Significant shifts in market expectations – weekly update 3 July

A look back over macroeconomic and market events for the week ending 30 June. Markets were taken by surprise when the heads of the Central banks in the Eurozone and UK gave particularly hawkish statements at a Central bankers’ forum. This caused sharp movements down for government bonds and up for sterling and the euro, and could potentially mark an inflection point in the post-global financial crisis period of ultra-loose monetary policy.

Hawkish rhetoric from Central banks

Further synchronised hawkish rhetoric from major Central banks this week appears to have been the catalyst for significant shifts in market expectations. This could mark a key inflection point in the post-global financial crisis era of ultra-loose monetary policy. Key comments from the European Central Bank (ECB) President, Mario Draghi, and Bank of England Governor, Mark Carney, at the ECB Forum in Sintra gave the strongest signal yet of a shift away from the unconventional policy period of extremely low or negative interest rates and quantitative easing. From our point of view, this remains entirely consistent with our investment outlook, and market recognition that negative real yields on core European sovereigns should become a thing of the past will ultimately benefit our clients.

Draghi talks up strength in the Eurozone recovery

Soundbites such as “all the signs point to a strengthening and broadening recovery in the euro area,” as well as “deflationary forces have been replaced by reflationary ones,” have caught the most attention, causing a sharp move higher in sovereign bond prices and the euro. Such was the scale of the market reaction, ECB officials felt it necessary to intervene afterwards to warn that the market had overreacted to Draghi’s comments. From our point of view, it does seem that the market has been somewhat over-sensitive to this news in isolation, choosing to ignore much of the qualifying language in the speech, particularly around the need for continuing monetary support given that these inflationary pressures were “not yet durable or self-sustaining.”

We have argued that current headline inflationary pressures are transitory, and that Central banks will (and investors should) look to underlying economic conditions. These are indeed improving, which would justify removing some of the most active monetary policy support (such as quantitative easing) whilst still leaving monetary conditions business-friendly. It is noteworthy that this shift in tone comes as headline inflation has fallen again (headline CPI slipped from 1.4% to 1.3%) and Core CPI has strengthened (1.1% from 0.9% previously). Although the ECB has clearly not been as careful with its messaging as the US Federal Reserve has been – which, in turn, has learnt from its own ‘Taper Tantrum’ experience of a few years ago – the speech seems consistent with the broader economic landscape, and markets are recognising the dangers of earlier complacency.

Our Chief Investment Officer, Chris Godding, gave an update on Mario Draghi’s comments last week.

The Bank of England wasn’t to be outdone

Governor Carney told the forum that “more removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen…” This appeared to be in stark contrast to his recent dovish comments that we covered last week, and caused expectations for a rate hike this year to surge above 50%. Again, we believe markets have read a little too much into these comments, although they have moved gilt yields towards a more sensible level in our opinion. We interpret Mark Carney’s comments as reiterating the point that Central banks are looking through headline inflation, which is being driven by external factors. Instead, the Governor is waiting for the same factors to improve that we have highlighted before, namely real wage growth and business investment, which should be necessary pre-conditions for sustainable economic growth.

We also saw the BoE increase the Counter-Cyclical Buffer (CCB) from 0% to 1% by November, requiring banks to hold more capital to defend against defaults – this comes as consumer credit expanded another £1.7 billion in May (ahead of £1.5 billion in April and forecasts for a moderation to £1.4 billion). Our view remains that the UK needs to move away from debt-fuelled consumption towards stable consumption enabled by real wage growth and business investment. The stimulus injected by the BoE following the EU referendum last year now seems to have been unjustified, and managed withdrawal is appropriate – though further aggressive tightening would likely be a policy mistake. Our strategy remains to be doubly-negative on UK gilts, both by absolute exposure and by favouring low duration positions which are less sensitive to changes in the interest rate outlook, a position we have held throughout the year so far.

Last week’s other events

• In the US, Durable Goods Orders continued to disappoint, falling -1.1% month on month in May, down from -0.9% previously and short of expectations for -0.6%. The Dallas Fed Manufacturing Index slipped further than expected from 17.2 to 15.0 (16.0 expected). Against this, consumer confidence was improved with the Conference Board measure increasing from 117.6 to 118.9 (116.0 was expected). PCE Price inflation cooled from 1.7% to 1.4% year on year in May, with Core PCE inflation down from 1.5% to 1.4%. Personal Income rose 0.4% month on month (from 0.3%, with expectations of the same), whilst Personal Spending fell in line with expectations at 0.1% month on month (from 0.4%). The ‘final’ reading of Q1 GDP was also further revised up from 1.2% annualised to 1.4%, double the initial estimate of 0.7%

• Eurozone Business Confidence improved from 0.90 to 1.15 (0.94 expected), the highest reading since 2011. As mentioned above, CPI inflation fell 0.1% to 1.3% but was ahead of the 1.2% forecast, with Core CPI inflation actually increasing from 0.9% to 1.1%

• Japan’s industrial production for May increased from 5.7% to 6.8% year on year, while inflation remained unchanged at 0.4% year on year (0.5% was expected). Core inflation increased by 0.1% to 0.4% as expected, and unemployment rose 0.3% to 3.1%

• China reported official Manufacturing PMI as rising from 51.2 to 51.7 (51.0 expected) and Non-Manufacturing rose from 54.5 to 54.9

The markets

Sovereign bonds sold off significantly as sterling and the euro surged following comments from the relevant Central banks. Equities were marginally softer on the shock.

Equities – European equities were the most impacted of the major regions, with the MSCI Europe (ex-UK) falling -2.3%. UK equities fared slightly better, down -1.4% on the week, and, in the US, the S&P 500 shed -0.6%. Emerging Market equities were relatively unaffected, with the MSCI Emerging Markets index rising 0.3%. Japan also posted a positive return, up 0.2%.

Bonds – Core sovereign bond yields were sharply higher following the hawkish Central bank comments. In the UK, ten-year gilt yields rose 22 basis points (bps) on the week to finish at 1.26%, and the equivalent German bund yields rose 21bps to 0.47%. Ten-year US Treasury yields were also higher, increasing 14bps to 2.30%.

Commodities – Oil continued to recover, with Brent Crude oil rising to US$48.77 a barrel. Gold softened to US$1,240.70 an ounce whilst copper was stronger, finishing at US$2.70 a pound.

Currencies – Sterling and the euro strengthened on the week, with sterling faring marginally better out of the two. Sterling closed Friday at US$1.30, €1.14 and ¥146.

1 month performance of major asset classes

The week ahead

It is another busy week. We’re back to US non-farm payrolls on Friday, with the market looking for 177,000 jobs added, and ahead of that on Wednesday, the FOMC minutes from the most recent meeting are released. There will also be Industrial Production numbers out of the UK on Friday and PMI readings from China, the UK and the US (ISM figures) to look forward to (details below).

Elsewhere:

Monday: Early morning starts with the Tankan industrial activity gauges out of Japan, followed by the Caixin Manufacturing PMI reading from China for June (49.5 forecast from 49.6). Japanese consumer confidence is also released in the morning. After this, we have UK Manufacturing PMI (56.5 expected from 56.3), and the latest Eurozone unemployment reading. In the afternoon the US reports Construction Spending and the ISM Manufacturing PMI number (an increase from 54.9 to 55.2 is expected).

Tuesday: A fairly quiet day, with only the UK Construction PMI reading of note (55.0 from 56.0 expected).

Wednesday: UK Services PMI is released in the morning, with a marginal cooling from 53.8 to 53.5 expected, and this will be followed by Eurozone Retail Sales, which is forecast to have slipped 0.2% to 2.3% year on year. In the afternoon US Factory Orders and Economic Optimism from the IBD/TIPP survey are reported ahead of the FOMC minutes in the evening.

Thursday: The ECB Monetary Policy meeting minutes are released at lunchtime, and could provide some interesting insight in light of Mario Draghi’s comments last week. After that, we have the ISM Non-Manufacturing PMI measure from the US, expected at 56.5 from 56.9 previously.

Friday: Overnight, Japan reports Leading Economic Indicators and Coincident Index measures of industrial activity, followed later in the morning by UK Industrial Production – forecasts are for a recovery from -0.8% year on year to 0.2%. Along with Non-Farm Payrolls, the Average Hourly Earnings figure is likely to be closely watched, with market expectations for an improvement from 0.2% to 0.3% month on month. Friday also sees the start of the annual G20 summit, which could give us some talking points next week.