By Ashraf Laidi
As global equity indices decline 3-4% from their highs, questions emerge on the length and duration of the next pullback. Both the FTSE-100 and the Dax-30 staged a 13% rally into late January from their lows of late November. The Dow-30 rose by the same amount but started its rally two weeks earlier than its German and UK counterparts. It also sustained a 3% decline in the second half of December.
European equities are facing their first event-driven decline since the November declines, which were in sympathy of the US sell-off following president Obama’s victory and the ensuing implications for capital and income taxes. Once UK and continental European bourses rallied on the hammering of a Greek debt swap deal, US equities were left behind to worry about the cliff-on-cliff-off fears ahead of the December 31 deadline on avoiding the fiscal cliff. Meanwhile, European and Asian indices went on to chart +30% gains for the year.
Three months later, as we approach the four-year anniversary the multi-year bottom in global equities, the risk climate is no longer free. Two major event risks loom large into the horizon: the threat of Italy’s elections disrupting the nation’s path to economic reforms; and the possible “sequestration” of $85bn in US government spending cuts if no deal is reached by March 1st.
The consequences for each are grave. In the event that Monti’s centre left-Democrat coalition fails to win and Berlusconi’s rightist coalition takes on power and blocks reforms, Italian bond yields will regain the 5.00% level, reigniting speculation of Italy demanding the Outright Market Transactions from the ECB. Yields on 10-year Italian bonds have already hit a three-month high at 4.9%. The consequences are enormous for yields of the €1.98 trillion bond market to revisit their 6% levels.
In the case of the US, markets are already pricing another last minute solution between Democrats and Republican to avoid $85bn of automatic cuts. The Federal Reserve is keeping an eye, and as Chairman Bernanke indicated today, QE3 shall remain as long as unemployment is not reduced. The combination of continued Fed easing, renewed asset purchases from the Bank of England and the Japanese government’s appointment of the pro-reflation Kuroda, global equities are unlikely to sustain declines of more than 5% from current levels.
The Dow Jones Industrials Index is currently supported by the November trendline, coinciding with the previous resistance (now support) around 13,580. We expect renewed buying at those levels for a fresh revisit of 14,000, followed by 14,550s.
The FTSE-100’s is 50-60 pts above its own November trendline support, may give way to prolonged selling towards 6,080s. The index had consistently lagged behind its European and US counterparts through last year until catching up in late Q4. Just when it caught up with its peers, the FTSE shall require a fresh boost from the BoE to combat speculation of a triple dip recession and the threat of more austerity around the March Budget Statement.
DAX-30 nears the triple confluence of November trendline support, the base of the past four weeks and the intermediate high from September at 7,480s. In order for the DAX to lose footing below 7,300s, we have to see an Italy election impasse drag into late Q2 at the expense of further bailouts from Berlin, Frankfurt and Brussels. Markets will also watch Germany’s PMI indices (manufacturing and services) for a continuation of home-driven domestic demand overcoming concerns of a drag from the periphery. A break below 7,250 risks accelerating losses towards the 55-WMA of 7,050.
Ashraf Laidi is Chief Global Strategist at Leading Spread Betting Company - City Index