Why did the package of measures decided by the ECB, unanimously defined above forecasts, audacious and well constructed, produce an initial fall in the European stock markets and a strengthening of the euro? What does this reaction tell us about the positioning of the market, its psychology and its possible evolution in the coming weeks? Let's start with the exchange rate between the euro and the dollar. Two schools of thought have been fighting here for some time.
The first argues that, with European rates increasingly below zero and with American rates that can only rise, the dollar can only continue to strengthen and approach parity. It is linear reasoning, but as often happens on the markets, simplicity can be misleading. It's been more or less a year since the story of equality has come out and its supporters have been regularly frustrated for a year now. The second school of thought, minority but intellectually well equipped, argues instead that the dollar has already reached its cycle high some time ago and that it will weaken from now on. The main argument in support of this thesis is that the global economy continues to slow down and is increasingly at risk of recession in the future.
In a recessionary context the dollar historically tends to weakenpartly because the United States does not hesitate to tear it down when things go badly and partly because the operations of carry tradetypically funded in dollars. Another argument, which is new in this cycle, is that a weak dollar is the only thing that can keep the renminbi afloat. A dollar that is too strong, as we saw in August and January, in fact sets in motion capital outflows from China and, in this way,
destabilizes global financial markets.
Eventually the second school of thought will be right because one day, sooner or later, a recession will come. At the moment, however, not only is there no slowdown, but the first quarter, at least in America, is accelerating compared to the fourth quarter of 2015. As for China, however strong it is the media pounding on its slowdown, the target of 6.5 percent growth for the next few years was confirmed in the preparatory documents for the five-year plan which will be approved at the end of this year. If it were to be respected (and so far the plan objectives have always been achieved) the Chinese economy would be in December 2020 (i.e.
the day after tomorrow) 37 percent larger than today.
With all due respect to those who hypothesize hard landings and system implosions. But to us the exchange rate between euro and dollar still appears to balance on a level not far from 1.10. Europe doesn't need a weaker euro and America can't afford a stronger dollar. On the other hand, Europe would suffer from a premature recovery of the euro while America, on these levels, has amply shown that it can hold up. The argument that future US rate hikes should strengthen the dollar actually works the other way around. In fact, America will raise rates only if the dollar remains calm. The current level of the exchange rate will therefore only be seriously questioned, as we have seen, in the event of a recession or in the event that something negative happens in one of the two regions, either in America or in Europe.
As for the descent of the stock markets in the after Dragons, it's about something more than trivial profit-taking or a sell the news. It is evident that there is a psychological fragility of the bulls, still in shock after the heavy and unexpected fall in January, and their strong desire to realize at any cost. On the other hand, there is the determination of the bears, convinced that they can resume leading the game from now on.
Among the bears there are some who have been taken by surprise by the sharp rebound in oil and mid-February stock exchanges. However, the strongest and most prudent hands covered themselves in time before the recovery of the last few weeks took hold and brought home excellent gains. Now, with the market back close to the levels of the beginning of the year, they're trying again. Bears don't care too much that Draghi surprised positively (he used everything he had available, they wickedly say, and now he has nothing left) nor that there is no recession. What matters to them is the asymmetry between upside and downside potential. If all goes well, as Gundlach said, the upside will be small, if everything goes wrong, the downside will be much bigger. Furthermore, if all goes well, the Fed will raise rates.
Add to this the fact that policy makers don't want bubbles this time and the game is done. Two or three raids downwards during 2016, starting from 2000 of SP 500 and covering up to 1700-1800, and the year will have done well. Generally speaking the bearish argument seems robust to us, but it has two weaknesses. The first is the underestimation of policy makers' ability and willingness to react to excessive weakening of the markets. Kuroda in February and Draghi are now there to demonstrate it, not to mention the Chinese response, which is stronger and more organic than in August. The Fed, for its part, will not raise rates if markets are too unwilling.
The second weakness is the macro framework. Draghi has insisted a lot on the fact that the European economy is experiencing a recovery phase, certainly not spectacular, but solid nonetheless. Fiscal policy is now moderately expansive, monetary policy is ultra-expansive, the exchange rate is fine. It's good to the point that the ECB no longer wants growth driven by external markets but intends to rely on the internal market, without stealing growth from others with a further devaluation. The United States, for their part, are, as we have seen, accelerating and unemployment benefits, which have fallen to their lowest since 2009, have confirmed the structural strength of the American economy in recent hours.
As long as the macro data remain at these levels, the bears will find it difficult to push the stock markets back to lows. Certain, the referendum on Brexit is on the horizon, but it is still too early to embark on a campaign of fear. Nor should we exclude the possibility that the negativity, so widespread in the markets even in the upswings, will eventually produce portfolios so free of risk as to be exposed to the possibility of upward overshooting, perhaps at the end of the year, once it has been verified that we are all still alive. With oil holding up and macro data good, the wave of realizations won't be too long-lived.
However, any return of SP 2.000 above 500 will be very nervous and will need continuous confirmation from the macro and earnings sides. For this, more than a return to the bear market or a continuation of the rise of the last few weeks, we see a war of nerves between timid bulls and aggressive bears likely in the near future.
