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In recent days stocks in both the developed and emerging markets have come off hard on the back of:
1. Geopolitical: Middle East political uprisings fuelling investor uncertainty and weighing on risky assets like stocks.
2. Growth: Rising oil prices, which threaten the fragile economic recovery and may add to inflation concerns especially in Europe and the UK.
The sharp sell-off in risk can be seen in the chart below. It shows the spread between the Dow Jones Transport Index and the DJ Utilities Index. This spread has been widening since last Autumn as stocks really began their rally, with the defensive utilities sector lagging behind the more growth-sensitive transport sector. However, we have seen a sharp reversal in this spread in the last two days with utilities outpacing transport.
This suggests a few things:
1, utilities will rally as long as escalating problems in the Middle East cause investors to flee risky assets.
2, the equities' rally from 2010 was fuelled by growing optimism about the global growth outlook -hence the Dow was led higher by the Transport sector. If investors continue to pile into defensive stocks, this will spell a new paradigm for stocks and could see a more sustained period of weakness.
Spread between Dow Jones Transport Index and Utilities Index
Stocks are approaching some key levels:
S&P 500: 1,315 - 21-day moving average - currently the index is testing this support. Below here we could see back towards 1,285 - previous support and 50-day sma.
The FTSE 100 has already passed through its 50-day moving average at 5,981 (a support level we pointed out yesterday). Below here we could see to 5,851 - the 100-day sma. Below 5,800- a key support level since the start of the year - the FTSE's rhythm has changed and we could see a more sustained move lower.
To see a more sustained decline in equities then scheduled protests for tomorrow in Saudi Arabia would have to turn nasty and tension in the oil-rich state would need to step up a gear. This situation would cause a massive shift away from risk (the Saudi King is a major ally of the West) and a spike in the oil price. Equities would suffer a longer-term decline because an oil shock would weigh on global growth expectations. It's worth noting that every recession since the 1970's has been preceded by an oil price shock.
However, the worst may not necessarily be on the cards. The Saudi King has made some last minute efforts this morning to try and placate his population, including adding to the social security fund and pledging to boost employment. If this works then protests may peter out, which would be positive news for risky assets.
Right now there is still so much uncertainty sop risky assets are still in the danger-zone for further declines. In comparison gold, silver and the Swiss franc should benefit.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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