Risk Aversion Returning?

Giles Coghlan

What a difference a few weeks can make! Last month, we focused on the Fed’s talk about tapering, the possibility of the next rate hike being brought forward, and the ongoing question of whether the inflation we’re seeing is due to base effects and thus bound to be transitory, or not.

We looked to gold, the US dollar, oil, US equities and soft commodities such as sugar and coffee for clues. We found gold and DXY traders to be undecided, despite the recent gold rally faltering after Jerome Powell’s ever-so-slightly hawkish comments after the FOMC meetings, and an unexpected bout of US dollar strength. We also saw stocks undergoing a rotation back from value to growth, with tech stocks setting new record highs. Crude oil appeared to be one of the few commodities bucking the broader commodity sell-off, and everyday items such as coffee and sugar appeared to be on course in their up-and-to-the-right trend since last year’s COVID crash.

Rising Risks

Even a brief scan of recent headlines will reveal that global uncertainty has since risen. We’ve seen US inflation numbers climbing even higher and mixed labour market data, possibly suggesting the recovery may not be as robust as was thought. We’ve also seen coronavirus cases spiking with the new delta variant, despite vaccination numbers increasing, and civil unrest across continents as populations protest pandemic restrictions. We’ve had both natural and man-made disasters; fires, floods and even an underwater fire off the coast of Mexico. To top it all off, we’re witnessing an escalation of tensions with China, as both the US and UK have accused Chinese state actors of being behind the Microsoft hack.

US Equities

Looking at US equities, we see all the major indices off their highs, but not enough to signal a change of trend just yet. On Friday July 16, the S&P 500 sold off down to the 20-day moving average. On Monday, it gapped down even lower to touch the 50-day. The asset class as a whole has been looking toppy for some time, while continuing to grind higher; however, when you filter out the big tech names, the picture looks quite different.

Small caps have been hit particularly hard in this recent sell-off, with the Russell 2000 Index more than 8% off its highs since Friday; on Monday, it traded as low as 10.6% off its highs. Comparing the Russell 2000 and equally-weighted S&P 500 to the regular capitalisation-weighted S&P and NASDAQ, it’s clear that the outsized influence of a handful of big tech firms have been keeping US markets at their highs. While the market as a whole is still a way off from correction territory, there are two different stories being told depending on which charts you’re looking at.

S&P 500 / NASDAQ 100 Daily Charts

 
  

At present, the daily S&P 500 and NASDAQ charts suggest nothing more concerning than a mean reversion; they have yet to set a daily lower-low. Meanwhile, the equally-weighted S&P 500 and Russell 2000 appear to be much closer to rolling over. They also look completely different to the steady uptrend described by the cap-weighted S&P and Nasdaq.

The indices absent of the influence of growth stocks (or with that influence smoothed-out) appear to be in a large top formation that goes all the way back to February. As of Friday, the Russell 2000 was within 1.5% of setting a daily lower-low for the first time since March of this year. Taking Monday’s price action into consideration, it is now touching a support level that has held three times already: twice in March and once in May. The charts below look very much like a rally that ran out of steam a long time ago and is waiting to retrace.

Russel 2000 / S&P 500 Daily Charts

Sector Breakdown

Focusing on specific sectors, we see the areas of the economy that performed best during the reflation trade suffering the greatest drawdowns. Energy and Metals & Mining are currently leading the sell-off, both down almost 18% from their June highs. These are followed by Basic Materials and Aerospace & Defence, down 12% and 10%, respectively. Monday was a particularly hard day for the airlines and cruise operators, as fears that spiralling cases of the delta variant will lead to further lockdowns and business as usual will be off the table for a while longer. Financials were also down on the day, closing around 9% down as Jerome Powell’s recent dovish comments were digested by markets, and the possibility of a rate hike continues to be deferred.

DXY and Gold

Despite sentiment appearing to have taken a turn for the worse, the dollar and gold have yet to pick a definite direction. The DXY recently reached highs last seen in April of this year, but even this is still a lower high relative to March’s high, and on steadily decreasing RSI readings. This too signals a move in danger of running out of steam. The same can be said of gold, despite the longer-term chart appearing much healthier than that of the DXY. However, at the moment, gold bulls have yet to prove anything, with the yellow metal currently trading more than 5% off its June highs. A risk-off scenario seems to be in play, but the assets that are the safest bet have yet to be identified, with so much up in the air.

Final Thoughts

As with all markets, there are always traders on the sidelines, looking to get in at a better price. If the equity sell-off proves to be more than just a blip on an otherwise upward trend (particularly for big tech), it will be important to have a strategy for oversold assets. Gold is definitely one to have on the radar, as are other commodities that suffered heavy losses recently. Crypto is also a market to pay attention to, seeing as it has already shed most of the gains it made this year. With violent swings from one regime to the other due to high levels of global uncertainty, these assets are likely to over-correct in both directions, opening up opportunities through both overbought and oversold conditions.

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HYCM is the global brand name of Henyep Capital Markets (UK) Limited, HYCM (Europe) Ltd, Henyep Capital Markets (DIFC) Ltd and HYCM Limited, all individual entities under Henyep Capital Markets Group, a global corporation founded in 1977, operating in Asia, Europe, and the Middle East. 

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Giles Coghlan

Giles Coghlan is the Chief Currency Analyst at HYCM, one of the oldest brokers in the industry. Since joining the company in April 2018 Giles has played a key role in providing his expertise to HYCM’s investors.

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