovich says it’s the day they’ll have around $30 billion in cash left.
“The Bipartisan Policy Center estimates the Treasury will exhaust its cash reserves sometime between 10-19 November,” Franulovich said.
That could be problematic as Franulovich thinks “A round of brinksmanship thus seems assured and risk premiums are apt to rise into the November deadline(s)”.
He highlighted the ructions the last debt ceiling impasse caused.
In late 2013, when the US government shutdown and the debt ceiling was threatened 1mth T-bills spiked 45bp (intraday highs) while the USD index traded on the backfoot, though some weakness at the time will have been traceable to the Fed’s earlier decision to delay tapering asset purchases. US T-bills have already priced in some inconvenience/payment delay risk but it looks like it has further to run if the 2013 impasse is anything to go by.
In the end though Franulovich says that Westpac assumes, “the debt ceiling and funding of the US government is resolved as it ultimately always is but not without some form of grandstanding that weighs on the USD and equities”.
2 – IMF decision on Chinese Yuan (CNY) inclusion in its SDR basket
Franulovich says that a majority of pundits expect the Chinese Yaun to be added to the IMF’s SDR (special drawing rights) basket in early November. The best way to think of SDR as a kind of the currency for central bankers.
But Franulovich says, “there many technical hurdles still exist and the seemingly ad-hoc and not well communicated changes to its currency regime in recent months will have raised questions within the IMF”.
And that’s the risk he sees because the IMF could push the vote into 2016. That in itself won’t rattle markets, but if the IMF, instead of postponing a decision, explicitly rules out inclusion of the CNY in its SDR basket, things could get ugly.
The MSCI’s decision that mainland Chinese equities were not yet ready for inclusion in their indices back in June was a contributing factor to the then bursting of China’s elevated stockmarket. A decision by the IMF to not include the CNY in the SDR could well trigger a major bout of volatility and capital flight from China
Thankfully though Franulovich highlights that with China’s rise comes clout. So in the end he says “politics and diplomacy dictate that the odds of a ‘no’ decision have be quite low.”
3 – The December 16th FOMC meeting
Franulovich says that “the market implied odds for Dec lift-off have settled in the 30-35% range in recent sessions.” And he adds given competing voices from Fed speakers, data dependency of the decision, and the impression that all options remain on the table means “that lift-off odds will probably never exceed 50/50.”
Franulovich believes that the “overall US data flow has stabilised recently, our US data surprise index taking a more consolidative posture lately.” But, he adds financial conditions in the US have tightened enough that the “US data flow (is) looking tepid at best.”
If however it starts to look like the Fed will move he said any “Fed hike risk in the lead up to 16 Dec thus arguably plays USD negative/risk appetite supportive”.
4 – The prospect of expanded QE programs from both the ECB and the BoJ
The ECB meets to determine policy both this Thursday the October 22 and December 3, while the Bank of Japan meets next week on October 30.
Franulovich says that recent comments from ECB Governing Council members Coeure and Mersch and board member Nowotny suggest this week is probably too early for more QE. But, he makes a strong argument that a wait and see approach could be the wrong one.
Wait and see appears to be the main theme, even as one could argue the risks to Eurozone growth and inflation from the EM slowdown may already be materialising. Very soft German IP, exports and factory orders data in August and a renewed slump in inflation in September certainly warn as much.
December 3 seems more likely he says because “that meeting will be accompanied by fresh staff projections, often a trigger for fresh policy action by the ECB, not to mention other central banks”.
He thinks perhaps the ECB might continue to hold fire, but adopt a more aggressive approach to thye Euro to try to drive it lower.
He doesn’t explicitly mention the Yen or the BoJ other than to say that they are risks. But the linkage here is, like the Euro, the BoJ probably wants a weaker Yen (perhaps above 125) to help the economy. Likewise the BoJ, is desperate for inflation to pick up and this may also help.
5 – China’s 18th Central Committee 5th Plenum
Next week the Chinese Communist party gathers together it’s key leadership in a meeting to be held between October 26-29. The focus will be on the 13th 5-year plan.
Franulovich says that while reforms are always important the market will focus on the GDP growth target.
“A 6.5% growth target, down from 7%, is probably a source of consternation initially but appears to be widely expected. The risk of an even lower growth target, say 6% is non-trivial, though it would likely be accompanied by positive surprises on the reform front,” he said.
Key here, if a lower growth target is announced Franulovich says is that the “implied message that policymakers are willing to sacrifice growth in the short term may prove more overwhelming initially, triggering a bout of global risk aversion.”
A Chinese growth target of 6% would certainly spook markets even though man7y traders and investors have been leery of the current published numbers.
6 – Spanish general election
This is one many might not have thought of, but Franulovich says the Spanish election on December 20 is important for Europe.
He says the fractured politics of Portugal which has resulted from recent elections could be instructive for Spain. He notes “the government lost its parliamentary majority, the political landscape there now highly fragmented, heavily compromising the center-right’s ability to govern effectively, if at all.”
That’s important he says because even though a “nearly overwhelming policy firewall is now in place in the Eurozone (QE, OMT, TLTRO) the prospect of Spain swinging from “reliable reformer” to policy paralysis and possibly even backsliding on fiscal adjustment/reform could still deliver a jolt.”
Greece is back in the spotlight again too. So even though markets are more settled Franulovich says “sovereign stress of course damages confidence in the Eurozone project but perversely EUR has more often than not risen when stresses have flared, reflecting the region’s external surplus and the funding status of the currency.”
That is like Japan money goes home in times of market strife, stress and trouble. That in itself though can be destabilising.
Tying it all up
Risk is always two way, up and down, good and bad. So while none of these things could roil markets Franulovich says:
It is far from given that each of these aforementioned event risks will play out in a risk friendly direction. Even in the unlikely event they do, risk premia across most asset classes have fully unwound the summer surge, implying further meaningful downside in volatility will be tough to come by.
This week’s quiet on markets could soon be a thing of the past if Franulovich is right.
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