Financial markets remained in a state of heightened volatility throughout the last week of October, but showed reassuring improvement from earlier weeks. During the month, the S&P 500 lost 16.9% and oil lost 32.6%, while the dollar gained 6.8% against the broad basket. Financial actions to prop up banks and restore liquidity – both within domestic markets and cross borders, have shifted concern from the credit crunch to its economic consequences.
Last week’s Fed action to open swap lines with four key emerging markets was a key step, bringing emerging market volatility under control, and hopefully moving fears of s systematic breakdown off the immediate agenda. Inter-bank rates continue to decline and the market is steadily working through its stresses. The delevering process will still prove painful and carry more severe economic consequences than previously seemed necessary. But we can now have a reasonable degree of confidence that the process may occur without pulling down the global financial system, and, hopefully, without unleashing an extended era of deflation.

Such relative relief brought markets back from the abyss. Last week, the S&P 500 rallied an impressive 10.5%, and oil rose 5.7%. The MSCI Emerging market index climbed 20.4%. At the same time, the VIX dropped back 24%, and emerging market CDS spreads declined from imminent default levels. Volumes are still tight in emerging markets though, reflecting an understandable continued nervousness.

There is a fair chance that these prices reflect the bottom for emerging markets, but if they do not, then everyone has had ample opportunity to understand the downside risk in structurally weak markets.

Volatility – Down But Not Out

The key event this week is the US election, which is a win-win for the global system. Washington’s political impasse has clearly worsened the credit crisis, and the subsequent economic slowdown, both domestically and internationally.
While the election will dominate all else, economic data are also gaining importance once more as the financial meltdown eases, and the economic consequences move to the fore. Here are some of the data we are watching this week:

Monday
US – ISM Manufacturing. Likely to worsen from an already very low level. This data point is of limited importance to the economy, but the market always listens to it. Generally it only responds in the short term, since manufacturing represents such a small part of the economy. This is just as well, considering how low the index has gone. And yet, exports have become an increasingly important economic driver, implying that the index is now of greater importance than previously.

Tuesday
US – Elections. The only discernible threat is a tight race and a protracted dispute over who wins. A win for McCain would shock the market, perhaps causing a short-term volatility boost, but the more likely success of Obama should allow the market to continue rising, in the short-term at least. In reality, the new president has his work cut out, the election rally will give way to harder times.

Wednesday
Eurozone – Retail Sales. Expect further signs of weakness, but these are September data, mostly baked into the cake already.
US – ISM Non Manufacturing. As with the manufacturing number, this index is also declining. This is October data, which will shed light on how well economic pressures are priced-in, and may prove relevant in the short-term.

Thursday
BoE & ECB – Rate Decisions. Both are expected to cut by 50 bps, larger cuts are conceivable, and anything less will rattle the markets.

Friday
US – Non Farm Payrolls, Unemployment Rate, Wholesale Inventories, Consumer Credit. These are the key job data, expectations are negative (-200k jobs, and unemployment at 6.3%) but they are not classical recession numbers, hence there are downside risks here. Inventory and consumer credit data will likely show further entrenchment.