8th September 2014 by The Harried House Hunter
In the last Market Thinking, I discussed the euro against the dollar, pointing out the likely conclusions that chart followers might draw from the apparent reversal of the euro strength from the lows of 2012. The moves by the European Central Bank (ECB) to cut the already low short rates will have given some further impetus to that directional move, with the currency now moving below 1.30 for the first time in 13 months. Perhaps more powerful than the drop in the lending rate are the changes to the overnight deposit rate. Effectively the ECB is now charging banks 0.2% to leave money at the ECB, forcing foreign liquidity out of the euro. However this is not just a euro story, the Yen has also broken out against the dollar and at over 105 has hit the highest (weakest) level since the 2008 financial crisis. If we were to look at the same Fibonacci retracement chart for the Yen that we did for the euro last note, we would see that the Yen has now retraced almost exactly 61.8% of the rally from the 2007 peak.
This would suggest that the next target would be 112 and then 123. Again I stress, I am not making currency predictions, rather highlighting the possible thought processes that might be going through the minds of traders assessing longer cycle trends. Fundamentally, the fact that the US is close to ending QE while Europe and Japan essentially began in 2011/12 and are likely to be increasing rather than decreasing efforts to stimulate their economies through looser monetary policy, fits with a reversal back to the pre-crisis norm. The importance of the Yen and the euro in US trade has meant that the trade weighted dollar has until now, been relatively weak, but if we look at the DXY Index we see clear signs of strength, looking to break out of the top of the 78-84 band it has been in for the last two years.
These long term fundamentals and technical patterns are likely to be bolstered by a lot of ‘noise’, with economic and geopolitical data that is largely positive US, and negative everywhere else, being used to support traders’ attempts to trigger stop losses or force hedging of currencies by long only investors.
Escalation of the situation in Ukraine is an obvious example of macro uncertainty that markets are trying to price. Ever tougher sanctions against Russia are not good for the German economy, but this is being offset by a weaker euro, helping exporters in particular – as I noted last week. The European equity markets have thus rallied as the euro has weakened, with emphasis on cyclicals, financials and exporters. To the extent that this was unwinding previous gloom it is acceptable, but the similarities to the way the Japanese market has traditionally rotated within a reasonably wide band in response to macro news flow and noise is yet another way in which Europe is emulating the lost decades of Japan. Weaker currencies do make imports more expensive, although for now the stronger dollar is making for lower commodity prices meaning that in euro or Yen terms commodity inputs are relatively stable. Another reason for weaker commodity prices is that demand is falling short of (increased) supply in many areas. Interesting to see therefore the announcement of a tie up between Russia’s state owned holding company Rostec and China Shenhua to develop coal deposits in Far East Russia. Rather like the pipeline announcements this is a consequence of Russia focusing more eastwards in response to its falling out with the West, but also suggests that the current weak coal price is likely to remain for some time, helping some of the pure play power plans such as Huaneng Power. The flip side of this of course is that a lot of the commodity producers, especially the smaller players are really struggling – new lows on Fortescue Mining this week for example, one of the most highly geared stocks to the iron ore price which is off 17% on the month while Rio Tinto, almost entirely an iron ore play, but much bigger and much lower cost, is off only 3% on the month. This may also be exaggerated by the short bonds/long commodity trades that were the consensus at the beginning of this year, as proxied by the chart below. The black line is the broad commodities index, while the orange is the ETF of the long bond, shown inverse, i.e. a short position therefore a rising line is profitable. Clearly since April this has not been working very well at all.
Elsewhere in Asia, no news on our Shanghai joint venture as I am going next week, rather than this week as mentioned in the last note (oops), but more meetings and articles on the Shanghai Hong Kong Stock Connect. It is all supposed to kick off in October, which is going to be a tough deadline. We should not lose sight however of the huge significance this has for the opening up of the Chinese capital account.
One of the things that will not encourage the international investor is the concern over possible stock frauds. This was a big issue with the likes of Sino Forest a year or two ago and taps into a concern that many corporates in Asia generally, but China in particular, view a stock listing as a way to get money out of the company (and often the country) rather than as a source of long term risk capital. The questions raised this week over the recent IPO by chemical firm Tianhe and also sausage skin maker Shenguan and their subsequent suspensions are thus unsettling. Innocent until proven guilty of fraud, the investigations also raise issues about other business risks – Tianhe’s concentration on one particular customer for a major product for example – that might nevertheless lead to some reassessment of prospects. In any event it is likely to raise the equity risk premium.
Another area of concern remains gaming and luxury goods. The crackdown on corruption continues and this is definitely hurting areas of conspicuous consumption like jewellery and watches (our old friends Chow Tai Fook) as well as other ‘related areas’ such as the Macau gaming stocks. The latter are unwinding a lot of last year’s big momentum trade. Readers may recall the discussion at the start of the year about how cheap it was to hedge positions in Galaxy Entertainment Group with put options when it hit $82 back in January and how we suggested that it might well have been a way to reduce the size of the very successful off benchmark bets from 2013. Also for the contrarians, Galaxy had risen from only $30 in March 2013 and its Chairman had just been declared the second richest man in Asia. For earnings momentum models as well as price momentum, the analysts started to downgrade in May on the back of the weakening fundamentals, not just at Galaxy but across the whole sector.
Now back at $56, Galaxy has given back almost exactly half of that 2013 gain, a level it has tested several times since May and if that breaks then the traders (Fibonacci again) would be looking for $50, then $42. Melco Crown Entertainment, another stock from 2013, rose from $17 to $45, has given back 62% of its gain, with Las Vegas Sands which ‘barely doubled’ last year also losing 62% of its gain (another Fibonacci, there could be something in this!).
As an indicator of what might happen next, traditional luxury goods did not have a good 2013 as earnings momentum peaked at the end of 2012. LVMH for example bounced around between 120 and 150 all year before ending at the lower end, while Prada traded 70-80 before dropping sharply early this year into the 50s. But the problems may not be over yet. We have just been hearing however that the latest twist in the anti-corruption drive is for the authorities to ask luxury goods stores in China for a list of their top customers. It looks like in mainland China conspicuous consumption is going rapidly out of fashion.