The first week of November did not offer many surprises with global equities clinging to the uptrend and rising to historical highs, not unlike the latest iPhone. Shares in Apple did well thanks to the release of the new phone and supported the S&P 500 index. Robust earnings also contributed to the positive momentum in Europe and Japan.
In commodities, crude oil prices continued to rise. This was fuelled by news that the crown prince of Saudi Arabia launched a series of anti-corruption arrests firming his grip on power, but also risking what some analysts see as political instability in the largest OPEC producer. Brent was trading at above USD 60 a barrel at the time of writing.
The volatility indices have remained low. Several events could have injected a dose of volatility into the markets, but failed to do so. The US House of Representatives agreed on a draft tax reform bill; President Trump picked the next chair of the Federal Reserve; the Bank of England raised interest rates for the first time in a decade; and the turmoil over Catalonia’s quest for independence lingered as a Spanish judge issued a European arrest warrant for regional president Puigdemont who fled to Belgium.
Boe RAISES RATES FOR 1st TIME in 10 years…
The Bank of England decision to raise interest rates did not surprise markets, but its cautious tone and the fact that two out of seven policymakers opposed the increase was thought-provoking for many market participants. Indeed, a previously hawkish tone had induced many investors to price in not only one rate rise, but a whole tightening cycle running into 2018.
As a result, the market reaction was the opposite of what a rate rise usually implies: bonds rallied and sterling fell. But, as our Macro Team notes, the BoE still managed to tighten financial conditions compared to August levels.
…FOR THE RIGHT REASONS?
Even though UK inflation has picked up, we still think, along with our Macro Team, that this rate rise is a mistake. Firstly, we believe that most of the current inflation stems from a weaker sterling pushing up import prices. This effect should not be sustainable. What counts is domestically generated inflation (DGI), which has remained weak.
Looking at unit labour costs or unit wage costs as a proxy for DGI, the pressure appears to be quite muted. As pointed out by the two BoE committee members who opposed the increase: “Recent experience suggested that wage growth could continue to be less responsive to falling unemployment than past experience would suggest”. Moreover, Brexit-related uncertainties would favour cautious financial tightening.
All in all, we believe the BoE’s credibility in terms of pursuing a proper tightening cycle has been hit. Market participants have started to reprice assets, reflecting what looks like a ‘one and done’ rate rise.
US tax reform: PLANS ARE getting clearer…
The House of Representatives agreed on a draft tax reform proposal seeking to stimulate the economy with a series of tax cuts, while simplifying the tax code. The Senate will present its own version of the bill this week.
Several controversial points are expected to be fiercely debated. Measures such as the repeal of the state and local tax deduction or the cap reduction of mortgage interest deduction on new home sales will require great negotiation skills to gain passage, even within the Republican party.
…AS IS THE OPPOSITION
Lobbies usually on the Republican side do not support these plans. The National Federation of Independent Business contends that the tax cut on pass-through entities would not favour small businesses. Pass-through entities allow business owners to have business profits taxed as personal income, so the proposed reduction would benefit only those who are currently in the highest tax bracket.
Other powerful lobby groups such as the National Association of Homebuilders oppose the bill as it would reduce the incentive to own a home and hurt developers. We believe the final bill will have to include ways to fund the reform without widening the deficit. Although the Wall Street Journal reported that the tax law changes would be permanent, our Macro Team believes that they will need to include expiry in 10 years’ time for them to make it through the reconciliation process.
long AUD bonds versus US Treasuries: now fullY closed
We took profits on the remaining half of our long Australian government bonds versus US Treasuries trade. Australian and US yields continued to converge, notably driven by news of disappointing retail sales in Australia in September (flat versus a forecast 0.4% MoM rise). This position is now fully closed.