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By Swissquote Analysts
Themes Trading

Rising potential for a second wave sell-off in equities and the weak USD

By Ipek Ozkardeskaya
Published on

In a record-breaking rally, the US stocks have fully recovered from the Covid-19 sell-off at the beginning of this week. Despite the real damage to economic and company fundamentals, the unprecedented monetary and fiscal support led to a V-shape correction, rising many eyebrows.

While more than 20 million Americans lost their jobs, the corporate debt rose to distressed levels and the US economy is expected to have contracted by more than 30% in the second quarter, many wonder whether the strength of the latest equity rally is justified.

The rising prospects of a second wave of contagion add to the signs of fatigue in the market.

Especially from a valuation perspective, we have been seeing a worrying divergence between the asset prices and the underlying fundamentals since at least half a decade. So, this is nothing new. The massive monetary support is undoubtedly what provokes and maintains this deviation, and equity investors know that cheap liquidity is good for the medium and long-run, although the price-fair value divergence magnifies the severity of downside corrections in times of global sell-offs.

In the short run, there is one serious downside threat to the actual recovery in US equity markets. And it is not the uncoupled price-valuation dynamics, the distressed level of company debt, nor the 50% rise since the March dip, but a second wave of Covid-19 contagion which could lead to another period of confinement and economic shutdown.

In this respect, the latest news is not promising in the US. The recent rise in new Covid-19 cases in Florida and Texas hint that the second-wave scenario may be more than just an underpriced tail risk.

The fear of a renewed jump in new cases and the overstretched nature of the latest equity rally pulled the S&P500 to 3000 mark on Thursday and indicate that a deeper downside correction could be around the corner.

If investors start jumpshipping, then the global stock markets would be hit by another wave of a severe sell-off. This time, however, the dip could be limited as those who regret being too skeptical regarding the Federal Reserve’s (Fed) capacity to resuscitate the market would probably take a second chance to join the market at a dip without too much hesitation. The irrefutable fact is losers of the latest bullish run were those who have been too doubtful to jump on the back of a bull.

Technically, a move below the 3000 level, which shelters the minor 23.6% Fibonacci retracement on March – June rebound and the 200-day moving average, should pave the way toward the key technical support to the actual positive trend: 2830, the major 38.2% retracement, where we expect to see a temporary dip and a rebound. If the latter support is broken, the S&P500 would then step into a medium-term bearish trend.

The Fed-parachute

Despite the best jobs report in history, the Federal Reserve (Fed) maintained a cold-headed approach to the economy in its latest monetary policy announcement. The FOMC’s Summary of Economic Projections showed high unemployment, low inflation and the commitment to near-zero rates and massive bond purchases at least through 2022.

The Fed Chair Jerome Powell said on Wednesday that the committee is ‘not even thinking about thinking about raising rates’ and probably even less about scaling back its asset purchases. So, the Fed will continue buying $80 billion worth of US treasuries and $40 billion worth of mortgage-backed securities per month.

As a result, the Fed will continue to be the ultimate parachute to a renewed market rout and the extended period of cheap liquidity will inevitably boost asset prices, even if we see a temporary rout in equity prices due to a mix of second-wave fear and tactical correction.

The US dollar

The US dollar has been a major winner of the Covid-19 sell-off. The greenback has been the safest safe-haven asset during the free-fall in global risk markets at the beginning of the year. Investors who liquidated their positions in equities, bonds, funds, and other holdings piled into US dollars during one of the most impressive market routs of modern times. The US dollar appreciated 7% in inflation-adjusted, trade-weighted terms between January and April according to Bank of International Settlements data.

So, it is no surprise if the reversal in global risk appetite and a mass return to risky assets hit the greenback over the past couple of weeks. But the greenback’s longest losing streak since 2006 is about to be over for two reasons.

One, signs of an imminent downside correction in global equities should give some support to the US dollar. Inflows may remain softer compared to what we have seen at the heart of the Covid-19 sell-off, as not all investors may seek refuge in US dollar as they liquidate their risky positions. In fact, we expect to see a certain diversification among risk-haven assets. Thus, a part of the safe-haven flows could be channeled towards gold, yen and Swiss franc. But the US dollar will inevitably gather a part of the safe-haven traffic.

Second, the weak US dollar should have an extra positive impact on demand for USD and USD-denominated assets led by treasuries, and throw a floor under the recent USD decline.