Weekly review and global economic outlook for the week ahead – week commencing 4 June 2018

Political developments in Italy dominated market performance over the week.

Summary

• Political developments in Italy dominated market performance over the week.
• Sharp volatility in Italian and other Eurozone equity markets and yields on 2-year Italian government bonds rose to their highest levels in over five years. Developed government bond yields rallied in response.
• US data releases pointed to strength in the domestic labour market while PMI releases indicated consolidation in global economic activity.
• We added a relative equity position favouring US over eurozone equity markets, reflecting underlying economic strength in the US economy.
• PMI releases in the US, eurozone and China will provide a guide on the strength of global economic activity next week as the focus should shift away from political developments in Italy.

Strategy review

We added a relative equity position favouring US over eurozone equity markets, reflecting underlying economic strength in the US economy.

Market and economic review

Political uncertainty in the eurozone periphery dominated market direction

Italian politics remained in focus with President Sergio Mattarella giving approval on Thursday to a coalition government comprised of the League and the Five Star Movement, ending three months of political uncertainty. The news helped stabilise Italian assets, which have been roiled with the prospect of fresh elections after the President rejected the coalition’s proposed economic ministerial candidate at the start of the week.

As a sign of stress in Italian assets, yields on 2-year Italian government bonds rose to their highest level since August 2012 (to over 2.7%), before retracing most of the moves to around 0.75% at the time of writing. Yields on developed government bonds including US treasuries, UK gilts and German bunds fell sharply earlier in the week in response to the evolving Italian political developments, which helped to mitigate some of the impact on the portfolio’s exposure to risk assets. Attention will refocus now on previously announced policies that have included tax cuts, additional welfare spending and a rollback on pension reforms which in aggregate could represent fiscal expansion.

Elsewhere, in Spain former opposition leader Pedro Sanchez succeeded Mariano Rajoy as the next prime minister, after the outgoing leader lost a parliamentary confidence vote triggered by a long-running corruption trial involving members of his party. Spanish political change poses a lesser systemic threat to the eurozone than Italy due to Spain’s combination of stronger economic growth, better public debt dynamics and a pro-European bias to its political setup.

US imposes trade tariffs prompting retaliation

The US administration withdrew previously granted import tariff exemptions to the EU and its partners in the North American Free Trade Agreement (NATFA) paving way for duties of 25% and 10% to be levied on steel and aluminium imports, respectively from Mexico and Canada from 1 June. Tariffs on EU imports are expected to take effect from 20 June. Mexico and Canada responded swiftly with retaliatory tariffs on a range of US imports while the EU is considering a co-ordinated response with affected countries.

While the macroeconomic implications of these measures should be limited to individual firms and sectors, further escalation in retaliatory tariffs could undermine global growth which we already anticipate to be slowing later in the year.

Economic releases were mixed, continuing recent trend

US data releases over the week were mixed. The second reading of US Q1 GDP growth came in at 2.2%, down from 2.3% reported previously, amid revisions to inventory investments and consumer spending. Personal spending rose 0.6% in April with upward revisions to March allaying concerns of a more protracted slowdown in domestic consumption after the Q1 GDP reading. Elsewhere the Chicago purchasing manager’s index (PMI) was strong and the Beige Book stressed the tightness of the labour market. Above consensus non-farm payrolls growth in May (of 223,000), along with a rise in average hourly earnings at 0.3%, also pointed to stronger labour market dynamics.

Elsewhere, PMI releases from China, Germany, Japan, UK, France, Italy and the US remained expansionary albeit showing signs of some consolidation after a period of synchronised upswing in global cyclical activity last year. Lastly, inflation data in the Eurozone surprised to the upside.

Geopolitical anxiety reflected on risk asset performance

Reflecting geopolitical concerns, equity markets remained volatile with divergent regional performance as key equity markets in the eurozone underperformed the US. The US mid-cap oriented Russell 2000 Index has continued to deliver positive returns for the fourth consecutive week. Reflecting stronger growth dynamics in the US, we implemented a relative position on the US versus the eurozone equities this week. We also added an upside option position on US equities to further diversify portfolio exposures.

Outlook

Next week the release of composite PMI surveys in the China, US, Germany, Spain, France and the eurozone will likely guide the pace of global economic activity. The final reading of April US durable goods and capital goods orders will be additional data of interest.

Apart from macroeconomic data releases, we await further developments on the EU’s response to US trade tariffs and political developments in the Eurozone.