It was a busy week for markets with news from the European Central Bank (ECB) and the UK election. In the US all eyes were on former FBI director James Comey as he testified before the Senate Intelligence Committee on Thursday. The Federal Open Market Committee (FOMC) meets next week where the Committee is widely anticipated to hike the fed funds rate by 25 basis points. Against this backdrop, risk assets have performed very well with equity markets moving higher and credit spreads getting tighter. The S&P 500 Index closes the week near an all-time high at 2,429 helped by a rally in bank stocks.
At the ECB’s meeting this week the Governing Council left things fairly static with no change to key interest rates and no changes in their asset purchase program. ECB interest rates are expected “to remain at their present level for an extended period of time, well past the horizon of the net asset purchases“. The Governing Council upgraded their outlook for economic growth but also downgraded their outlook for inflation. As was widely anticipated the Governing Council removed their easing bias for policy rates citing that risks to the growth outlook were now balanced. Furthermore, domestic developments could pose an upside risk to the growth outlook.
While the discussion around the growth was somewhat hawkish, there was plenty of dovish talk around the inflation outlook. In Mr. Draghi’s press conference, he stated that the economic expansion has yet to translate into stronger inflation dynamics. In fact, the ECB’s forecast for inflation was revised downward from 1.6% to 1.3% in 2018 and to 1.6% in 2019. Clearly the risk of a scale back in assets purchases or of a rate hike have diminished. So the asset purchase program continues with no formal discussion of a taper. Meanwhile, we all know that a taper is coming as the ECB is rapidly running out of bonds to buy.
In the UK, Theresa May’s decision to call for an early election to help strengthen her position in the Brexit negotiations with the European Union (EU) backfired. May’s Conservative party lost its governing majority and the UK now has a hung Parliament. The Conservatives previously held 330 seats and a slim majority. After Thursday’s defeat, the Conservatives only hold 318 seats and will need to rely on the Democratic Unionist Party to form a coalition government. While May’s future as Prime Minister is very much in doubt, she has for now vowed to stay on and says she intends to start working with European leaders on Brexit negotiations as scheduled on June 19.
The surprising result in the UK election has left May weakened and there are calls for her to resign. That could in turn lead to a call for another round of elections. So political uncertainty is rising at the same time Brexit negotiations are set to begin and the two year clock is ticking down on the UK’s exit from the EU. The election did provide some greater clarity in that the Labour party remains in the minority and there is diminished support for a re-vote on Scottish independence. Post election results, the British pound fell 2% versus US dollar and the Financial Times Stock Exchange 100 Index (FTSE) was surprisingly up 1%.
In the US, former FBI director James Comey’s testimony to the Senate Intelligence Committee stuck closely to his prepared remarks. While the testimony recounted President Trump’s “hope” that the FBI would drop its investigation into former national security advisor Michael Flynn, there is still no clear evidence of obstruction. While Trump’s pressure was wrong, it was not illegal. The cloud around the Russian investigation and Comey’s firing remains. As long as D.C. lawmakers remain focused on these investigations they delay action on the Trump economic agenda including tax cuts and healthcare reform.
For now, markets are largely oblivious to the political wreckage around them and to the nearing removal of unconventional policy accommodation from central banks. Risk assets continue to perform well with strong demand for equities and for fixed income credit. This last week saw the largest bond fund inflows in over two years. All the excess liquidity created by the central banks needs to find a home with some yield. For now, ignorance is bliss.Download to read more