Risk Off Resurfaces

Volatility made a big comeback this week as the S&P500 index saw its first weekly loss in two months and the crude meltdown showed no signs of letting up. After two solid months of declining oil prices, the more than 10% drop in WTI futures this week, from $65 to below $58/barrel, finally triggered some significant risk-off behavior over deflation concerns. Most market watchers continue to tout the economic benefits of lower oil prices, but the speed of the decline has become unsettling. The jittery market largely ignored more strong US economic data, including excellent November retail sales and a 7-year high in the University of Michigan confidence reading, and gave more weight to ugly European industrial production and CPI data. In China, the November CPI and PPI inflation readings were concerning, with CPI hitting a five-year low, while additional economic and political reports cemented the expectation that China will reduce its official growth target for 2015. The DJIA had its worst week since late 2011, dropping 3.7%, while the S&P500 fell 3.5% and the Nasdaq lost 2.7%.

US Treasury yields have seen a notable contraction this week. On Friday, the 30-year UST ended around 2.74%, the lowest weekly close since the end of 2012. The yield on the 10-year UST fell as low as 2.09% (Recall that during the height of the Ebola angst in mid-October, the 10-year and 30-year yields briefly dipped as low as 1.86% and 2.67%, respectively). Spreads have narrowed as short-dated yields climbed in preparation for Fed tightening, further flattening out the yield curve.

The oil shock is rippling throughout global markets. Investors pulled nearly $1.9 billion from high-yield debt funds this week as lower oil prices exacerbated fears that smaller oil names could run into financing trouble. Energy debt currently accounts for around 16% of the US junk bond market. Russia continues to suffer from the oil swoon - the ruble lost another 10% against the dollar this week and not even another rate hike by the Russian Central Bank (the one-week auction rate was raised 11 bps to 10.5%) was able to arrest the slide. Meanwhile, major airlines should end up as a major beneficiary of lower oil prices. Industry group IATA forecasted 2015 airline industry profits of $25B v $19.9B y/y thanks to lower oil prices and higher worldwide GDP growth.

In Europe, deflation is looming. Core inflation rates, excluding the downward pressure of slumping energy prices, has gone negative in some euro zone peripheral nations. In the largest euro economies, France's headline November m/m CPI was -0.2% while Germany was at 0.0%. The data intensifies pressure on the ECB to launch its planned sovereign QE program as soon as possible, especially after this week's disappointing second TLTRO allotment, in which banks took only €130B, less than half the available credit on offer. The euro recovered from last week's 28-month lows, rising to 1.2500 from lows around 1.2250.

Comments from banking executives this week put some shade on the outlook for big US banks. At an investor conference, Bank of America's CEO warned that Q4 sales and trading revenue would be lower y/y and q/q. At the same conference, Citigroup's CEO warned that the bank would take a $3.5B charge in Q4 for legal investigations and would be marginally profitable after the charge. In addition, the Fed proposed a larger capital surcharge on the eight largest SIFI banks, and called out JP Morgan as the only large bank that might need to boost capital (by as much as $22B) to satisfy new capital rules.

On the merger front, Merck said it would buy Cubist Pharmaceuticals for $9.5 billion including debt, expanding its footprint in the market for drugs that target antibiotic resistant superbugs. The all-cash deal is valued around $102 per share, a 35% premium. Merck got a rude surprise just hours after announcing the deal: a US court curtailed all but one of the patents covering Cubist's top seller, Cubicin, which delivered most of the $1 billion in 2015 revenue Merck expected from the acquisition. Generics could launch as soon as mid-2016.

Japan Q3 final GDP confirmed a technical recession with a 2nd consecutive quarter of negative growth. Despite expectations of a shallower contraction via an upward revision in the CapEx component, corporate spending actually fell by a steeper 0.4% margin than the 0.2% initially reported. Since the release of the GDP report, questions over the efficacy of Abenomics policies have become more prevalent going into this Sunday's parliamentary elections, even though the initial polls suggest the opposition remains too disorganized to muster a successful government challenge. Meanwhile, general risk-off market sentiment and more vocal public opposition to excessive Yen weakness has sent USD/JPY lower on a weekly basis for the first time in 8 weeks, with the pair falling over 3 big figures, below ¥119.

A broad range of November data out of China continued to point to a gradual slowdown coupled with policymakers' attempts to manage the soft landing and also acknowledge the changing nature of the economy. The headline trade surplus topped expectations, but imports fell for the first time in 3 months amid lower shipments of hard commodities and exports were also below expectations. The further decline in oil prices has also helped to bring CPI down to a 5-year low of 1.4% - below consensus. Industrial output fell to a 3-month low and also its 2nd worst level in 5 years, while fixed asset investment hit a 13-year low and property investment a 5 1/2 year low. Only November lending figures were notably better than expected at CNY852.7B vs CNY655B consensus amid speculation that policymakers are endorsing a higher lending ceiling of CNY10T in 2014, up from CNY8.9T in 2013. On Friday, a Chinese press report citing cabinet sources indicated the concluded Economic Work Council meeting will recommend lowering the official 2015 GDP target from the 7.5% rate in 2014 for the first time in 3 years.