Weekly Pulse: What happened? Last week’s markets explained

While last week had five days to it, investors will only remember what happened during the second half of the week as a number of different markets came under considerable selling pressure.

One of the main drivers of the weakness was the market’s response to the Federal Open Market Committee meeting on Wednesday and its statement. While the Federal Reserve enacted “Operation Twist” to try and flatten the yield curve, the committee also noted that there was significant downside risk to the U.S. economic outlook.

While Fed statements are not usually leading indicators and while investors should not have been surprised to hear that economic growth was under pressure, the market used this opportunity to sell and liquidate positions resulting in a material sell off for global equities, commodities and some currencies such as the loonie.

Compounding problems this week was the ongoing European debt saga. Once again we heard that Greece would default and once again we heard the Greeks deny that was going to happen. The International Monetary Fund didn’t help sentiment much by downgrading their outlook for the global economy and for many individual economies as well. Even the Chinese contributed to the selling pressure as manufacturing statistics from China showed that economic activity remained somewhat subdued.

This data only provided more incentive for many investors to sell down resource stocks which certainly didn’t help the TSX Index in Toronto. For commodity prices, supply fundamentals were thrown out the window this week as macro driven demand was all that investors seemed to really care about. By the end of the week we saw oil prices dip below US$80.00 again, base metal prices were under pressure and gold prices fell materially by approximately US$150 an ounce.

Another factor behind commodity weakness was the surge in the U.S. dollar as investors sought liquid markets. The Canadian dollar was a victim of this trade as the loonie fell over three cents by the time the week was over and now finds itself below parity for the first time since January.

The trading week ahead

After a week like the one we’ve just witnessed, it’s very difficult to gauge where investor sentiment will lie come Monday. But what is obvious is that the bigger macro and financial problems facing the market will still likely be the main drivers behind equity, commodity and currency price performance in the week ahead.

We expect meetings amongst European and G20 finance officials will continue and hopefully we’ll see some progress towards a global response to what is truly a global economic and financial problem.

When we look at the economics calendar we will see a number of releases out of the United States. However, most will likely tell the same story we’ve heard for a while now – that the U.S. economy is struggling, housing market is poor, and economic growth is hard to come by. We will also see more manufacturing data out of China which will either reinforce the growth concerns raised this week or ease some of those concerns if next week’s data shows that the economic situation in China is not as bad as once thought.

Commodity prices will continue to face macroeconomic headwinds as outlooks are not expected to change for the better. While we may see some short term bounces in the next five trading days, it will be difficult for oil and base metal prices to rebound materially on a sustainable basis. We would not be surprised if we saw investors turn back to precious metals next week as the reasons for owning gold in particular have not changed. However, gold prices will be hard pressed to regain all of the US$150 per ounce lost since Monday.

If commodity prices remain stuck at lower levels then we also expect to see the Canadian dollar remain under pressure. However, it is conceivable for the loonie to regain some lost ground if currency traders focus back on Canada’s stronger fiscal fundamentals.

Question of the week

What happened to gold? I thought gold was supposed to stay high when the markets fall?

Gold did not have a great week, then again not many equities, commodities or currencies posted anything close to a positive return. But why did we see gold fall approximately US$150 an ounce this week and US$250 per ounce since the beginning of September? Shouldn’t gold have acted like a hedge against a market downturn? While such an assumption is fair to make, we saw three factors influence the selling of gold, especially on Thursday. First, Thursday’s market action was a session of capitulation where many investors simply wanted out of the market and wanted to sell into cash. We have seen capitulations like this in the past where the first reaction is to sell and then think later. Usually we see some kind of rebound from these capitulations in order to soften initial losses.

Second, and likely the most influential driver of gold price weakness, was the need for investors to liquidate some of their gold positions to raise cash or meet margin calls. Here, investors are not selling gold because they don’t like it, they’re selling it because they have to.

Third, we saw investors use the U.S. dollar as the first “safe haven” to turn to whereas gold has normally been that safe haven at other times during the year. With the U.S. dollar increasing in value, gold prices and other commodity prices fell. We witnessed the exact same thing happen in 2008 when the U.S. financial system started to collapse. It was fair for investors back then to assume gold would benefit as the outlook for the U.S. dollar was very poor. However, investors still looked to the U.S. dollar for safety as the U.S. capital markets still have the greatest depth and liquidity of any market in the world. When liquidity starts to tighten, suddenly we find investors putting their money in investments and currencies that they can get in and out of very quickly.

So does this mean that gold prices are going to continue to fall? In the short term anything is possible; however, we don’t think the fundamentals that have been driving gold prices higher have changed at all. Therefore, we believe that gold prices will have another opportunity to move higher again in the future. The global economy is slowing down, the debt situation in Europe will take years to resolve, and the U.S. can’t get its act together on job creation or reducing the deficit; therefore, there are still many reasons why investors should stick with their precious metal holdings during these difficult times.

Gareth Watson is the Vice President, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends.

Gareth Watson