The Russell 2000 briefly turned negative on the year last Friday before closing positive. It is up 0.05% year-to-date.
Make no mistake, fundamental investors are watching small caps closely.
As a reminder, they are the only liquid and somewhat correlated hedge for high yield, emerging market and private equity investors in the case of war.
The iShares Russell 2000 ETF (IWM) closed below the 200-DMAVG last week for the first time since June 2016.
The iShares Russell 2000 ETF (IWM) relative to the SPDR S&P 500 ETF Trust (IWM/SPY ratio) is close to breaking below the November 2016 level when small caps began their outperformance following the surprise election of Donald Trump.
We would note that high yield, as measured by the HYG ETF, is already down 2% off its recent high with Treasury yields having fallen during the process. Typically, a move of that magnitude correlates to a ~4% selloff in the S&P 500.
Why do we highlight the yen and US high yield?
Because there are some that believe that a stronger yen and weaker high yield asset class portends to a weaker emerging market environment – this year’s best performing theme.
After all, the memory of this statistic is not forgotten easily:
Since 1990, every year, emerging market equities have seen at least a 10% equity correction and 60 basis point credit spread widening.
Despite the euro (EUR/USD) hitting a new high (i.e. 1.1868) earlier this morning, the key theme over the last 24 hours from non-investors is caution.
Please note the fundamental juncture, or divergence between the European currency and bond market. European government bond yields have widened relative to US Treasuries over the last two weeks, retracing 38.2% of the tightening from June. However, the EUR/USD has continued to appreciate, which is an anomaly. Historically, there has been an extreme correlation between 2-year and 5-year nominal and real rate spreads and EUR/USD’s value.
Additionally, two noted technical analysts have also become bearish on the Euro due to its apparent frothiness.
Lastly, it is worth noting that the closer we get to 1.195-1.205, it is not unreasonable to believe that European Central Bank President, Mario Draghi, will then send out a Governor to jawbone the currency lower.
The Eurozone unemployment and core inflation data was better than expected today. The retail sales data was better than expected in Germany. The unemployment data was better than expected in Italy.
There is little reason not to expect that the PMI data tomorrow, always released on the first day of a new month, will not be in-line or stronger than expected.
Conversely, this week’s upcoming US data releases (Tuesday: June PCE, manufacturing ISM, Thursday: services ISM, Friday: NFP) are unlikely to change the consensus view on the path of Federal Reserve Policy (i.e. balance sheet announcement in September/October and an interest rate hike in December).
If, anything, following last week’s misses on GDP, the mindset is that the risk is a miss relative to expectations in some of the US data this week, and all of this is pushed out to 2018.
If you were long on the euro, here is what we would be concerned about.
Foreign exchange professionals are now tracking equity flows closely. Usually, it is the other way around – that is, equity investors becoming a transient expert in another asset class. This is important to recognize because foreign equity investors are now a HEADWIND to a higher euro exchange rate if they begin selling their exposure. As a reminder, there have been inflows into European equity strategies (which are long Euros) for 27 consecutive weeks.
Over the past few years, many foreign investor purchases of European equities have been made on a currency-hedged basis, to remove any risk of a change in the FX rate. For example, a foreign investor would buy a European stock in local currency and then sell an equal amount of the same.
From an FX perspective, when a US-based investor went into European equities, they effectively bought EUR/USD when they purchased the stock (i.e. they “sold” US dollar cash to buy Euros in a stock), and then hedged their purchase by selling an equal amount of EUR/USD in the spot market.
At this juncture, EUR longs should be more nervous that the DAX and Eurostoxx drop ~3% down to their respective 200-DMA's, and breaks through it, which would say that the market does not think the underlying economic strength warrants an overshoot in the currency to hurt exporter-based company’s earnings.
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