Growth, reforms and change at the Fed’s helm could propel US dollar

Sterling in limbo amid data and political wobbles

09 Oct 2017

  • The US economy is improving
  • UK: further macroeconomic disappointments may halt sterling’s recovery
  • Asset allocation: long IBEX vs. MIB equity trade maintained

US equities touched further record highs, but elsewhere, equity markets were rather unexciting. Emerging market equities did well, led by Asian stocks. US small caps continued to gain on the back of tax reform talks. Meanwhile, the VIX volatility index held at extremely low levels (see chart). In currencies, the US dollar continued to strengthen slowly, while sterling weakened. Commodities had a mixed week.

Crude oil gained on positive news of talks between Saudi Arabia and Russia to strengthen their cooperation to curb global oversupply. However, the gains were wiped out by market concerns over fallout from hurricane Nate, which hit the US mainland over the weekend.

US Treasury yields rose on the back of positive macroeconomic data. The German Bund moved sideways over the week, while Spanish bonds started the week with a rally amid the political unrest in Catalonia before reversing as the mood appeared to become more reasonable and as economic data such as the purchasing managers’ index (PMI) remained strong.

 

US: ECONOMY IMPROVING ON A NUMBER OF FRONTS

This week’s macroeconomic numbers were on the whole positive. While the eagerly awaited jobs data surprised to the downside (mainly hurricane-related, with largest drops seen in the leisure and hospitality sectors), market participants focused on indicators that are pointing to an improving economy and a tightening job market. The unemployment rate, which stems from the household survey as opposed to non-farm jobs which are based on a survey of businesses, fell by more than expected, to 4.2%. We believe this number is more relevant since people not at work due to bad weather are not considered jobless. Average hourly earnings (see chart) – surely the focus of the employment data – highlighted the ongoing tightening of the job market.

Car sales for September underscored the improvement in the economy, partly reflecting higher demand to replace damaged vehicles after the recent hurricanes, but nevertheless well above market expectations. Leading indicators suggested stronger GDP growth. The manufacturing PMI soared to its highest since May 2004. The report pushed the US dollar higher.

 

US DOLLAR: UPSIDE AHEAD

In our view, accelerating US growth and renewed discussions on tax reform should support the US dollar. The currency could also gain once Fed Chair Janet Yellen’s successor is known. The two names that appear to be holding the market’s attention are Jerome Powell, currently a member of the Fed’s board, and former Fed board governor Kevin Warsh. Both appear to favour a more hawkish policy. We see Powell as the frontrunner and believe he would bring more policy continuity than Warsh, who has vocally opposed quantitative easing. The appointment may be announced in the coming days.

ECB policy could also be supportive of the US dollar as a dovish stance weakens the euro. ECB Chief Economist Praet has said “a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term”. According to Praet, the ECB appears to be contemplating cutting its asset purchase programme significantly, but extending its duration.

 

UK: FURTHER MACROECONOMIC DISAPPOINTMENT MAY HALT GBP RECOVERY

Prime Minister Theresa May struck a reassuring tone on Brexit at the annual Conservative party conference, but did not present any details, while the UK-EU negotiations on a trade deal are at a standstill. The ruling Conservatives look more and more divided and there have been calls for May to resign. We do not expect this as replacing her would waste more time in the negotiations and could entail a risk of a Labour victory if general elections had to be held.

Recent data has disappointed. The composite PMI rose slightly due to improving services sector figures, but the manufacturing and construction PMIs fell. New vehicle sales decelerated for the 6th month in a row, highlighting consumer uncertainties. We are closely watching the data to assess whether the Bank of England will want to remain hawkish in the medium term.

 

ASSET ALLOCATION

Our long IBEX versus MIB trade, illustrating our preference for the Spanish equity market over the Italian bourse, suffered over the unrest related to Catalonia’s independence bid. We are maintaining our position with our positive outlook supported by upbeat macroeconomic indicators, but we will continue to monitor the political situation.

 

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