Continuity bests ruckus, setting equities up for October gains

Converging Australian and US yields spark profit-taking

30 Oct 2017

  • Spain takes control after Catalonia declares independence
  • ECB prolongs quantitative easing programme
  • Improving fundamentals await the next chair of the US Federal Reserve
  • Asset allocation: closing half of long Australian bonds versus US Treasuries

While we believe the Bank of England is getting ready to raise interest rates, ECB President Draghi announced an extension of its inflation and growth-boosting bond purchase programme until 2018, while halving the amount of monthly purchases. Market participants took this as a dovish move which supported European equities and caused the euro to weaken, while German Bunds rallied.

In the US, the low-volatility market environment was jolted by speculation over the next Fed chair, tax reforms moving closer to a deal in Congress and a busy week with company earnings reports. In all, this resulted in higher Treasury yields amid improved economic indicators and a strong Q3 GDP growth number.

Yet, the best-performing equity market was Japan which continued to enjoy Prime Minister Abe’s recent election victory and the likely continuation of loose monetary policy. Among currencies, the US dollar index rose further, up by almost 4% since its September low. Sterling gained on the back of stronger GDP figures.

In commodities, energy was the best performer even as US crude oil inventories rose for the first time after four consecutive decreases, drawing support from news that Saudi Arabia favoured extending the existing OPEC production cuts beyond next March.

In emerging markets, the South African rand tumbled and government bonds sold off after Finance Minister Malusi Gigaba almost halved his GDP growth estimate for this year from 1.3% to 0.7% and forecast larger deficits over the next three years. With South African bonds representing about 10% of the JPMorgan GBI index, the news caused the EM debt benchmark to fall.

Spain takes control after Catalonia declares independence

The struggle between Spain and Catalonia deteriorated further as the Catalan parliament declared independence and Spain’s prime minister responded by securing Senate approval to overthrow Catalan President Puigdemont and bring the region under Spanish control. PM Rajoy has the backing of EU leaders who generally oppose states fragmenting and who will not easily recognise an independent Catalonia nor grant it EU membership.

To avoid a policy mistake and prevent the situation from escalating further, Rajoy called for early regional elections on 21 December. This will be a key vote as it will be legally recognised by Spain (unlike the controversial 1 October referendum) even if the vote is won by a pro-independence party. As highlighted in our previous weekly comment, we remain constructive on Spain, but our Macro Team reckons that a disorderly exit would be catastrophic for Catalonia. Many companies have already relocated their headquarters in other Spanish regions.

ECB PROLONGS quantitative easing

The ECB prolonged its bond purchase programme until September 2018, while halving the monthly purchases to EUR 30 billion from this January. This had been well flagged to market participants. In fact, many had expected a bigger reduction to EUR 20-25 billion, especially after ECB Chief Economist Praet highlighted that the recovering economy could make do with a longer programme extension, thus hinting at a deeper cut in the purchases.

President Draghi stressed that growth was solid and broad-based, but also noted that “domestic price pressures are still muted”. He repeated that interest rates would remain low well past the end of the programme, adding that QE would not stop abruptly next September and could even be extended again.

Improving fundamentals await the next US Fed Chair

US President Trump is expected to name the next chair of the Fed soon. According to US media leaks, the incumbent, Janet Yellen, could be replaced by Jerome Powell, who already sits on the board of Fed governors. In an interview, Trump said “(the appointment) won’t be a big shock”. The reports pushed Treasury yields higher.

More importantly, news of progress on tax reform supported risk assets. The House of Representatives passed the 2018 budget following Senate approval, marking an important step towards changing US tax law. The House is expected to present its version of the tax bill on Wednesday (1/11) and the Senate should follow suit next week. Our Macro Team now believes there is a two-thirds chance of tax cuts passing into law by the end of Q1 2018.

The US economy continues to strengthen. So far, the company reporting season has provided mainly positive figures, with 80% of the companies reporting beating analysts’ earnings per share forecasts and about 70% exceeding sales estimates, marking the highest percentages since Q2 2011. Information technology stocks in particular surged on the back of excellent sales growth in the sector. More generally, US GDP recorded solid growth in the third quarter, up by 3% YoY and helped by a sharp rise in inventory investment. As for the soft data, the flash estimate for the purchasing managers index for October surprised to the upside: the composite PMI came out at its highest since November 2015.

Taking profits on Australian bonds vs. treasuries

We took profits on our relative long Australian government bonds versus US Treasuries trade. We had opened this position, expecting Australian yields to fall since most of the positive economic news had already been priced in. We had expected sluggish inflation and a dovish Fed to leave room for an upside surprise in US yields. As Australian and US yields converged, our target came into sight and we closed half of the position at a profit.

We remain 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.

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