Markets steer clear of getting into a tangle, allowing Goldilocks to prevail

IBEX/MIB trade trimmed amid Catalonia uncertainty

16 Oct 2017

  • US: inflation disappoints again; Fed rate rise less likely?
  • Brexit talks: a stand-off
  • European politics: new integration hurdles after Austrian elections?
  • Asset allocation: reduced IBEX versus MIB over near-term uncertainties

The ‘goldilocks’ scenario persisted as equity markets set new highs, while on the data front, the latest US inflation numbers disappointed anew. Asian equities outperformed developed markets, but were outpaced by emerging market (EM) equities. In currencies, the Mexican peso suffered after the Trump administration put into question the Nafta free trade deal and proposed a steep increase in the North American content of cars and a minimum of US-made content. In commodities, crude oil rose by about 4%, helped by OPEC’s increased 2018 demand forecasts as well as reports that Saudi Arabia was planning further production cuts.

Politically, it was a choppier week, with uneasy Brexit talks resulting in ‘deadlock’, elections in Austria putting the conservative party in the lead, and polls in the German state of Lower Saxony dealing Chancellor Angela Merkel’s CDU a setback which could complicate coalition negotiations. In Catalonia, uncertainty over its quest for independence remains, but so far, the Spanish bourse has rebounded from the lows reached after the region’s 1 October referendum.

US: INFLATION DISAPPOINTS AGAIN

September’s rise in US inflation was mainly driven by higher energy prices after recent hurricanes hit refinery output, but it fell short of market expectations. More importantly, core inflation was barely positive. The data followed the release of the minutes of the FOMC’s September meeting which highlighted policymaker concerns that weak inflation was due to secular factors such as the effect of technological innovations on competition and pricing.

The minutes noted that ‘patience’ on the path to central bank policy normalisation was ‘warranted’. Charles Evans, a typically more dovish FOMC member, said: “It might take something like a 3.5% unemployment rate before you really see inflation pick up”. However, Fed Chair Janet Yellen reiterated her confidence that inflation should gradually start to rise. That said, market participants generally read the minutes as dovish and the market-implied probability of a December rate rise fell after the disappointing CPI data (see chart).

BREXIT TALKS: IMPASSE

Brexit negotiations have “reached a state of deadlock”, EU negotiator Michel Barnier told a conference, given that no progress has been made on defining the settlement bill, which is seen as a precursor to talks about an EU-UK trade accord. His warning that “no deal will be a very bad deal” added to the pressure on sterling, but this reversed after German newspaper Handelsblatt quoted Barnier as saying a two-year transition period was still possible (see chart).

Meanwhile, the British government indicated it was preparing “for any eventuality” and that this included minimising disruptions to businesses and travellers. Brexit will be on the agenda of this week’s European Council, which may offer more clarity on the EU stance in the case of a no-deal outcome. We still expect a deal to be struck or at least an extended transition period to be agreed. A prolonged stalemate could bring uncertainties at the expense of sterling and could cause the Bank of England reassess its interest-rate tightening policy.

AUSTRIAN ELECTIONS

With the conservative ÖVP led by Sebastian Kurz winning Sunday’s legislative elections and the social democrats and the far-right Freedom Party neck and neck, a new grand coalition might prove hard to put together. The elections had been called amid growing disagreement in the SPÖ/ÖVP government and forming another such grand coalition could be “very difficult”, according to Chancellor Kern, leaving open the possibility that the conservatives will team up with the far-right FPÖ.

Austria’s swing to the right in the polls is not unlike the rise of Germany’s AfD, based on growing anti-immigration sentiment and opposition to further EU integration. Accordingly, plans by French President Macron and Germany’s Merkel to push for closer integration including a common budget and an EU finance minister face fresh hurdles.

ASSET ALLOCATION: REDUCED IBEX VERSUS MIB

We have cut by half our long IBEX versus MIB trade after the Spanish market’s recent rebound. Last week, regional leader Puigdemont proclaimed Catalonian independence, but at the same time suspended it as he sought a dialogue with Madrid, stuck as he is between the more extreme separatist camp and the powerful pro-Spain business lobby. Failing any clarity from Puigdemont, Prime Minister Rajoy could trigger article 155 of Spain’s constitution and take control of the autonomous region. He could also call new regional elections, which could be seen as a more agile political move.

Meanwhile, the uncertainty remains, causing many businesses to move their headquarters out of the region. Halving our exposure reflects these short-term uncertainties which could exacerbate market volatility. We are keeping part of the position as we remain confident that in the longer run, Spanish equities are better positioned and can outperform Italian equities.

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