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Market sentiment flips! Are headwinds building for risk assets?
Lucia Han
2021-07-22 693

Abstract: The volatility index (VIX) was soaring! Risk aversion was spreading in global markets as the Delta variant continued to worsen in parts of the world. Strong demand for U.S. debt sent long-term Treasury yields to their lowest level since February, whilst global stock markets and most commodities tumbled. However, ultra loose monetary policies and rapid economic expansion in large countries would boost risk assets in the long run. So what are the investment opportunities during the current uncertain market conditions?

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Most of the risk assets were sold off as the spread of the Delta variant sparked fears of a slowdown in the economic recovery. Stock markets in Europe and the US, which had repeatedly recorded new highs, were especially hit hard by the panic selling. The STOXX Europe 50 plunged by 5.7% from its record high in mid-June, while the S&P 500 fell by 3.7% to 4,233.13 from its recent all-time high of 4,393.68. What's more, commodities including crude oil have been battered by a stronger dollar. As a result, U.S. crude and Brent crude both fell below $70 a barrel, their worst performances since late May. In addition, demand for Treasurys surged amid pressure on risk assets, and the yield on the 10-year Treasury note briefly slipped below 1.2%, its lowest level in nearly five months. Many in the market believed that the current panic caused by the virus was likely to be short-lived, and the economic recovery would continue in an orderly manner on back of gradually rising vaccination rates. Still, the sudden shift in investment winds suggested that financial markets, now gripped by the panic, were bracing for more volatility. So how should investors respond to the volatile market? What trading opportunities should investors look out for?

Would the U.S. stocks climb higher after a retreat?

The previous surge in inflation led to concerns that U.S. stocks were overvalued. But U.S. stocks have been buoyed by news that second-quarter earnings were about to be announced, investors forecast more upbeat earnings numbers, and the Federal Reserve (Fed) changed to a dovish tone, reaffirming that inflation is transitory and the prospects for economic recovery remain uncertain. Still, there were two big concerns for the market:

1. Inflation may not be temporary. Market sources said that the inflation was previously expected to last 1-3 months, but the latest expectations have been upgraded to 6-9 months, some even as long as 1-2 years. According to Bloomberg, earnings conference calls tracking companies in the S&P 500 index this month showed 87% of the companies mentioned "inflation," up from 33% a year ago. Thus, corporate and investor concerns about inflation would undoubtedly weigh on U.S. stocks.

2. As the U.S. stock market was rising, the technical panic it was facing gradually intensified. Since mid-June, the S&P 500 has been climbing and breaking record highs, as shown below:


Source from: Mitrade

The S&P 500 had been climbing for nearly a month. But a long period of high-level U.S. stocks only added to the technical panic. That, coupled with the continued deterioration of the virus and inflation fears, ultimately pushed the S&P 500 below its 20-day and 50-day moving averages. However, the U.S. economic recovery went ahead of other economies and the government's stimulus measures showed no signs of scaling back, so U.S. stocks could continue to notch new highs. But if the panic persists in the near term and institutional investors move aggressively out of the market and into fixed income assets, the S&P 500 may face more downward pressures.

European stocks fell after a rally, but there was still potential for gains

The STOXX Europe 50, which measures the performance of the Eurozone's top 50 blue-chip stocks, had hit new highs. On the one hand, European stocks were pushed higher as inflation fears swept through the market, sending investors back to value stocks. On the other hand, continued quantitative easing (QE) by the European Central Bank (ECB) and a stronger than expected recovery in the European economy have encouraged investors to jump into European stocks. Many in the market saw more optimism ahead for European stocks, thanks to the improved pandemic situation, which shifted economic growth from China to the U.S. and is now shifting to the Eurozone. The inflation rate was creeping up in the region as well, but higher inflation could help reverse its long period of low inflation rate. As a result, the ECB may be more resistant to higher inflation than the Fed and its long-term accommodative macro conditions would facilitate European markets.

Does the collapse in oil prices mean a bargain-hunting opportunity?

OPEC and its allies recently ended a two-week standoff with a deal to increase production. The deal allows the allies to boost production by 400,000 b/d from August until the remaining 5.8 million b/d supply cuts are unwound. But the main reason for the plunge in oil prices was not just concern about rising supplies. More importantly, risk aversion intensified as the spread of the Delta variant shook confidence in the global economic recovery. Therefore, investors were starting to assess the impact of increased supply and reduced demand from the virus, and fears of supply and demand imbalance contributed to the plunge. U.S. crude and Brent crude fell to $65.6 a barrel and $67.88 a barrel, respectively, down 14.8% and 11.7% from the month's highs, as shown below:


Source from: Mitrade

From a technical perspective, Brent crude remained below the key support level of the 100-day moving average, and if the panic persists and oil bears dominate the market, estimates put the important support level at around $65 a barrel. Otherwise, investors should watch for the $73.5-a-barrel resistance if the weakness in crude oil is reversed. Separately, Goldman Sachs reiterated its previously expectation that Brent crude would rise modestly to $80 a barrel during the summer because it believed the OPEC meeting remained focused on maintaining tight spot markets and guiding future production increases. However, crude prices have risen so much over the past few months that short-term oil market turmoil may be inevitable.

To sum up, the increase of vaccination rates will it impossible for the Delta variant to prevent a global economic recovery. But the virus will fuel risk aversion and weigh on markets for risk assets such as stocks and commodities, which have been at high levels for a long time. Thus, the opportunities for short-term volatility are worth paying attention.


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