Shifting Portfolio Preferences Continue to Drive Capital Markets

There are powerful moves
underway in the capital markets.
  Some are new, and others have
accelerated in recent weeks.  The moves have stretched technical readings,
but key drivers not only remain intact
but may strengthen over the next week.  
We argue that
there are two main forces driving the shifting portfolio allocations. 
The first emanates from the US and the second from Europe.
 
There is
growing confidence that the Federal Reserve will hike rates next month, and
more next year. 
 Nevertheless, the market does not
have two Fed hikes priced in for next year, suggest there is scope for
additional adjustment. Two hikes next year will likely be the base case for
many forecasts. The dramatic rise in long-term Treasury yields is the direct
consequence anticipation of fiscal stimulus when the economy is already growing
toward trend. Both US presidential candidates’ programs call for fiscal
stimulus.  Trump’s was larger and included significant tax cuts as well.
 
While many of
the comparisons between Trump and Reagan are superficial and faddish, one
kernel of truth may be found in the
policy mix. 
An
expanding fiscal policy and a monetary policy that was becoming less
accommodative characterized Reagan’s first term and coincided with the first dollar
rally post-Bretton Woods. Of course, Trump as not assumed office yet, and he
will have to negotiate with a more austere Republican leadership in Congress.
  A deft negotiator may secure Democrat support for spending increases and
Republican support for tax cuts.   
However, the
economy that Trump will inherit is significantly different from what Reagan
received. 
Presently, the US economy is growing near-trend, and unemployment has slipped below
5%.  Many investors suspect that may prove to be inflationary.  
 Four months ago the yield was just above 1.30%.  It finished last
month a little above 1.80% and closed last week near 2.35%. Ironically, despite
the continued expansion of the US economy and rising price pressures, the
10-year bond yield is still below last year’s high seen in July near 2.50%.
 
Long-term
interest rates remain lower than what used to be
associated with the current economic conditions and price pressures. 
 The US 10-year yield peaked near 16% in Q3 1981. One
does not have to assume that secular downtrend in interest rates is over.
 There have been other significant counter-trend moves.  However,
 the trend could be over as deflationary forces have been arrested and global growth appear to be
stabilizing.  
 This
week’s data is unlikely to alter views
but may strengthen the appreciation of the solid economic performance since
struggling in Q4 15 through Q2 16. 
  Growth in Q3 is expected to be
tweaked up to 3.0% in this week’s revision.  The US economic data
continues to be mostly reported stronger
than expected.  The NY Fed estimates that US economy is tracking 2.5%
growth here in Q4, while as of the middle of last week, the Atlanta’s Fed model
was more optimistic; tracking 3.6%. 
At the same
time, investors will be reminded of the
proximity of the Fed’s objectives. 
 The core PCE deflator is expected to
have remained steady in October at 1.7%.  The Fed’s target is 2%.  
At the end of the week, the US reports the November jobs data.  It is
expected to show solid, even if not spectacular job growth of 175k-185k.
 The unemployment rate is expected to be unchanged at 4.9%, and hourly
earnings are forecast to be steady at the 2.8% year-over-year, the highest rate
in seven years reached in October.  The bond market and the dollar, given
the recent tight link, may be particularly sensitive to downside surprise in
the unemployment rate or an upside surprise in earnings.  
Many are
concerned about the protectionist signals sent by candidate Trump. 
 The widening of the trade deficit the coming months
as a result of growth differentials may make for fertile ground for the
rhetoric to be operationalized.  The implication of less commitment to
free-trade while the US is a net international debtor  (the world owns
more US assets than American own foreign assets) is not clear.  Those issues seem to be a medium term
challenge, and by the time they are salient the world could look a lot
different.   
That brings us
to the second driver of the shift in the investment climate: Europe.
  It is not the European economy per
se.  Eurozone growth is near trend, and the flash November PMIs raise the
hope of some modest improvement.  However, unemployment has been slow to
improve.  After finishing last year at 10.5%, it has been stuck at 10.0% since July.  Money
supply growth has stabilized near 5% since the middle of last and lending is
slow.  Both will be on exhibit to start the week.  
Those at the
ECB who want to extend the asset purchases anchor their arguments in the weak
price pressures.
  The preliminary CPI will be the last
look at inflation before the ECB meets on December 8.  The headline rate
may tick up slightly to 0.6% from 0.5% in October.  It would be a two-year
high, but the increase since the  0.1% rise in July is largely a function
of oil prices, as the core rate has been steady at 0.8% in recent months and is
expected to remain there in November.  
The prospect
that the ECB could alter is self-imposed rules about its asset purchases, which
would allow it to buy more German bunds helped drive the German two-year yield
to new record lows last week. 
 The yield fell to minus 76 bp ahead of the weekend before
closing near 74 bp.   Although most of the media coverage has focused on
the rise in US yields, last week, the German rate move was larger  Its
two-year yield fell almost eight bp,
while the US two-year yield rose less than five
bp.  
Another
consideration that may have contributed to the pressure on German yields is the
rising political anxiety.
  At the end of next week, Austria
elects a new president, and Italy holds a
referendum on constitutional changes to the Senate, after earlier reforms for
the Chamber of Deputies was approved.  
The Austrian
election is a do-over after the May election
results were voided by the courts for the improper handling of postal votes. 
  The populist-nationalist Hofer is polling a little ahead of the Green’s von der
Bellen.  A victory would make Hofer the first far-right head of state in
Europe since WWII.  The post may be largely ceremonial, but the symbolic
victory may be underestimated by the
focus on the Italian referendum.
Expectations
that the referendum will not be approved are widespread.
  The key unknown is what follows.
 Although Renzi has threatened to resign if the referendum fails, his
signals have been ambiguous.  If he resigns, the idea is that the PD would
select a caretaker, perhaps a current minister, that would attempt to complete
the political reforms and hold the parliamentary
election as scheduled in 2018. 
However, Renzi
could force an early election.  It is a scenario he played down but came back to the fore last week.
 
 The
most important point is that investors’ anxiety over the possibility that
5-Star Movement is swept is getting ahead
of events.  However, a weak government or a caretaker government means
that the reform efforts slow.  Italian assets have underperformed recently as the referendum drew near.   The
Italian 10-year premium to Germany widen nearly 50 bp over the past month, and
at 1.85%, is the largest in more two and a half years.  The rising
sovereign yield (Italy’s 10-year yield has risen 63 bp over the past month, the
most in Europe) is one of the factors that have weighed on bank shares.
 The Italian bank share index is back to its lowest level since early
October. 
Looking further
down field but already shaping scenarios for next year, the French presidential
election. 
 The prospect
of a populist-nationalist victory is a source of anxiety.  Investors are
demanding a higher premium to hold French paper instead of German.  On
two-year money, the French premium has risen from 3-4 bp before the US election
to 16 bp before the weekend, the largest since mid-2014.  The 10-year
differential widened from 31 bp to 55 bp, the most in a couple of years.  
Meanwhile, EU
tensions with Turkey have escalated following last week’s European Parliament
non-binding resolution to end accession talks over Erdogan’s repressive
response to the coup attempt.
  In response,
Erdogan threatened to abandon the
agreement to limit the immigration into Greece.   The decision on talks
resides the foreign ministers, not the
European Parliament, and they are reluctant to break off accession talks.  Should Erdogan re-open the borders, it
would likely strength the appeal of the populist-right forces.  
Elsewhere, OPEC
is a wildcard next week. Since the summer, the ebb and flow of speculation
about OPEC’s ability to reestablish some order to the oil market drove prices
between roughly $42 and $52 a barrel (basis the front-month futures contract). 
 The central problem is that Saudi Arabia cannot abide
by sacrificing market share to other OPEC members, especially Iran, and Iran
for its part cannot accept a freeze of output until it fully recovers from the
embargo.  That issue does not appear resolved, and that appears to be the
reason Saudi Arabia pulled out of the meeting with Russia that was to be held
on Monday (November 28).  Meeting with Russia without a full agreement
from OPEC members to cut output puts the cartel at a disadvantageous
negotiating position.  Separately, the restoration of Libyan output and the expansion of Kazakhstan’s
production warns that it will be difficult to reduce supply.  

More broadly,
the CRB Index rallied 5.2% since November 14, but the momentum was sapped by energy and the grains. 
 The price of gold has fallen about 10% in its
three-week drop that has left prices at nine-month lows.   Industrial
metals have been the strongest part of the commodity complex, ostensibly on
stronger US growth and a Chinese economy that is stabilizing.   

Amid the portfolio
adjustments, emerging markets have fallen out of favor, particularly bonds.
 The sharp rise in US Treasury yields
forces many emerging market rates higher too.  Rising rates and a stronger
dollar lifts the cost for emerging market economies to borrow funds and to
service their dollar-denominated debt. The MSCI Emerging Market equity index
snapped a four-week, 7.5% decline last week.  The 1.3% rise was broad-based.   In contrast, major US
indices, including the Russell 3000, are at record highs. Europe’s Dow Jones
Stoxx 600 has rallied for three consecutive weeks for about 4%. It muted
performance leaves it straddling the 100-day average, which is nearly 17.5%
below the record high set in the middle of last year.   Japan’s Topix has moved higher for eleven straight sessions coming into this week.  It has advanced for three consecutive weeks (~8.5%) and in six of the past eight weeks.  

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