views

MAYBE THIS IS AS GOOD AS IT WILL GET

<strong>TAKING A VIEW Trading Outlook</strong><br />BRIAN DOLAN<br /><strong>CHIEF CURRENCY STRATEGIST, FOREX.COM</strong><br /><br />AS SUMMER draws to a close, indications are increasing that the risk rebound has run its course and that markets are likely entering a more difficult phase of the global stabilisation/recovery story. On the technical side, in stocks, bearish divergences between price and momentum abound in major indexes like the S&amp;P 500, FTSE, and the MSCI World. In currencies, the &ldquo;risk on&rdquo; trade, eg long carry trades (such as long on yen crosses with the Australian dollar, Canadian dollar or the euro) and short US dollar, is also faltering and never lived up to expectations raised by the highs in stocks, which &ndash; importantly &ndash; came on weak volume.<br /><br />On the fundamental side, upbeat economic data is increasingly being shrugged off. August German IFO and Eurozone Purchasing Managers&rsquo; Indices (PMI) just made new highs for the year, but there was a palpable lack of response from European investors. Similarly, US consumer confidence for August just surprised with a stronger than expected reading, but shares were unable to sustain gains on the day. The same goes for August US housing data, which arguably provided the best case yet that the US housing market has reached a bottom. It could be a simple case of summertime lethargy, but more likely risk positioning has reached an apex and investors willing to pile in at current levels are increasingly scarce.<br />Perhaps nowhere is the divergence more apparent than in commodities, which might be seen as the closest barometer of growth expectations. If production is going to ramp up and personal consumption is expected to recover, commodities should be gaining ground. But the Reuters/Jefferies CRB index peaked on 6 August, posting another bearish divergence between price/momentum relative to its 11 June high, and has been declining since then.<br /><br />There's a built in circuit-breaker of sorts between commodity prices and other risk assets on either of two counts: 1) Higher commodity prices lead to higher final product prices, sapping disposable income and damping a consumer-led recovery, undermining corporate profitability; and 2) If producers choose to eat higher input prices, corporate profits typically suffer and stock markets tend to underperform. <br /><br /><strong>NEAR-TERM RISK</strong><br />The greatest near-term risk emanates from China, which has recently announced efforts to rein in lending by state-owned banks to companies and to cut back on industrial production investment. Keep in mind, China and the rest of Asia were supposed to lead the rest of the world toward recovery. But with China's nearly $600bn (&pound;370bn) fiscal stimulus package exhausted earlier this summer, that source of further growth also looks to be fading.<br /><br />The chart below shows the China Leading Index and the Baltic Dry Index, a measure of commodity shipping demand. Note that the Leading Index is nearly back at mid-2007 highs, when global growth was at its peak. Does anyone seriously think the global economy is anywhere near to mid-2007 levels? More striking is the divergence between the two indexes, which had been closely correlated until earlier this year. The outsized surge in the Leading Index since then suggests potential for a significant cut-back in Chinese production, which would undermine global asset markets overall. If so, buckle up for a bumpy autumn and a relapse in risky assets.