Strategy: Risk events cause a ripple rather than a tidal wave

05 Dec 2016

  • Limited equity market volatility despite risk events
  • Favourable PMIs, with developed markets leading emerging markets
  • OPEC deal: will oil prices rise sustainably?

There has been no lack of eventful developments lately. Purchasing manager surveys point to robust growth in developed economies, but less so in emerging markets. Australia published weak housing data, lifting the odds of another policy rate cut soon, while the Brazilian central bank cut rates as expected. OPEC agreed to cut oil production, sending prices higher.

On the political front, the Austrian presidential election led to a victory for the pro-European candidate, while in a referendum in Italy the government’s proposal for constitutional reform was rejected by a bigger majority than the polls had suggested. We have written a separate note on the Italian referendum result.

After an initial decline in the euro, European equities and higher bond yields and risk spreads, market recovered quickly following Italy’s ‘no’. We had been sceptical that such a vote would trigger a short-term sell-off, but we do think that Italy’s meagre growth prospects, the blow to the reform process and the weakness in the Italian banking sector are reasons for concern.

While financial markets were volatile early on Monday, equity markets lost ground last week for the first time since the US presidential election as the ‘sugar rush’ on hopes of stronger economic growth on the back of fiscal stimulus wore off. Overall though, volatility in equity markets has been limited, bond markets have suffered more.


Our preliminary global GDP-weighted manufacturing PMI rose by 0.3 points in November to 52.5, its highest since September 2014. While it does not suggest that the global economy is leaving sluggish growth behind, momentum at least has turned positive. Especially in developed economies PMIs have improved in the past three months. PMIs in emerging economies have also gained, but less impressively so than in developed economies. The gap widened due to a still subdued PMI in China and lingering weakness in Brazil and South Korea. The Mexican PMI dropped over uncertainties following the US presidential election result.

PMIs in the services sector show a similar divergence with broad-based positive momentum in developed economies and emerging markets lagging. But the steep decline in the Indian services sector PMI had an outsized impact. At 46.7, the Indian PMI stood at its lowest since December 2013. This must be related to the demonetisation measures under which INR 500 and 1000 bank notes – 98% of consumer transactions in cash for about 600 million Indians without bank accounts and limited access to bank branches and cash machines – were suddenly cancelled and with the replacement process going far from smoothly.


November US data was not strong, but not weak either. Employment growth stayed on a slowly moderating trend, which should be no surprise with a labour market approaching full employment. The unemployment rate dropped to 4.9%, its lowest since August 2007, but partly for the wrong reason: a decline in the participation rate. Wage growth was missing notably. Still, we think that this labour market report was strong enough for the Federal Reserve to raise US interest rates this month. Several measures of labour costs have been stronger than the data for average hourly earnings in the labour market report.

In the eurozone the ECB will decide on 8 December on its monetary policy stance. The bank will also publish revised growth and inflation forecasts. With inflation forecasts probably to be far below the ECB’s objective, we expect the monthly asset purchase programme to be extended beyond March 2017, mostly likely by six months. The amount of the asset purchases could be lowered to EUR 70 billion, given the relatively robust growth of the eurozone economy and the scarcity of bonds available for purchase. The latter has already been addressed in part by the recent rise in bond yields, which has made more German bonds eligible for ECB buying. Still, other self-imposed limits on the bonds that can be bought may be eased.

There are two arguments against slowing the monthly pace of purchases. One is the risk of a spike in yields in the wake of the Italian referendum. Second is the lingering discussion about the ECB tapering its quantitative easing. We are not sure the ECB wants to run the risk of a negative market reaction so it may as well leave the volume of bond buying unchanged.

In Brazil the central bank cut rates as expected by 25bp. With real rates now at 5.2% and a disappointing economic recovery lately, the bank will likely have to cut rates much further. We think international developments and the recent weakness in the Brazilian real kept the bank from cutting rates by a more aggressive 50bp.

After two rate cuts this year, the Australian central bank is expected to stay on hold this week. However, October’s building approvals were the weakest since October 2011, while construction work in the third quarter was the weakest since the fourth quarter of 2000. Coming on top of wobbly retail sales and wage growth and labour market data, a weakening housing market could fuel rate cut expectations, which are currently hardly discounted by the markets.


Perhaps the most important part of the production accord reached by OPEC is that it saved the cartel of oil-exporting countries from becoming irrelevant. Rising and unsustainable budget deficits for some members had made an output cut imperative. The deal includes a reduction by 1.2 million barrels per day (bpd), while non-OPEC members should cut output by 600 000 bpd. Since compliance by OPEC and non-OPEC producers is not guaranteed and higher prices could revive US shale production, we doubt a sustainable rise in oil prices is on the cards.


We closed the final part of our overweight in inflation-linked bonds. As we said last week we think the energy price base effect has by now been largely discounted and since we have not seen any improvement in wage dynamics, we decided to gradually take profits on the strategy.

In the past week developed equities retreated for the first time since the US elections. For now the economic data looks quite solid, but markets seem to have realised that things could change before the US fiscal stimulus kicks in, corporate taxes are lowered and the favourable treatment of profit repatriation in particular could have a meaningful impact. A higher US dollar, higher bond yields, higher oil prices and the prospect of a Fed possibly hiking interest rates at a faster pace to prevent inflation from rising too much later in 2017 or in 2018 have all led to tighter financial conditions in the US. This could make for a more challenging environment even for global equities.

WSU 05Dec16

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