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Q3 looks more supportive for risk assets - Westpac

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Fuseworks Media
Fuseworks Media

There has been no shortage of reasons to be cautious on risk assets in Q2 - the negative US/China/global data flow, EU peripheral debt stress, China monetary tightening and the end of QE2. The net effect has been that the S&P500 spent Q2 consolidating in a wide 1250-1370 range, 10yr yields fell 90bp from their Feb highs to their June lows, the US investment grade credit index widened 20pts and the USD firmed moderately in Q2.

Our best guess is that the US data backdrop will be patchy for around another 2-3 weeks. There is the risk of a sub-50 ISM given the negative cues from the Empire and Philly surveys (due 1 Jul), most data points to another weakish payrolls (8 Jul), and consumer confidence and weekly chainstore sales suggest another weak retail sales is likely for June (14 Jul). Beyond that and for the balance of Q3 however the picture looks more risk supportive. But, even then there are still some headwinds.

Crude oil prices have reversed much of the MENA unrest inspired rally from $85 to $115/bbl. Overlaying crude oil over retail gasoline prices suggests the latter could easily fall from around $3.55p/g to $3.00p/g in the next few months, freeing up a decent amount of consumer cash flow.

Our data surprise and data pulse indices for most of the global economy are at levels where they tend to stabilise and reverse. Our global data surprise index (WSURGLBP Index on Bloomberg) notably is at unsustainable 27 month lows. As the next slide shows the correlation between our global data surprise index, the global PMI and risk appetite since late 2008 has been exceptionally high. A higher global data surprise index would be associated with stronger PMIs (obviously) and firmer risk assets.

The Richmond Fed index surprisingly firmed in June and it has a history of leading other regional surveys. On its own it's not enough to revise ISM expectations for June but it does hint at potentially firmer regional PMI's for July. Backing that, Ward's Auto estimates US auto production schedules will surge through Q3. From a May assembly rate of 7.9mn units, June is projected to rise to 8.5m and then to 9.5mn for July. Note that even as auto sales have fallen off auto inventories declined even further confirming the weakness in this sector is as much a supply disruption story as anything else. Recent firmer Japanese factory sector data has been encouraging for this story.

US 10 year yields, the Shanghai composite index and copper prices have all turned sharply higher in the last week, giving the impression that an important low for risk assets could already be in place. Each market will trade off its own idiosyncratic factors but the overall message is undeniably positive for risk asset broadly. The tail-risk of an immediate Greek default has been averted too. However, there are important offsets. The Greek drama will become a focus once again in September when the next tranche is due and QE2 will be officially complete by 30 June.

Navigating all the landmines above, our feeling is that the atmospherics for risk assets will remain patchy in the next 2-3 weeks. Given that we are inclined to maintain a positive USD index bias on a 1mth horizon - on the proviso that bullish trendline support going back to early May holds (currently at 74.1). Beyond that however the risk backdrop looks less supportive for the USD. By then the next round of regional PMIs will be due and they should begin to capture improved business conditions and our surprise indices will be turning higher. We strongly doubt however that risk assets will return to their prior highs during this phase - Greece will eventually flare up again and the tailwind of Fed liquidity provision is no longer there. Moreover, the lesson from 2010 was that even when Greek default risk was taken off the table it was no panacea for risk assets. Greece was cauterized in May 2010 but the AUD and the S&P500 did not bottom out until a full 1 and 2 months respectively later. Overall the picture looks more risk supportive in Q3 but there are still some notable headwinds.

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