Originally posted at Briefing.com
It's August in the Northern Hemisphere, which means things are hot — or at least hotter than they are the rest of the year. It's only fitting then that things have heated up in the capital markets on some burning issues.
The Burn Unit
According to the National Institutes of Health, there are three levels of burns: first degree, second degree, and third degree.
First degree burns affect only the outer layer of skin. Second degree burns affect both the outer and underlying layer of skin. Third degree burns affect the deep layers of the skin. Using this grading system, we'll now assess where things stand in the capital markets as summer draws to a close.
Stocks: first degree burn
Nothing major, but definitely some pain and redness in recent weeks as premium valuations have been called into question amid lackluster earnings guidance, soft economic data around the globe, and the Federal Reserve posturing about raising the fed funds rate soon.
High Yield Bonds: first degree burn
Credit spreads have widened as participants have fretted over commodity producers' ability to repay their debts on time. The burn here has started to hurt with spreads widening 117 basis points in the past month and 63 basis points in the past week alone as oil prices flirt with .00 per barrel versus 7.00 per barrel in June 2014.
Even so, the current spread of 572 basis points is not far out of line with the 20-year historical average, which is why it can still be viewed as a first degree burn overall.
Currencies: second degree burn
The U.S. dollar has been singed recently by chatter that the Federal Reserve might not raise the fed funds rate at its September meeting. That chatter has been borne out of several factors, none more prominent of late than China's devaluation of the yuan. The latter has been construed as a competitive devaluation given its timing (i.e., right after a report showing exports declined 8.3% in July).
Furthermore, it has stoked concerns about potential currency wars and the specter of disinflation/deflation being exported across the globe. Given that, it can be said that China's move, which has weighed heavily on regional currencies, has affected both the outer and underlying layer of skin for global currencies.
Commodities: third degree burn
Excess supply, weak demand, and/or the stronger dollar have all burned commodities very badly regardless of their orientation. Energy, metals, food and materials, grains, and livestock are all pretty much down on the year.
There are a few exceptions, like New York Harbour RBOB Gasoline (+14%) and cotton (+10%), yet double-digit percentage declines are a more common sight.
Oil, copper, and lumber, which have primary leading indicator status, are down 20%, 17%, and 23%, respectively, year-to-date. Those losses are the equivalent of full thickness burns.
Treasuries: No burn
There were a few sizzling moments early in the summer, but as stocks, currencies, and commodities have burned, Treasuries have been thought of as providing fireproof protection.
The yield on the 10-yr note, which flirted with 2.50% in June, backed down to 2.13% recently, which is where it stood right after Memorial Day. The 2-yr note yield, which has gyrated at times on rate hike concerns, also revisited Memorial Day levels (0.66%) recently before it bumped up to where it started the year.
Burn, Baby, Burn
Stocks, high yield bonds, currencies, and commodities are burning right now to a different degree. The biggest mess is the conflagration in the commodity space, which is throwing off a lot of heat that is melting expectations for earnings, economic growth, sector returns, and investor confidence.
Commodities should be poised for a nice bounce if the dollar starts to melt. As of now, they continue to melt down in a broad-based fashion that suggests to us it's more about demand than supply. In that vein, the stocks of transportation companies, whether they operate by land, by sea, or by air, or whether by international or domestic channels, have broken down this year in baffling fashion at the same time fuel prices have collapsed and as the U.S. economy's growth potential has been talked up.
[See: Commodity Weakness Persists]
Elsewhere, China lit a match in the past week when it devalued the yuan and burned down a number of East Asian currencies. China naturally downplayed the notion of doing so to drive its exports, but that's exactly what it will help do, if only on the margin (did you really expect officials to say, "Yep, we did it for our own selfish reasons, so deal with it"?).
China played the devaluation card beautifully if you ask us, hiding behind the smoke screen of working toward a more market-driven approach to valuing the currency, which it knows should improve its chances next year of being included in the International Monetary Fund's basket of reserve assets known as special drawing rights.
Effectively, then, China created the impression at an opportune time of taking a high, reform-minded road while sneakily placing its exporters on a separate path paved to increase their competitive advantage.
We point this out as one example of a brush fire that seems likely to keep burning as the impact of that particular move, and the breakdown of many foreign currencies before the move, spreads through global trade channels in coming months.
What It All Means
With September around the corner, early hints of fall will arrive as NFL teams kick off their seasons and Major League baseball teams make a final pitch to qualify to play in October. Things are apt to stay hot in the capital markets, though, knowing that the September 16-17 FOMC meeting dissects the month.
The Federal Reserve's policy of holding rates near the zero bound has made the capital markets' world go around since 2009. Heads have spun this year in particular on the question of when the FOMC will raise the fed funds rate for the first time since June 2006. The September meeting has been seen as a potential launching point, yet it has remained quite the guessing game, which is why the capital markets have been acting like a cat on a hot tin roof all year.
[You may also like: Jobs Data Strong Enough for Fed Hike]
September, incidentally, has been the worst-performing month for the Dow and S&P 500 since 1950 with average declines of 0.8% and 0.5%, respectively, according to the Stock Trader's Almanac. It has also been the worst-performing month for the Nasdaq since 1971 with an average decline of 0.5%. Average is the operative word there, because it implies September isn't always a down month, only that the losses in the years it has gone down have exceeded the gains in the years it has gone up.
This September will be a month to remember because of the FOMC decision and perhaps for other reasons too. There is no specific telling for the capital markets, which have experienced brush fires all year that have clearly burned hotter in some spots than others and have yet to be extinguished.
Burn units are now on standby waiting to see if the Federal Reserve pours fuel on the fire.
