Trader’s thoughts: trade war hopes rise, but fundamental factors still at play

Stocks finish week on solid footing

Global equities finished last week on a solid footing. Across Asia, Europe and North America, the major share indices closed both Friday and the week in the green – the only notable exception being the FTSE 100, which has dipped (typically) because of a stronger Sterling. The solid run into the week’s close came courtesy of more friendly-trade-war headlines, suggesting that significant progress is being made in US-China trade negotiations. A bit of headline jumping, sure. But these headlines were a little brighter than what has been received of late. In short: a final agreement on currency manipulation has been reached, an extension of the trade war truce is likely, and a trade-deal is more likely happening than not.

Risk appetite piqued

This is all according to US Donald President Trump, so the gut says it be taken with a pinch of salt. Equity traders heard enough, however, driving the rally in global stocks. Chinese equities led the gains on both the daily and weekly charts: the CSI 300 was up 2.25% on Friday and 5.43% for the week. Growth currencies also rallied into the week’s close. The AUD has climbed back to 0.7129, the NZD is fetching 0.6844, and the CAD (supported by higher oil prices) has broken above 0.7600 once more. Most promisingly of all is price action in commodities. The Bloomberg Commodity Index is at a YTD high, led by a break higher in copper prices.

Venezuela and oil

In commodity-land, arguably as it always is, oil is hogging the conversation. News in the last fortnight that the Saudis intend to deepen production cuts has formed the fundamental basis of oil’s rally. The short-term factors though pertain to the humanitarian crisis unfolding in Venezuela. The (possible) impending civil war aside, the prospect of social and economic chaos in Venezuela has lifted the price of WTI to levels not registered since November last year.

Oils omnipresence

The importance of oil in the context of fundamental economic strength, along with financial market activity ought not to be understated. One of the key drivers of Wall Street’s major correction in Q4 2018, as well as the US Fed’s adoption of a dovish stance to interest rates, was the collapse of oil prices. Some of the junkiest of US junk-bonds are held by highly leveraged shale-oil firms, meaning the collapse in oil prices last year greatly increased credit-risk in US markets – dragging down equity prices with it. Furthermore, the fall in energy prices dragged diminished inflation expectations, inhibiting the US Fed’s ability to reach its mandated inflation target of 2% subsequently.

The financial markets’ contradiction: While it has to be said it isn’t the most important variable in financial market activity more-often-than-not, a constant awareness of oil prices is valuable. The two-top themes that are of greatest concern to market participants is the interplay between Fed policy and the growth outlook. If one digs down here, there is a contradiction presently between both narratives, which opens the possibility for volatility somewhere down the line. The Fed has definitely given the greenlight to be bullish, and chase yield in risk-assets. This is what’s propping-up US stocks. The dilemma is, though, earnings growth is deteriorating along with the global growth outlook – a trend that could strip most-incentives to pile into stocks any further.

The rates and earnings balancing act: The fact is the S&P 500 has never posted a positive year when annualized earnings growth has contracted. The US reporting season is coming close to being done-and-dusted, and on a quarterly basis, earnings contracted on an annualized basis (in aggregate) across Wall Street equities. Forward earnings estimates still have US stocks experiencing respectable growth in the year ahead, however there has been a recent trend of downgrades in this metric. Expectations are that the Fed will stay steady this year, before cutting interest rates in 2020 or so, which will support stocks. The basis of future gains will be striking the right balance between sustaining positive earnings and experiencing interest rate setting that keep financial conditions supported.

The ASX to follow Wall Street: Either variable could turn on a coin, but this is being read as a low probability at the moment. The S&P 500 looks quite adamant it wants to challenge 2815, at which that index failed on several occasions to break through late last year. Although more sensitive to the global growth narrative, the ASX 200 is taking its lead from Wall Street, and eyes its own milestone of breaking September’s closing price at 6230. Rallying commodity prices will underpin the ASX 200’s strength, as will the tumble in bond yields, which are still adjusting to the prospect of rate cuts from the RBA. Just in the day ahead, SPI Futures are indicating an 8-point jump for the index at today’s open.