Stimulus hopes let the sun shine on US and Japanese equities…

…but clouds have appeared over US small caps

23 Oct 2017

  • Japan elections: LDP coalition win keeps Abenomics alive
  • China’s Communist party congress: growth in focus, policy changes to come later
  • ECB: expect a material cut in asset purchases, but also a programme extension
  • Asset allocation: closed long US small caps vs. large caps at a profit

Last week financial markets continued to price in hopes of US fiscal stimulus as the Senate passed a budget resolution that opened the door to tax reform. As a result, US equities touched record highs and yields on the 10-year US Treasury bond rose by 11bp. However, emerging market equities fell slightly, reflecting investor worries over higher core market yields and what to many is looking like an over-extended rally. The other big performer – Japanese equities – rallied by close to 2% as investors started discounting an election win by Prime Minister Abe.

On the data front, the most notable release was that of Chinese activity figures for Q3. GDP growth, for instance, came in at a robust 6.8% YoY, broadly in line with market expectations. The strong numbers did not suffice to further boost China-linked assets, including emerging markets. The headlines from China’s 19th party congress did not move markets either.


Abe’s coalition won a super majority in parliament, but this does not necessarily reflect overwhelming support for the PM. A weekend poll showed 51% of those polled do not want Mr Abe to continue in the job. Despite the limited political support for Abe, the pro-growth, pro-inflation Abenomics programme remains in place. The election gains should also clear the way for BoJ Governor Kuroda to be reappointed, allowing unconventional monetary policy to continue. A consumption tax rise and further fiscal stimulus measures will likely be announced. Overall, the outcome has reduced policy uncertainty, enabling Japanese equities and the yen to rally.


Another important political development in Asia was China’s 19th Communist party congress. President Xi Jinping did not mention a GDP growth target in his opening speech, which left some observers speculating that economic growth might have ceased to be a policy priority. Xi focused on improving the quality of growth rather than chasing a set growth rate. He did confirm the goal of doubling China’s per capita real GDP by 2020 from 2010.


Our Macro Team reminded us that the congress ratifies government personnel changes, but no policy changes. The political calendar in the chart shows the sequence of events where policy decisions are likely to be taken. Conventionally, details of economic reforms and policies are announced at the Third Plenum of each five-year congress. Thus, any policy changes that may come prior to this plenum, such as currency reform (e.g., a possible widening of the CNY-USD trading band), expanding the renminbi offshore market and increasing access by foreigners to the onshore market, will be the result of the decisions made before the current congress.


The crisis in Catalonia deflected attention from this week’s ECB meeting at which the policy-setting council is likely to announce changes to its asset purchases for next year. Our Macro Team expects the council to extend the quantitative easing programme by nine months, reducing the pace of purchases to EUR 25 billion per month and removing the easing bias to policy. It is not expected to set a clear end date for QE. The council may try to camouflage the sharp slowdown in the pace of net purchases by shifting attention to the pace of gross purchases which include reinvestments as bonds already in the central bank’s portfolio mature.

We expect the council to apply firmer language in its guidance on the circumstances under which interest-rate rises would come into play, in other words, it would provide more information on the sequencing of the steps leading to the ECB exiting QE. The central bank already faces a shrinking pool of asset to buy from, so it makes sense for it to reduce the purchases, while extending the programme. The latter move and guidance on interest rates can be seen as the ECB seeking to avoid a de facto tightening in monetary conditions. While winding down QE as the eurozone economy recovers may look justifiable, inflation is still well below the ECB’s target (see chart) and we believe the outlook does not yet warrant tighter policy.


We closed our long US small caps versus US large caps trade at a profit. The main reason was our concern that the fiscal package in the US might end up being less friendly for companies than envisaged. In particular, we see greater risks that the focus will be on cuts in personal tax rather than corporate tax. In that case, small caps are not likely to benefit as much as expected.

We remain underweight duration, particularly in European bonds. If the ECB decides to materially reduce the pace of its asset purchases (as we expect), European bond markets may sell off, even if the QE programme is allowed to run for longer.


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