Fed plans, trade negotiations and Brexit in focus
With Thanksgiving passed, markets are now focusing on the de facto final four weeks of the year with trade and the US Federal Reserve likely topping the bill. In the short term, the outcome of the meeting between US President Donald Trump and Chinese President Xi Jinping on the fringes of the G20 summit in Buenos Aires this weekend will be a major talking point. Following a phone conversation in early November, President Trump has sounded increasingly upbeat on the prospect of negotiating a settlement with China. However, barbed exchanges between Xi and US Vice President Mike Pence at the APEC Summit, and the start last week of a public consultation into whether or not the US should strengthen restrictions on technology exports have reduced such hopes.
The outlook for the meeting is uncertain, but we still consider it likely that the current 10% tariffs will be increased to 25%. We do not, however, expect to see any further escalation beyond that. In the longer term, the final US Federal Reserve meeting of the year, on 19 December, is coming into view. Recent commentary from Fed doves has raised doubts about the scale of further rate hikes and even Fed Chair Jerome Powell’s comments have sounded more cautious, in the face of recent market volatility. On Wednesday, Powell will address the Economic Club of New York, before Fed minutes are published on Thursday. We fully expect a 0.25% hike in the Fed Funds Rate to 2.25-2.5% in December. We also acknowledge that the Bank will be more cautious in tightening policy next year as interest rates approach the Fed’s estimate of the neutral rate. However, we still believe solid growth and a tight labour market will underpin the ongoing gradual adjustment. We forecast three hikes next year, which is more hawkish than current market sentiment but this includes an expectation of a pause during the year and that the tightening cycle ends in 2019.
Sunday’s European Union summit saw the approval of the UK’s Withdrawal Agreement from the bloc. It also included a political declaration for a future trade deal, albeit with a last minute carve out for Gibraltar, which the UK has accepted will not necessarily be covered by the same future agreement. This Summit formalised the fact that the EU and UK have negotiated a Brexit deal. It now remains to be seen if that deal is politically acceptable, particularly in the UK. The immediate reaction suggests it is not. A string of MPs, including those from the Democratic Unionist Party (DUP), the opposition parties (Labour, the Liberal Democrats and the Scottish National Party) and a number of Brexit and remain-leaning Tory MPs suggest they could oppose this deal. This will make it difficult for UK Prime Minister Theresa May to pass a bill. A Parliamentary vote is expected before the middle of December and May will now try to convince MPs and the wider public to support her deal.
Beyond the promise of peerages (for example, John Hayes MP) that opposition parties have suggested are linked to support of her deal, May’s argument should be supported by analysis from the Treasury and Bank of England over the course of this week. Both will provide economic assessments of the different proposed scenarios. Both are expected to warn of an unprecedented supply-shock if the UK leaves without a transition arrangement. However, comparison to the status quo is also likely to raise the case for a second referendum. Parliamentary rejection of the Brexit deal would open the path to significant political uncertainty, including the possibility of a leadership challenge, an early General Election, or even a second referendum. We continue to suggest that the most likely outcome would be a second Parliamentary vote. And, should this happen we think it would likely result in the approval of the deal. But, such a second vote would likely only materialise after other political options had been exhausted and that would likely prove a volatile period for UK asset markets.
Disappointing PMIs and slightly encouraging news on Italy: Euro area Flash Composite PMIs failed to rebound in November and declined further to 52.4 (after 53.1 in October), the weakest print in nearly four years. Manufacturing, hurt by external demand weakness, continues to drive the slowdown, but services sentiment also came in on the weak side. Worryingly, forward-looking components kept on deteriorating, limiting the prospects of a GDP rebound in the fourth quarter: PMIs point to a 0.3% increase in euro area GDP in Q4, in line with our forecast.
On the Italian budget saga, this week opens with a softer tone from both Rome and in the Brussels, while markets are pricing in this window of opportunity and the possibility of a political deal on the Italian budget bottleneck. The situation remains fluid as the Italian government is scheduled to meet on Monday night to discuss the matter, but we think it is positive on the margins. Of course, long-term constraints (e.g. low potential growth) remain untouched by the short-term political scenario. On that side, we do not expect new elections anytime soon, as the margin to form a “new-old coalition” between Matteo Salvini’s Lega and Silvio Berlusconi’s Forza Italia is simply too slim according to the latest polls.
Credit markets had lagged the correction in equity markets until two weeks ago. Since then we have seen a more meaningful spread widening across credit markets globally, with US high yield (HY) particularly in the spotlight. This is for two reasons. First, US HY had been the standout outperformer until the fourth quarter of this year, its spreads trading at very tight levels within an unprecedentedly narrow range. US HY spreads have, however, now broken out of this range after widening by over 100 basis points (bp) since their early October lows to 430 basis points, although they continue to outperform year to date. Second, the repricing has been led by the Energy sector which has recoupled with oil markets, and has mirrored the over 30% decline in oil prices seen since early October.
It’s not all doom and gloom though, as this long overdue repricing has injected some much needed value into credit. Indeed, the recent theme in US HY ETFs appears to be ‘buying on weakness’. While price action has been negative, fund flow action has been positive as days of inflows have outstripped days of outflows. Notably, US HY spreads are still trading 150bp below their 585bp average since the global financial crisis, so further widening may materialise. That said, a spread widening to 500bp would take the yield to 8%, an attractive level that is likely to br noticed by investors, signs of which are already visible in US HY ETF flows.
Euro Area: French Insee consumer confidence, Italian ISTAT business & consumer confidence (Tuesday), EU19 M3 Money Supply (Wednesday), EU19 Business & Consumer Confidence, German Unemployment, flash CPI & HICP, French Consumer spending & Q3 GDP and Spanish flash HICP (Thursday), EU19 unemployment & flash CPI, French & Italian flash HICP and Italian Q3 GDP (Friday)
US: House Price Index and Conference board consumer confidence (Tuesday), Q3 GDP, Core PCE price index, Goods trade balance, New home sales and Powell speaks at Economic Club of New York (Wednesday), PCE Price index, Personal income & Spending, jobless claims, pending home sales and FOMC minutes (Thursday), Chicago PMI (Friday)
UK: CBI Distributive trades survey (Tuesday), BoE publishes Financial Stability report and bank stress test results (Wednesday), Mortgage rate approvals, Consumer credit M4 money supply (Thursday), GfK consumer confidence (Friday)
Japan: Housing starts (Friday)
China: Industrial Profits (Tuesday), Official PMI (Friday)
Market and asset types measured by the following indices: Equities = MSCI. Fixed Income = JP Morgan and BofAML.
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