The global stock market recovery is credited to dovish ECB

Outlook:

The global stock market recovery is credited to the dovish ECB, to the seeming end of the oil price drop (at least for the moment) and the absence of any additional bad news out of China.

To call the ECB dovish is to understate Mr. Draghi’s resolve. Let there be no doubt—this guy is in charge and visibly capable. We enjoy watching the Draghi press conferences, carried in full on Bloom-berg TV—especially in contrast to the Fed press conferences. Draghi’s manner is natural and he speaks at a normal pace. He doesn’t talk down or evade straight answers. He’s friendly and tells reporters when they have asked an astute question. Watching Fed chief Yellen is much harder. She is clearly worried to an extreme extent about being misunderstood. In return, the press at the Yellen events is combative, even hostile, whereas the European press engages with Draghi on a friendly, good-faith basis. Besides, Draghi has that charming accent. Yellen could use some voice lessons.

In addition to the assertion that the ECB has plenty of tools and will use them if needed, Draghi made some other remarks worth tucking away in the back of your mind. First, European financial institutions are in pretty good shape and display none of the distress we saw ahead of the last crisis, i.e., 2008-09. Secondly, China has a history of responsible management and Draghi sees that continuing. It’s rare to have a central bank chief praise any government. Third, the ECB is not just dismissing oil prices as a temporary, short-lived event. Oil prices have secondary effects all through the economy. Oil is down 40% just since the last ECB meeting in Dec and must be heeded.

Also, the notional exchange rate is not a central bank policy target. The ECB looks at the exchange rate on a trade-weighted basis. Yeah, sure.

Finally, today at Davos Draghi went out of his way to praise the Fed’s management of the first rate hike, saying it was “flawlessly executed.” It’s as rare as hen’s teeth for one central bank chief to praise anoth-er central bank. We can’t remember another instance. The implication is that a properly managed central bank can make a giant change without markets running off the rails. Are you listening, PBOC?

As for China, Draghi is right that China has a history of “responsible” management. From the West it looks like they don’t always know what they are doing—witness the now-removed too-small stock mar-ket circuit breakers—but we should not be freaking out over the Chinese system going down the tubes. It’s not.

Having said that, there are some serious faultlines that can still deliver explosive outcomes that scare everyone all over again. Reuters reports one—investors, including mutual funds, replacing equities with private placements of high-yield private debt, i.e, junk. “Newly announced private placements - high-yielding bonds sold directly to institutional investors in one-to-one deals - were more than 60 billion yu-an ($9.12 billion) in November on the Shanghai exchange alone, more than the total new corporate debt issued in both Shanghai and Shenzhen as recently as April. Shanghai-listed placements were up 450 percent on the year in October and November, and accounted for a third of all bond listings.”

Many are ultra-risky because in the declining energy and heavy industry sectors. “Of 58 private place-ments listed in Shanghai in November, a full 48 were real estate, energy, steel or local government con-struction and investment firms - all indebted sectors partly locked out of public lending markets and key clients of the murky shadow banking system.” The new junk yields 6-9% but nobody really knows how it should be priced because the deals are one-to-one—no “market scrutiny.”

So, this one is easy to fix—in a system prone to cronyism and corruption, ban private placements not priced independently. Now go invent an honest ratings agency.

And finally, oil. Nothing has changed in the fundamentals, meaning we have no reason to believe the bottom is in. That means yesterday’s action is just a short-squeeze and we should probably assume the downmove will resume after a correction. The Saudis are still in denial. The Aramco chairman told the WEF in Davos that oil under $30 is “irrational” and prices will recover this year. An excessive drop, maybe, but hardly “irrational.” Meanwhile, Moody’s joined the oil-lower forecaster club with the new forecast of $33 this year for both Brent and WTI.

No one can say whether it’s time to go bottom-fishing. The FT reports “Funds invested in US stocks counted $4.2bn of withdrawals in the week to January 20, equating to the largest three-week period of outflows since April, according to data from EPFR. The redemptions take outflows since the year began to nearly $29bn and those over the past seven weeks to more than $42bn. Global exchange traded funds that track equities have seen more than $7.77bn in outflows so far this year while bond ETFs have seen inflows of $8.46bn, according to data tracked by Markit.”

In addition, “Junk bond funds in the US were struck by another wave of withdrawals, with redemptions reaching $3.4bn. Even the haven of US money market funds, to which many investors turn as a proxy for cash, were hit with roughly $11bn of outflows.”

So, where is the money going? “… investors piled into mutual funds and exchange traded funds that buy US government paper. Treasury funds counted $2.5bn of inflows in the past week — their greatest weekly influx in nearly 10 months — as municipal funds reported $530m of new money, data from Lip-per showed.”

You’re right—the numbers don’t line up. US equities had $4.2 billion outflow while Treasuries and mu-ni funds had $3.03 billion in inflows. The Markit numbers don’t match, either, albeit in the opposite di-rection, more inflows to bonds than outflows from equities in the ETF world.

Finally, we are starting to hear that the Fed is not closing its hand and leaving the table for the rest of the year, after all. This is not 2008-09. Oil and equity declines are not the equivalent of financial institution failures. Granted, there is an equity market drop that would stay the Fed’s hand in March, but we are not getting it—yet. The Fed has another two months to judge outcomes. The January meeting was never go-ing to deliver a hike, anyway.

The Fed will have a credibility problem if it delivers just “one and done.” It wants to do at least one more this year, if not the full four announced. Deferring another hike in March will be bad enough, if the new economic projections call for delay, but the Fed needs to keep up the story that the trajectory is up-ward. If not March, then June. Wells Fargo is one outfit that agrees, seeing Fed funds at 1.25% this year and 2.25% in 2017, according to Market News. "Central bankers take a longer view than we denizens of the markets. Monetary policy still works with a lag, and that lag is much longer than one month."

This is a useful observation. We are all overly short-term oriented and altogether too prone to pro-ject current sentiment onto the Fed several months out. Now if only we could get Yellen to stand up on her hind legs and speak as forcefully and convincingly as the noble Draghi.

As noted above, we expect the euro to continue downward and make a second break of the 62% retrace-ment line and thus a test of the Jan 5 low at 1.0708. If not today, then next week.

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