This Week's Market Outlook

Highlights

• Risk rally stalls for the moment
• Sterling set to remain on the defensive
• Earnings still show little organic growth
• Treasury auctions again in focus
• Key data and events to watch next week

Risk rally stalls for the moment

Despite the crescendo of USD negativity this past week (e.g. CNBC devoted a full day's worth of programming to the weak dollar theme), the greenback actually held up pretty well, while the JPY struggled further as the biggest loser. On the week, the USD is better against the JPY, GBP, and CAD, and slightly weaker against AUD, EUR, NZD, CHF, gold and silver. Perhaps interestingly, EUR/USD broke above the psychological resistance level of 1.5000, made little progress and looks set to close just below it for the week. Eurozone finance ministers and ECB President Trichet did their best to talk down EUR/USD, but the market paid little attention. Cable experienced a massive rejection from a break above its Ichimoku cloud on strength early this past week and looks quite vulnerable (see below). CAD went on a roller coaster ride, but ultimately fell against the buck on more strident warnings from the Bank of Canada against further strength. BOC Gov. Carney used the "I" word (intervention) and traders reacted for the time being with further short-covering in USD/CAD. We are cautious that markets will continue to heed the BOC threat, but excessive USD-short positioning there may see further gains toward the 1.09-1.10 area, where we would reconsider selling USD/CAD. The 21-day sma at 1.0550 may be the trigger higher, and a daily close above would be bullish in our view.

It's too soon to say the risk rally is reversing, but it certainly feels as if investor euphoria has run its course. Stocks (S&P 500) lost ground on the week despite some better 3Q earnings (see below) and Treasury yields finished out the week at their highest levels since the end of summer. Still, we have no firm technical clues of a broader reversal and instead must reckon with further consolidative price action in the week ahead. However, due to extreme positioning (short USD, record long gold) a reversal could get messy in short order, so we will be on high alert for signs of a larger reversal. In addition to the weak USD and risk on/off themes, it looks like a case of increasing differentiation between economies based on the fundamental outlook. We expect the differentiation theme to continue even if a USD-positive correction should occur. In order of appeal, we would use pullbacks as multi-week buying opportunities in AUD, NZD, and CAD as mentioned above. In order of aversion, we would look to continue to sell JPY and GBP on remaining strength.

Sterling set to remain on the defensive vs. the EUR in the approach to Nov MPC

The plunge in the value of the pound following the release of shockingly poor UK Q3 GDP data (-0.4% m/m) begs the question of whether sterling can stage a turnaround in the coming sessions. Against the EUR, the outlook for the pound has been worsened by the perception that the Eurozone recovery remains on track. Friday?s releases of the German Oct IFO survey and the Eurozone Oct PMI both showed further improvement. Both Germany and France returned to growth in Q2 2009 and these numbers combined with a worse than expected contraction in the UK economy during Q2 played a significant part in depressing the value of the pound vs. the EUR through the summer. Looking ahead, the prospects for UK Q4 GDP will be supported by the VAT hike on Jan 1, 2010 which is likely to lead to some front-loading of expenditure. That said, UK economic potential will be dampened for some time by rising unemployment, higher savings rates and the reining in of fiscal stimulus. With the gap between the recovery in the Eurozone appearing to accelerate away from that in the UK and given the ongoing concerns about the UK?s appalling fiscal position the value of GBP vs the EUR is likely to remain severely weakened for some time. Forthcoming UK house price data is likely to show further stability, while lending data are also expected to confirm that conditions are less bad. The CBI distributive trades data may also show signs of an improvement in the high street activity. However, in the wake of the horrible Q3 GDP release none of these data releases are likely to be strong enough to push the risk of further QE from the BoE off the table. In the approach of the Nov 5 MPC meeting sterling is likely to trade on the defensive. A break above the EUR/GBP 0.9200 level could lead to a jump higher to the 0.9310 area.

We remain cautious with regards to the potential of such a pickup given the dreadful state of the consumer balance sheet and the awful employment landscape. Given that, by our calculations, the consumer still needs to unwind roughly $500 billion in non-real estate credit to get back to sustainable debt/income levels and that unemployment will continue to rise in the first half of 2010 right through 10% makes this sort of organic growth questionable to say the least. This is the main premise behind our view that the current rally in equities is well overdone and a sharp short-term correction is looming.

The next two weeks will paint a better picture of the current earnings landscape as we have 290 companies slated to report. As such, the price action in all markets will be beholden to the outcomes in this space. Given very strong inter-market correlations - with commodities, stocks, and yields all moving opposite to the US dollar - we could be setting up for a significant reversal in the recent trends. In other words, should earnings disappoint on the top-line, we would expect the US dollar to find a solid short-term base and see a significant pick-up in buying interest. Those likely to suffer the most on earnings disappointments are AUD and CAD as much of the near-term strength here (economic fundamental improvement notwithstanding) can be directly attributed to the euphoria in the commodities space. The gold bulls will also undoubtedly head for the exit.

Earnings still show little organic growth

With about 1/3 of S&P 500 companies having reported 3Q earnings, the picture remains eerily similar to the 2Q results. The bottom-line results (EPS) are coming in 16% above expectations while the top-line sales figures have registered marginally below conservative forecasts at -0.1%. This suggests businesses continued to drive the bottom line via cost-cutting, mainly on the employment front. We didn?t get that net -768,000 job loss in the quarter by accident. With the consumer seemingly in deleveraging mode (as per recent trends in consumer credit data) and the unemployment rate likely to be sticky above 10% well into 2010, driving organic earnings growth will be extremely difficult still. If nothing else, these rather lackluster earnings reports suggest a potential short-term top in the equity space as the price action looks to have overshot reality. Indeed the US market is now trading at a 20.5 price-to-earnings ratio ? about 17% above the long-term average valuation. Long-term fundamental difficulties notwithstanding, the USD could be poised to carve out a short-term bottom over the next week or so if this pattern on the earnings front continues to play out. The buck has seen a -95% correlation with equities thus far this year, so any reversal in risky assets should elicit a nice pop in the US dollar.

Treasury auctions again in focus

The US Treasury is scheduled to offer a record $123 billion in notes next week and the outcome of these auctions could have serious implications for the US dollar. Among these are 2-year ($44b), 5-year ($41b) and 7-year ($31b) offerings. The key metrics in terms of gauging the health of the auctions will be the bid/cover ratio, the indirect take and the market tail. The bid/cover ratio measures the amount of interest in the auction relative to the amount being offered. Thus a bid/cover of 2.7 or greater for the 2-year, 2.3 or more for the 5-year and 2.5 or above for the 7-year would be considered healthy participation. The indirect take is used as a proxy for foreign central banks, so a higher percentage suggests more foreign interest for US paper. An indirect take above 50% would be a good sign that foreigners are not shunning USD-denominated debt. Lastly, the market tail measures what yield the auction participants bid at (in other words what return they deem as compensation for their risk) relative to where the market is trading. Should the tail come in above 4 basis points (0.04%) or so, this would suggest investors are demanding more return for holding US paper than what the current market is offering. This means holding US paper is deemed more risky at the margin. So a positive tail above that 4bp threshold would be a USD negative as yields would likely spike. A large positive tail coupled with a weak bid/cover and thin indirect take would be decidedly US dollar negative. For now, however, the demand for US paper remains robust and has shown little signs of waning.

Key data and events to watch next week

The US data week begins with the little-advertised Chicago Fed National Activity Index on Monday. Case-Shiller home prices and consumer confidence are up on Tuesday while Wednesday sees durable goods, new home sales and the usual weekly oil inventory report. The highlight of the week comes Thursday with 3Q advance GDP along with the typical jobless claims data. Personal income/spending, Chicago PMI and the University of Michigan consumer sentiment index round out the week on Friday.

The Eurozone kicks off with German consumer confidence on Monday. French consumer confidence follows on Tuesday while German CPI is up on Wednesday. The Eurozone business climate indicator, Eurozone consumer confidence and German employment are on tap Thursday. Eurozone CPI and German retail sales close things out on Friday.

The UK has a light week on deck and starts with the CBI distributive trades report on Tuesday. Consumer credit and mortgage approvals are up on Thursday while consumer confidence is due Friday. The Bank of England will also release a report on the asset purchase facility on Monday and this could be market moving as well.

Japan is on the busier side for a change. Retail trade kicks off the action on Tuesday. Small business confidence, PMI manufacturing and industrial production are due Wednesday while Thursday has employment, household spending and consumer prices. Housing starts and the Bank of Japan rate meeting are up Friday.

Canada also has an important week ahead. Data is on the light side with industrial product prices on Thursday and monthly GDP on Friday. However, we also have Bank of Canada Governor Carney speaking on Monday and Finance Minister Flaherty on Tuesday. Given the recent musings with regards to concern about the Canadian dollar strength, these speeches could offer up some market moving tidbits.

The calendar down under is more lively than usual. In Australia we have PPI on Monday, CPI on Wednesday, leading indicators and new home sales on Thursday. New Zealand starts with consumer confidence on Tuesday. Business confidence, trade and the RBNZ rate decision are all due Wednesday while building permits round out the week Thursday.

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Weekly Market Wrap

Earnings season hit its stride this week, although the effect on markets has been hardly salutary. Trading in US equities was highly volatile, with the leading indices whipsawing back and forth in the absence of any overall negative or positive theme. The DJIA spent most of the week above 10,000, but closed out on Friday below this key psychological level. Economic data played a minor role, with most attention paid to another brace of mixed housing numbers. September housing starts and building permits fell below August levels, while the September existing home sales data over 9% sequentially. With the holiday season imminent, a National Retail Federation poll showed that US consumers plan to spend 3.2% less on a y/y basis on holiday shopping in 2009, stating that "Americans are not ready to declare an end to the recession." Meanwhile, third quarter GDP reports from China and the UK impacted FX and bond trading. China's GDP growth was stronger than the prior two quarters at +8.9% (though slightly below consensus), while a dismal UK GDP data reading of -0.4% shocked investors and took the wind out of sterling. The Fed confirmed this week that it has been testing reverse repo operations for several months, calling it a critical part of its eventual exit strategy, although it declared that the tests do not signal any imminent policy shift. Note it was just last weekend that Barron's implored Fed Chairman Bernanke to raise the Fed Funds Rate to 2%, and later in the week the FT speculated that Fed governors may soften their commitment to the zero rate policy via wording in the FOMC statement. For the week, the DJIA fell 0.2%, the S&P 500 declined 0.8% and the NASDAQ Comp slipped 0.1%.

Tougher government regulation of telecommunications and the financial industry occupied Washington this week. It was hard to avoid news of moves by the Treasury's "pay czar" Feinberg to slash executive compensation at TARP recipients and examine even wider restrictions on pay at banks. The Fed began its own review of pay in the financial sector, noting that up to 28 large banks would face special "horizontal" compensation reviews. On the Hill, the House Financial Services Committee voted in favor to speed up implementation of elements of the Consumer Financial Protection Agency. The FCC moved closer to adopting "net neutrality" as official policy, with exceptions for "reasonable" network management needs.

On Wednesday Morgan Stanley was the final big banking firm to report earnings. Morgan blew out estimates and returned to profitability after three quarters of losses. Morgan Stanley's CFO insisted that putting losses behind the bank is not a relief but an affirmation of its strategy. Leading regional banking name Wells Fargo also crushed expectations, although many commentators have expressed concern that the bank continues to rack up more non-performing assets and higher provisions for credit losses. Dick Bove spooked markets on Wednesday afternoon with a big reversal on Wells Fargo following the bank's report. Bove, who had initially called Wells Fargo a big winner just after the earnings came out, seemed to change his mind by afternoon and downgraded the name to a sell upon closer examination of loan loss figures. The regional banks appear to be splitting into groups of winners and loosers, with solid results from Bank of New York and US Bancorp, and more losses from Fifth Third, KeyCorp and SunTrust.

Many quarterly earnings reports are apparently repeating the pattern established in the prior earnings season: EPS meets or exceeds consensus expectations while revenue results lack the surge in sales that would indicate a firm economic recovery. A look at the DJIA components which reported results this week illustrates the point. Thanks to a big tax benefit Caterpillar's earnings were nearly an order of magnitude better than the consensus view, while revenue fell short of expectations. DuPont's earnings outperformed while revenue fell somewhat short. Other leading names are in the same boat: Honeywell's EPS was slightly better than expected, while revenue missed the consensus view somewhat. The firm's CFO said top-line performance will remain challenging. Railroad Burlington Northern also had solid earnings but underwhelming revenues, while its forecast for next quarter was weaker than expected. Oil services name Schlumberger was in line with earnings expectations and revenue was a hair below expectations. Boeing's loss was a bit steeper than anticipated and revenue missed expectations. The aerospace giant also took a hammer to its 2009 guidance, citing the continuing problems in its 787 Dreamliner and 747-8 projects.

Tech earnings continued to be an exception to the rule. Apple yet again surprised to the upside, beating top- and bottom-line expectations handily, and even exceeded "whisper" numbers. On the conference call, Apple executives said iPhone supply was short "virtually everywhere," and bragged that the iPhone has been deployed in more than 50%+ of Fortune100. SanDisk and Yahoo blew out consensus estimates across the board. Amazon beat on EPS by a large margin and met revenue expectations. Texas Instruments modestly exceeded expectations. Broadcom and STMicro were tech losers, with both semi manufacturers missing bottom-line goals by wide margins (ironically, both beat on the top line). Microsoft capped off the week in tech, rising over 5% on Friday on the strength of its earnings and revenue results.

The military-industrial complex had a solidly profitable third quarter. Dow component United Technology, Northrop Grumman and Lockheed Martin all beat earnings expectations, although LMT's revenue was a bit behind the Street. Big pharma had a good Q3, as evidenced in reports from Merck, Novartis, Schering-Plough and Bristol-Myers. Earnings at all three firms were more or less in line with expectations, although Bristol-Myers and Novartis were a bit behind on the top line.

With corporate earnings in the spotlight, Treasury yields have quietly moved higher this week as the liquidity driven rally across a broad spectrum of asset classes appears to be taking a breather. Next week the Treasury returns after a two week hiatus with a record $44B in 2-year, $41B in 5-year and $31B 7-year notes up for grabs, alongside $7B in 5-year TIPS. Although higher, yields have broadly speaking remained range-bound. The 2-year yield managed to test the 1% mark for the first time in October after the FT reported that FOMC members were considering altering their commitment to keeping rates at the zero bound for "an extended period" in an effort to manage inflationary expectations. The 10-year Note is only a few basis points away from the 3.50% level (not tested since late September) while the 30-year Bond finished the week above the 4.25% mark.

The UK surprised many by failing to join Germany and France in technically escaping recession on Friday, posting its 6th successive quarter of negative growth. The considerably worse than expected reading meant the deepest downturn for the UK since records began in the mid 1950's and has heightened expectations for an expansion of quantitative easing from the Bank of England next month. US GDP data is due Thursday, and whilst the market is expecting a firmly positive reading (and by extension, an end to the US recession) the potential for both upside and downside surprises will number provide further event risk for bond traders next week.

Strong corporate earnings in the US and rising commodity prices around the world helped drive the euro to fresh highs against the greenback and the Swiss Franc this week. There was also a fair amount of talk regarding shifting away from the USD as a reserve currency following last week's heated debate. Former US Secretary of State Kissinger commented that China's goal was to dislodge the dollar's position at the heart of the global monetary system, noting that any moves to alter the dollar's reserve status would be made over a long period. PBoC Governor Ma noted that dollar weakness would trigger domestic inflation in China, leading to vague reports that China was looking to help curb USD weakness. The EU EcoFin conclave sent a letter to the chairman of the G20 stating that economic recovery was increasingly apparent and fears of a prolonged recession were fading. The unexpected GDP contraction in the UK took the wind out of sterling and sharpened the debate over a potential expansion of the BoE's £175B QE program. By Friday, dealers couldn't help but notice that the interest yield differentials between US and Germany have been trending in favor of the euro, as the benchmark 2-year yield spread moved towards the 50bps, its highest spread since early June.

EUR/USD tested and then broke above the 1.50 level mid week on continued chatter that Eastern European names were buying euros and that Russia was seeking to reduce the USD weighting in its currency basket to 33% from 55%, although Russian Central Banker Ulyukayev said he sees the weak dollar as a correction rather than devaluation. EUR/USD hit a high water mark around 1.55, a level last seen in early August 2008 before consolidating around 1.50. The German Export Assoc (BGA) believes the euro could rise toward $1.60 over the next few months before settling down to a 1.45-1.55 range. French Presidential Advisor Guaino commented that a sustained bout of EUR/USD above 1.50 would be a disaster for European industry. GBP/USD maintained a constructive tone throughout the week into the UK Q3 GDP data, climbing past a 14-month downtrend line of 1.65 before giving up its gains because of the weak GDP figures.

USD/JPY progressively over the course of the week despite BoJ's Hayakwa comments that Japanese companies were not asking the government to do something to weaken the yen. The BoJ released its quarterly regional report, noting that the economy remains severe in some regions but is improving overall. The currency's weakness late in the week was attributed to press reports that the BoJ expects continued deflation in Japan through 2011, when the Core Consumer Price index is projected to decline for the third consecutive year. The carry-trade sentiment rose a bit for the yen as dealers noted that the report was another indication that the central bank would keep interest rates near zero for the time being.

The trading week in Asia centered on economic data out of China mid week, where the Q3 GDP reading was released concurrently with the monthly industrial production, retail sales and inflation metrics. Despite the multi-month highs across these figures, markets expressed mild disappointment, with the Shanghai Composite extending its losses in the wake of the data. The 8.9% GDP reading was a one-year high, but came in just short of expectations of 9.0%. Industrial production hit a 14-month high at 13.9% and topped estimates of 13.2%, but fell short of the earlier press whisper number of 14.1%. Inflation is declining more slowly and retail sales met expectations.

The rhetoric from the Chinese government was barely optimistic: officials stated the economy still faces insufficient external demand and warned that building up domestic demand remains challenging. Moreover, NDRC researcher Wang said the fundamentals of China's economic recovery are still not sufficient, and top central bank advisor Fan Gang urged policy makers to maintain fiscal stimulus through 2010.

On the monetary front, the minutes of the latest Reserve Bank of Australia policy meeting shed some light on the central bank's decision to become the first G20 nation to raise interest rates. The RBA's focus revealed growing concerns over inflation bottoming at much higher level than previously expected and possibly rising again in 2011. In addition, the RBA forecasted economic growth will return to trend in 2010, and could rise to above-trend levels by 2011. Policymakers also did not appear to be fazed by the rally in AUD, suggesting the Aussie dollar rise reflects improving market sentiment and may actually help to contain inflation.

Trade The News Staff
Trade The News, Inc.

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