Global macro-economic commentary from Insight Investment for the week ahead (week commencing 14 May 2018)

From

Michael Ford

Summary

  • The price of oil rose through the week as the US exited the nuclear deal with Iran. The potential inflation impact of this helped push up rates and the US dollar, and emerging market assets suffered.
  • A weaker-than-expected core US inflation outturn then prompted these moves to be partially reversed.
  • We added a couple of new defensive option trades to further improve portfolio diversification.
  • Next week, the focus should fall on key Chinese activity data, comments from Federal Open Market Committee (FOMC) members and labour market data out of the UK and Australia.

Strategy review

We added a couple of new defensive option trades to further improve diversification in our portfolios.

Market and economic review

Geopolitics – US and China no closer to a new trade agreement and the US withdraws from the Iran nuclear deal

Financial markets started the week with news that trade talks between China and the US had ended without agreement on how to move forward. Possible solutions looked harder to reach when data revealed Chinese exports had risen 12.9% in April – helping the trade surplus rise to $28.8bn (around $1bn more than analysts expected). There is an increasing focus on the potential disruption to tech company supply lines. If this was to materialise then this could have a material impact on equity markets due to the size of the technology sector.

With the trade issues rumbling on in the background, President Trump decided to ramp up the geopolitics on Tuesday by pulling out of the deal that President Obama struck with Iran, whereby economic sanctions have been eased in return for the shuttering of Iran’s nuclear capabilities. The Trump administration plans to re-impose sanctions in the nuclear sphere, and to introduce “the highest level of economic sanctions”. It will also try to punish those countries that don’t make significant cuts in their purchases of Iranian oil. All of this will be imposed after a wind-down period so there is time for proposals to be watered down or for US-designed amendments to the agreement to be made (as the other signatories to the agreement would like). But, at this stage, that looks very unlikely. With US oil inventories also falling more than expected, the oil price rose through the week, reaching its highest level since 2014 (at around $78/bbl).

Equity markets rally despite geopolitical uncertainty and emerging market stress

Equities generally rallied through the week despite the increase in geopolitical uncertainty. The oil price rise helped energy stocks to outperform and fears of a potential global slowdown reduced somewhat following a reasonably good set of purchasing managers’ surveys.

US bond yields and the dollar rose in the early part of the week due to concerns over the possible inflationary impact of higher oil prices. A weaker-than-expected US inflation number on Thursday then saw most of those increases reversed. Having flirted with the 3% level in the middle of the week, the 10-year US bond yield was more or less at its start-of-week level on Friday morning (UK time).

The initial strength of the dollar had a large negative effect on emerging market assets – with many bond and currency indices hitting the lowest levels since just after the election of President Trump. Countries with high dollar-denominated debt suffered most – with Argentina ultimately having to ask the IMF for help to deal with its twin inflation and debt problem (having already raised interest rates to 40%), and Turkey having to promise to introduce measures that will ease the pressure on its exchange rate and interest rates. But, as the dollar eased back after the US inflation surprise, all of the major asset price indices returned to start-of-week levels.

US inflation disappoints once again, easing the pressure for rate rises

Core US CPI came in at a lower-than-expected 2.1% (unchanged from the previous month). As usual, analysts who were the wrong side of the number pointed to price reductions they say won’t be sustained or repeated to justify their more bearish views (falls in used car and airfare prices this time round). But the fact remains that wages and inflation continue to come in lower than expected despite low unemployment and the output gap being closed.

Ahead of the US inflation numbers, the UK Monetary Policy Committee (MPC) announced it was keeping interest rates unchanged. Further rate hikes are still projected by the Committee (three 25bp hikes by 2021), but the inflation outlook has been adjusted to account for the fact that the currency effects on inflation are unwinding more quickly than it expected. Notable rate bears – Saunders and McCafferty – were the only members of the Committee to vote for a hike this time round.

Outlook

Next week sees the release of key China data on sales, production and investment. The focus here will probably be on the production numbers, with markets looking for any signs of a further slowdown (remember a slight drop in the rate of production growth last time round took the gloss off a reasonable GDP outturn).

In the US, it’s a fairly light data week, with regional manufacturing surveys, retail sales and some housing stats released. The sales number should help determine how consumption is shaping up in the post-tax-cut environment. A number of Federal Open Market Committee (FOMC) members will be speaking. Most are expected to reiterate the point that Raphael Bostic, President of the Federal Reserve Bank of Atlanta, made this week that inflation should overshoot the FOMC’s target by a small amount this year, but given the symmetry of the target, that won’t mean a more aggressive path for rates. Nominees for the Federal Reserve Board of Governors, Richard Clarida and Michelle Bowman, will testify before the Senate.

Away from the US, the minutes of the May meeting of the Reserve Bank of Australia (RBA) will be released. We expect little in the way of news from these. Indeed, the labour market data that is also released next week should be much more instructive. Last time round, full-time employment was disappointing. We believe consistent gains in this area will be needed before there is any further change to the RBA policy rate.

In Europe, the ZEW survey will give markets another steer on just how quickly, or otherwise, growth is slowing. In the UK, data from the labour market – earnings growth in particular – should provide clarity on when the MPC might next change its policy rate.

By Michael Ford, Portfolio Manager in the Multi-Asset Group

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