How now?

Well, we’ve achieved a sufficient peak to trough drawdown in this initial leg lower in risky assets to begin wondering whether it’s time for a bounce (see yesterday’s post on past episodes of SPX weakness for details.)

Sufficient does not imply necessary, however, and European equities have lurched lower today, despite a relatively strong close in the US and a (small) positive day in A-shares. Macro Man cannot help but think that there remains a fair degree of complacency in the market; yesterday, for example, saw a reasonably large buy program in the FX carry trade even as risky assets appeared to be under pressure. Once the buy program finished, however, things have lurched lower in a hurry. The kiwi, for example, has started trading like a clay pigeon.

One question that Macro Man and others are wrestling with is how a move (albeit a large one) in Chinese equities could have kicked off such a large move in other markets. Granted, China is a hugely important driver of economic growth and financial markets, particularly at the margin. Yet Chinese capital markets are largely ringfenced from the rest of the world.

Sure, there are some funds that invest in onshore Chinese shares, but these have a reasonably small footprint in the West. Chinese domestic investors, meanwhile, do not even take up their full allotments in QDII quotas. It is difficult to credit that fears of Chinese capital repatriation could be behind the demise of risk trades on Tuesday. Moreover, the Indian equity market had had a similar downward lurch last week (albeit spread over a few days), with no discernible impact on developed financial markets. So what gives?

While the move in China clearly had some ‘shock value’, Macro Man believes that underlying conditions in developed market, specifically US, assets and macroeconomic conditions were just as much to blame. Recall that Tuesday saw the release of an off-the-charts bad piece of economic data (durable goods) even as the ABX market was publicly imploding. Surely there’s a case to be made that the SPX meltdown was just as much homegrown as it was imported from China- and that’s even with ignoring the Dow Jones fiasco.

If we examine the DAX, for example, which was trading during the release of durable goods, we can get an idea of how the data impacted stock prices (as indeed we can attempt to quantify the impact of China.)

The above chart shows intraday prices for the DAX on Monday and Tuesday. In it, the impact of China is pretty clear; prices gapped lower on the open and drifted down from there. So at 1.30 GMT on Tuesday, German stocks were down 1.7% from Monday’s close. Note the large blue down candle at 1.30, however: this shows the instantaneous reaction to the durables figure, and the immediate aftermath. From the release of the data to the German close (4.30 pm GMT, 11.30 am EST), the DAX dropped another 1.3%. Thereafter of course, US stocks continued to drift lower and collapsed around 3pm EST.

What does it all mean? Yes, China has an impact, and the recent volatility provides a timely reminder that what goes up can also come back down. But it’s important not to dismiss the impact of economic data; the US economy, at the very least, appears to be at an inflection point. The size of the forecast misses (durables, consumer confidence, new home sales, ISM) is growing, and the delta of the data is mixed.

Ultimately, this is a classic recipe for an increase in risk premia, which manifests itself in financial markets via risk aversion. It seems unlikely that economic uncertainty will ebb any time soon; indeed, the data could remain mixed for another several weeks. This leads Macro Man to believe that yesterday’s technical overlay for the SPX is not a bad roadmap, and that the worst is not over.

However, given his relatively constructive view on US and global growth from Q2 onwards, he expects asset market weakness to ultimately set up as a nice buying opportunity for risky assets. In the meantime, however, he will tread (and trade) lightly, try to be defensive, and look to close shorts/accumulate risk during phases of capitulation. That being said, nothing ever moves in a straight line, and there should be some nice trading opportunities over he next couple of sessions. Macro Man will look to take profit on long USD/ZAR, for example, at 7.33 spot basis.