Tax Cuts expectations continue to dominate Markets The US Federal Reserve raised interest rates by 0.25% on Wednesday, for the third time this year, as widely expected, to a target range of 1.25% to 1.50%. However, the yield on US Treasuries and the dollar subsequently sank, not helped by core inflation (excluding energy and food), coming in at a lacklustre 1.7% for the year. Having hit record highs at the start of the week, the US stock market gave up some of its returns as investors became concerned about the Republican party getting through its tax cuts by the end of the year. In Europe, markets were weak, despite the latest purchasing managers index, a key leading indicator, pointing to the Eurozone economy expanding at its fastest pace for almost seven years.
Mixed equity market performance over the week. As of Friday, 12pm London time, both the S&P 500 and the Australian S&P ASX 200 were flat for week, the US technology centric Nasdaq index was up 0.2%, the EuroStoxx 50 was down 1.17%, the Japanese Topix index fell 0.6%, whilst the UK’s FTSE All Share was up 0.7%, benefitting from the recent progress made on negotiations to leave the European Union . Emerging markets benefitted from the weakness in the dollar post the US rate rise decision, climbing 0.9% over the week.
Government bond yields, which move inversely to prices, fell in the US, with the yield on the 10-year US Treasury now trading at 2.35%. Similarly, UK gilt yields fell, despite the latest inflation figures exceeding expectations, with 10-year gilts now trading at 1.15%, as economists continue to forecast inflationary pressures easing in the UK with the effects of the devaluation of the pound largely in the past. German 10-year bunds are flat, yielding 0.30%, after a “steady as she goes” stance at its recent policy meeting on Thursday.
Despite the US Republican party reaching agreement amongst themselves to reduce the corporate tax rate to 21% from the current 35%, doubts have risen as to the bill being passed before the end of the year. The Republicans currently hold a 51 to 49 majority in the Senate, however, Republican Senator Bob Corker has already come out against the bill citing government expenditure needing to come down first. Florida’s Marco Rubio and Utah’s Mike Lee have since stated that they want to see the child tax credit expanded, designed to lower the tax bills of working families with children otherwise they will vote no. The situation will only become harder come January, since the state of Alabama has recently fallen to the Democrats for the first time since 1992.
The Bank of England and Norway’s Norges Bank also kept interest rates unchanged this week. However, the Norges bank brought forward the timing of its first projected interest rate rise by about a year. This is despite underlying inflation remaining at 1%, well below their 2.5% target.
The UK’s consumer price inflation rose in November, rising by 3.1% year on year, exceeding forecasts. However, economists continue to believe that inflation has peaked, with the impact of the drop in the pound set to fade over the course of 2018.
The European Central Bank left rates unchanged this week, but reconfirmed that it is has extended its bond purchasing programme to September 2018, whilst halving the monthly purchases from €60bn to €30bn. The ECB will continue to reinvest the proceeds of any maturing bonds within the programme. If the upswing in Eurozone growth continues into next year, expect the debate about ending the programme to become much more heated in the new year. The current President of the ECB, Mario Draghi, has indicated that the programme will not come to an abrupt halt next September, however, some of his potential successors are not in agreement. Draghi’s tenure ends in October 2019.
The oil price jumped higher on Monday after the UK’s North Sea main pipeline was shut, following the discovery of a leak. The operator, Ineos, announced that it would be shut for a number of ‘weeks’. Brent crude oil neared $65 a barrel, its highest level since mid-2015. In the same week, a gas explosion at one of the main gas hubs near Vienna, brought gas pipelines in Austria to a close. This was a key distribution hub for Russian imports, Europe’s biggest gas supplier. UK wholesale natural gas prices for same delivery leapt by nearly 30%, reaching their highest level since 2013. Energy stocks on both sides of the Atlantic rose higher. At the time of writing, Brent crude has settled back down at $63.50 a barrel, and US West Texas Intermediate is trading at $57.42.
At the time of writing, markets have experienced yet another year of returns that have exceeded the expectations of most investors, despite valuations being tight across most regions. However, what is different about 2017 is that this was the first year that growth became globally synchronised. Importantly, despite the cyclical upswing, and falling unemployment, inflation has not raised its head in any meaningful way, allowing central banks the freedom to tighten monetary policy gradually, with financial conditions remaining easy.
In fact, despite the US Federal Reserve beginning to taper its quantitative easing programme, the continuing asset purchases from the European Central Bank, Bank of Japan and Bank of England, have kept liquidity flowing and monetary policy remains at exceptionally easy levels.
We think the greatest risk facing financial markets is the re-emergence of inflation, followed by rising interest rates to contain the problem. So far, despite unemployment having fallen to 4.3% in the US, inflationary pressures, and particularly wage pressures, have remained subdued, and below the Fed’s normal target before raising interest rates. There have been a number of hypothesises put forward as to the reasons, including the effects of technology, or the percentage of the workforce under employed, and continuing to seek other work. However, monetarist economists argue that inflation is a function of the velocity of money, which has simply been much weaker in an environment where banks have been seeking to deleverage and build regulatory capital, whilst unemployment is simply a coincident indicator. This argument will likely play out over the coming months.
Going into 2018, it would be easy to become cautious on markets on valuation alone, however, the economic backdrop remains a positive one, with the added potential that President Trump might get his tax cuts through in the United States. Although we have doubts about the additional economic stimulus that this will provide, it would likely support the US stock market through further share buybacks. Historically, valuation alone has not been a good indicator of the end of an economic cycle.
Whilst we remain constructive on markets, believing that the risk of recession is low, we are also cautious that inflation could yet rear its head, which poses a risk for markets trading at current valuations. Additionally, many of the traditional safe haven asset classes would provide little protection in this environment, leaving cash and target return strategies as some of the few places to shelter for investors.
Aside from the risk of inflation, another risk remains Chinese indebtedness, which we do not see as an immediate issue, but will likely become so if they do not resolve it. There is a high level of indebtedness in China amongst state owned enterprises and local government, whilst debt at the national level remains relatively low, certainly in comparison to developed economies. The Fed’s tapering of QE has only just begun, time will tell whether the private sector has the appetite to fill the gap, therefore the bond yields could rise without central banks touching interest rates. Geopolitical risks such as North Korea, or unrest in the Middle East have also not gone away.
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