Broadgate: Weekly Briefing 17/11
17 November 2014
Last week saw the focus of the market switch back to the European Central Bank (ECB) and the US Federal Reserve (Fed). With regards to the ECB, all eyes were on the latest statement and the press conference that followed the governing council meeting. While the governing council didn’t deliver any ‘new’ news – or any all-out action like the Bank of Japan (BoJ) – it did make some subtle but important changes. These included attempts to increase the balance sheet back to early 2012 levels of around €3 trillion, with the target now formally included in the statement. The governing council is unanimous that further easing will be needed if two conditions are met: first, worsening inflation expectations, and second, that the measures already announced will not reach the target. We believe the chances of the second trigger are high; that the current measures – asset backed-security buying, covered-bond buying, plus targeted long-term refinancing options – are unlikely to get them to the balance sheet expansion that President Mario Draghi is looking for.
Still, that doesn’t make sovereign-bond buying a done deal. Political and legal hurdles remain. And in that sense, the first condition is also important; it cuts both ways. The target is data dependent and should the European economy find some support, the balance sheet expansion that the ECB feels it needs could actually be lower than that €3 trillion. To that end, purchasing managers’ indices last week showed some stabilisation in the economic future in the eurozone – aside from equity, which continues to worsen. For the Fed, it’s all about the timing and exit. So this week was about focusing on the data, with the latest non-farm payrolls coming out mixed and the ISM manufacturing data strong. Job additions for October were slightly below expectations, but still well above 200,000 (they were also revised up for September).
Importantly, unemployment dropped to 5.8%, even with the participation rate ticking higher. Although average hourly earnings growth continues to be moderate, hours worked increased, and the recent Employment Cost Index (the Fed’s favoured measure of wages) showed a pick-up earlier in the week. All signs suggest that improvements in the US labour market are finally starting to feed through to wage growth – and that is the key barometer for the Fed. So with tapering now complete, we expect the Fed to move toward the first of its gradual hikes in June of next year. Also in the US, we had the mid-term elections, which saw the senate switch back to a Republican majority – but with little overall market impact. The main implications at the moment are on the negative side: there are fears that the debt ceiling, due to be extended next April, may become an issue. On the positive side, there is more likelihood of a breakthrough on the transpacific partnership negotiations.
In markets, Japanese equities were unsurprisingly the biggest gainers, up 2.2%. This followed the prior 5% BoJ move, with dollar-to-yen now up to 114. US equities also rallied to just under 1%, continuing to outperform most other developed markets, excluding Japan. US equity exchange-traded funds (ETFs) continued to see heavy inflows from global investors. For European investors, this performance is enhanced by further dollar strength, with the euro-to-dollar exchange dipping below 124. Broad dollar strength was seen against most major currencies, both in the developed and the emerging worlds – something we expect to continue as the central bank provision of liquidity switches from the US to Japan and Europe. For emerging markets, this pushed performance down 2% last week: the markets were not helped by Brazil falling 3% (continuing its post-election doldrums) or by the new Ukraine offensive mentioned in talk of further escalation by Russia, which caused Russian equities to fall 3.5%.
It was a quiet week in the bond markets. After a recent sell-off, US Treasuries regained some ground at the end of the week and rallied on Monday morning, with two-year yields around 50 basis points and 10-year bonds now at 2.3%. Notably, despite the economic momentum in the US, 10-year yields are still below the levels seen before the Federal Open Market Committee meeting in September, reflecting global disinflation fears.
Falling oil prices positive for India
Aside from bonds and stocks, the biggest mover of note was oil, with West Texas Intermediate hitting a low of less than $80 – the lowest drop since 2009 –and down 20% year to date. The latest catalyst for the decrease was news that Saudi Arabia had cut its prices for US customers. Comments later in the week also suggested that OPEC may be willing to let prices fall to as low as $70 per barrel before it takes any action to curtail production. Falling oil prices provide another example of the increasing divergence across the emerging-market landscape. While several oil-producing countries, such as Russia and Venezuela, are struggling, India, a large oil importer, is receiving a significant tailwind. The country imports roughly 85% of its oil, so cheaper oil prices help lower India’s chronically high inflation – now down to 6.5% – and given large government energy subsidies, could help improve the country’s fiscal position. Lower oil prices, coupled with reforms from the new Narendra Modi-led government, helped Indian equities hit an all-time high in October.
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