Last week was quite busy on the (geo)political front as North Korea conducted a powerful nuclear test, which was widely condemned, prompting even Angela Merkel, the usually composed German chancellor, to state that Pyongyang’s provocative actions had reached ‘new dimensions’. For financial markets, that was one reason to adopt a risk-off mood, sending duration assets rallying and causing haven assets to outperform. It was not the only reason though, as we will see below. US Treasury yields fell to levels last seen before last year’s US presidential election. Gold did well along with traditional haven currencies such as the Swiss franc and the Japanese yen. The lower market yields hurt bank stocks, but did not help US real estate stocks as much as could have been expected. This may be due to the still-weak US dollar favouring large exporters over domestically-oriented companies such as property firms.
Regarding macroeconomic data, last week was more muted. In the US, durable goods orders for July fell short of market expectations. However, the core figure registered a slight increase. In Europe, the final eurozone composite PMI for August was unchanged. Flat eurozone producer prices also missed forecasts. UK figures disappointed, with August’s construction sector PMI surprising to the downside and the services PMI registering an 11-month low.
Our asset allocation remains unchanged.
Bonds have rallied significantly over the summer and especially so last week, driving US Treasury yields to close to a year-to-date low, and close to levels last seen before last November’s election of Donald Trump (see chart). This move was partly driven by North Korea’s bellicose actions, but other events were also instrumental.
A couple of US Federal Reserve speakers – Fed Governor Brainard and Fed President Kashkari – sent markets a dovish signal. Brainard is usually dovish, but US bond yields still reacted to her, which shows markets’ febrile nature. Kashkari highlighted the patience of the US Fed, pointing out that “it is very possible that our rate hikes over the past 18 months are leading to slower job growth, leaving more people on the sidelines, leading to lower wage growth, and leading to lower inflation and inflation expectations”.
The resignation of policy hawk Stanley Fisher from the Fed was seen as giving the dovish side another boost, adding to the pressure on yields. He had been due to resign in mid-2018, but he decided to step down earlier for personal reasons. This should give President Trump more leeway to reshape the seven-member Fed board as he wants.
The markets’ risk-off move was also due to uncertainty over hurricane damage to the US economy. The bad weather can be expected to cause some noise in US data over the next couple of months. Initial jobless claims have already been impacted. In Texas, applications rose by 52 000. That said, this should not derail US growth prospects in the medium term as more spending and economic activity will be needed to rebuild what has been damaged.
The US government debt ceiling issue was a further concern, but it was short-lived after it was resolved to postpone a solution until December. Failure to raise the spending limit could have led to a technical and unprecedented default on US government debt. President Trump surprised markets by agreeing with Democrat leaders on a three-month respite, going against the Republican stance by saying there were good reasons to remove the ceiling all together.
ECB: we are not saying yet…
There were no surprises from the ECB’s regular policy council meeting. President Mario Draghi did not comment on the euro’s strength. He only mentioned that ‘the recent volatility in the exchange rate represents a source of uncertainty which requires monitoring’. He actually downplayed any concerns by explaining that the euro’s rise was due to the improving economic fundamentals in the eurozone. This was reflected in the update of the ECB’s growth forecasts. Encouragingly, the recovery is broad-based and robust. There were minor changes to inflation expectations, with ECB staff apparently ignoring any pass-through impact from the stronger euro and also signalling a lack of concern. Currency investors viewed Draghi’s speech as a bullish signal and the euro continued to grind higher.
Draghi also said that ‘very preliminary’ discussions had started on the governing council about the future of the quantitative easing programme, suggesting an announcement on tapering could come at the next meeting in October.
Asset allocation: long US dollar; underweight duration
In currencies, we are maintaining our long US dollar position versus the euro. This is a long-term, high-conviction trade. The USD could rebound sooner rather than later. The apparent peak in the eurozone PMI could signal an upcoming change in market sentiment.
We are underweight duration, particularly in European bonds, as we expect the ECB to be one of the first major central banks to place greater emphasis on prudent management of financial markets.
As for our other strategies, we regard US equities as more overvalued than European ones. We are overweight eurozone equities versus US and UK equities.
On real estate, we are maintaining our overweight in US real estate as we expect this divergence to reverse over the coming months amid a pick-up in demand for US property.
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