Risk on despite more synchronous central bank tone

Abstract: closing short UK versus eurozone equities

18 Sep 2017

  • Central banks: getting ready to raise rates?
  • Political risk: keep monitoring
  • Asset allocation: USD strengthening over medium to long term

Despite renewed (geo)political tensions with North Korea, risk-on sentiment has come back into financial markets over the past week. Relieved after hurricane Irma caused less damage than expected, US investors pushed the S&P 500 equity index to record highs. Global equities did well. Bonds sold off, while other haven assets and bond proxies such as utilities and real estate underperformed. In currencies, the US dollar seemed to rebound from prolonged weakness. Sterling similarly recovered, erasing last month’s losses after a hawkish meeting of Bank of England policymakers that also triggered a sharp rally by gilts and weighed on the UK FTSE 100 share index. In commodities, the crude oil rally reflected market optimism as well as the reopening of several US refineries after their hurricane-related shutdown. Hopes over OPEC talks on prolonging production cuts also helped market sentiment.

 

CENTRAL BANKS: GETTING READY TO TIGHTEN POLICY?

The Bank of England surprised market participants with a hawkish tone. This followed consumer price inflation rising to its highest since December 2011 and driving gilt yields higher. Nevertheless, bond investors were not prepared for the BoE’s hawkish tone, which pushed yields higher still. A majority of policymakers reckoned that “some withdrawal of monetary stimulus was likely to be appropriate over the coming months” to return inflation sustainably to target. The BoE message was reinforced by the usually dovish (external) MPC member Gertjan Vlieghe, who said that “the evolution of the data is increasingly suggesting that we are approaching the moment when (the) bank rate may need to rise”.

These strong signals triggered a selloff in UK bonds, pushing 10-year gilt yields up by the same magnitude as after the announcement of snap elections in June. We are not convinced that raising rates in coming months would be right in terms of timing. Indeed, we reckon the current rate of inflation stems from currency pass-through effect caused by sterling weakness. This is a rather temporary effect that should not last the way domestically generated inflation would.

Moving on to the US, the Federal Reserve’s FOMC meets on Wednesday. An announcement on balance sheet normalisation seems to be well anticipated, but could still destabilise bond markets. We remember the selloff after ECB President Draghi’s speech in May, even though much of the expected balance tapering is now priced in already. Inflation surprised to the upside, ending a series of five consecutive disappointing data releases. This should not change the Fed’s cautious policy stance, tough. Core CPI was mainly driven higher by strong shelter inflation. However, policymakers typically look at the PCE inflation index which gives much less weight to shelter prices. We do not expect the FOMC to surprise markets. Its tone should remain cautious and rather dovish.

 

POLITICAL RISK: KEEP MONITORING

This Sunday’s elections in Germany are unlikely to add to political risk, but there appear to be plenty of other sources of concern to ensure that political risk remains a major driver of market sentiment globally. The UN agreed to impose additional sanctions on North Korea, but China and Russia made sure these sanctions were relatively minor. The trade restrictions were followed by more provocations. After this summer’s tension over the sabre-rattling, the reaction from market participants was muted. However, this political feud should be monitored closely since further escalation could impact US-Chinese relations.

In the US, plans for tax reform appear to be gaining momentum. With the debt ceiling issue postponed until later in the year, the Trump administration is now focusing on cutting corporate tax to 15%. The final tax rate remains unclear as Republicans have expressed concerns over the impact on the deficit. The first proposals are due at the end of the month. Fiscal stimulus could revive the so-called Trump trade, benefiting small caps and banks in particular.

 

ASSET ALLOCATION: CLOSING UNDERWEIGHT UK VERSUS EUROZONE

We have closed our short UK versus long eurozone equities position. The trade has suffered from improved UK economic performance on the back of a weak sterling, while the eurozone has had to deal with a stronger euro. This trend does not look like reversing itself in the short term. Moreover, our new forecasts for UK company earnings are less pessimistic. As a result, our conviction on this trade diminished and we closed the position at a loss.

In currencies, our long position in USD had a good run over the past week with the dollar index bouncing higher. Over the medium to long term, we see the USD strengthening, especially once the Trump administration starts implementing reforms and once the Fed goes ahead with its monetary policy normalisation plan.

 

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