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Broadgate: Weekly Briefing 19/9

19 September 2014

This week is set to be a key one for risk assets as we head towards the final quarter of the year. On the geopolitical side, Thursday’s Scottish referendum and the Ukraine situation dominate the headlines.

Less tweeted about, but equally, if not more, important, is the spectre of real central-bank divergence as we head into Wednesday’s Federal Open Markets Committee (FOMC) meeting in the US. Over the past week, these looming developments have reversed the recent positive momentum in markets. For equities, it was a down week. The S&P 500 fell back below 2000, while Europe’s recent European Central Bank (ECB) resurgence came to a grinding halt. Spain was hardest hit, both in stocks and bonds as the potential repercussions of a ‘Yes’ vote in Scotland raised claims for the unofficial Catalonian referendum to be granted more prominence by Madrid. Italy was also weak, partly on profit-taking from the ECB-fuelled peripheral asset rally, which reminded us that Prime Minister Renzi faces a testing time in the coming months for his reform drive.

Elsewhere, this week in France will see a confidence vote and speech from President Hollande on reform. However, for once the UK is centre stage, with markets finally waking up to the closeness of the Scottish referendum. Last Sunday’s poll giving the Yes campaign the lead for the first time sent sterling from 1.63 towards 1.6 against the dollar. By the end of the week, however, it was back above 1.62. Various polls in recent days show the result as too close to call. The only certainty is that the referendum will lead to changes in the UK, regardless of whether the result is a yes or a no. So currency volatility in sterling is likely to continue.

All eyes on central banks

Away from the UK, this is a key week for the US Federal Reserve (Fed). Recent economic data has shown steady improvement, but only limited signs that the drop in unemployment is feeding through to rising wages – the main focus for the Fed. This has allowed bond markets to remain largely sanguine. Two-year yields have risen over the summer and the dollar has embarked on a broad-based strengthening, but the longer-dated end of the yield curve has remained very range bound, until now.

The past week has seen the first signs that the extremely low bond-yield environment of the summer may now be shifting, with the 10-year bond moving up 15 basis points to 2.6%. On an absolute basis, 2.6% is still very low, but remember we started the year at 3%. The backup in yields has been quick and comes at a time when US equities are at record highs. The front end of the US yield curve has moved to price in earlier rate hikes, with June now favoured. In our mid-year outlook, we saw the Fed as the main threat to risk assets in the autumn. So far, that has been overshadowed by the ECB. But now it’s the Fed’s turn again, with this month’s FOMC meeting. Analysts’ eyes will be on whether the phrase ‘considerable period’ is again used. The 2017 ‘dots’ (the Fed’s own projections of where interest rates may be) will also be released, possibly giving more insight as to the likely terminal rate.

Back in Europe, this week sees the first TLTRO allotment – the targeted long-term repo operation announced by the ECB back in May. A total of up to €400 billion will be allotted to banks, with conditions to encourage lending to ensure the money enters the real economy. The original LTROs were successful at stopping the liquidity crunch that was enveloping the European banking system two years ago, but did little to spark lending activity, as most of the funds went into the ‘carry trade’ of buying peripheral government bonds. The TLTRO takeup is likely to be large, but questions remain about what banks will actually do with the money. Meanwhile, German bund yields are back above 1%, pulled up by the move in Treasuries and some realisation that sovereign quantitative easing is not a done deal.

China and Brazil reverse their rallies; Japan a bright spot

Further afield, emerging-market (EM) equities’ recent performance reversed, led down by China and Brazil.

For China, concerns over the government’s GDP targets are back, with recent economic data showing industrial weakness. China’s equities rally has gone long way, but needs a short-term catalyst to keep it going, given the economic reality of rebalancing. This could raise pressure for more government or central- bank easing support. The convergence of A-shares and H-shares has been helped by the ‘Shanghai Connect’ test trades, whereby offshore investors can now buy domestic equities. Similarly, the Bovespa has given back some of its exponential rally – a rally driven purely by hopes that political opposition can create another ‘Modi moment’. This has been enough for the equity market to defy the reality of a rapidly deteriorating economy on its way to stagflation with zero growth, but the risks are clear. For broader EMs, this compounds the risk of a more hawkish Fed that has seen EM currencies weaken versus the dollar. It is important to watch the ‘fragile five’ to see if the currency sell-off accelerates. Within Asia, our preferred area, Korea, has struggled recently, in part because of the weaker yen.

Finally, one bright spot in global equities is Japan. The Topix outperformed other major indices by rising over 1% last week. Having been range-bound all year, the dollar/yen has moved quietly, by 5 points to 107, and the Topix has pushed over the key threshold of 1300. With a weak yen, and news due about government pensions, Japan looks set to continue its stealth outperformance as markets’ attention stays firmly fixed on developments in Edinburgh and Washington.

BWB

The information set out herein has been obtained from various public sources and is by way of information only. Broadgate Financial can accept no liability of any sort in relation thereto and readers should obtain their own verification of any statement before making any decision which may have any financial or other impact.

Neither the information nor the opinions herein constitute, or are they to be construed as, an offer or a solicitation of an offer to buy or sell investments.

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