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Risk Aversion Returns to Markets

Weekly Investment View – 4 June 2017

Nervousness crept back into markets at the end of last week as recent US economic data in non-farm payrolls showed a lower increase than expected. 138,000 non-farm jobs were created in the month of May that fell short of the 182,000 that were expected. The Dollar tested the lows for the year treading water at pre US election levels from last year. The dollar Index (DXY) closing at 96.715 around the yearly support level. Earlier in the week China’s Caixin PMI manufacturing data also fell short of expectations casting doubts on the durability of world growth expectations. A terror attack in London over the weekend may also hit sentiment in the coming week. It was a big week for crude oil. The commodity finished the week lower with the WTI measure closing at $47.66 as markets assessed Trump’s anti climate change stance with respect to the Paris accord. The pull out signals a ‘freer’ US oil industry that could raise production levels from previously politically contested areas of the US shale industry. Simultaneously, The Energy Information Administration (EIA) published its report on US crude inventories that were down for the eighth consecutive week. American refineries continue to run at record output that is going hand in hand with strong export volumes. Domestic crude production now stands at 9.342 million barrels per day, the highest since August 2015. US stock market indices were at odds with the risk off tone, registering record closes in the Dow, S&P 500 and the tech heavy Nasdaq. Cash continues to flow into global equity markets from the US to Japan that has seen the recent earnings season pass with no real disappointments.

UK general election off the cards?

The UK terrorist attack over the weekend has opened the debate as to whether the general election can continue. Campaigning has already been suspended following the incident. Before this had happened, Theresa May’s Conservative Party has suffered a large fall in the opinion polls, with the UK general election due later this week”

Theresa May, UK Prime Minister, called a snap election last month for the 8th June in the hope of winning a larger parliamentary majority and strengthening her position ahead of crucial Brexit negotiations, with the start of those talks now delayed until 11 days after the election result. Mrs May’s Conservative party needs a good majority, although in recent days hasn’t looked so assured. Initially, she had been a clear front-runner. Some mistakes by Mrs May and her advisors, mainly relating to her having to make policy U-turns on social care and national insurance, have meant she is on the back foot. Opinion polls prior to the attack gave her a lead of just 5% that was down from a high of 23-25% just after the election was called. Her opponent, Labour leader Jeremy Corbyn exploited the U turns made by Theresa May in campaigning. As things stand, if the Conservatives lose just six seats, Mr Corbyn could become prime minister. This comes after the Conservatives made such large gains in local elections on the 4th May, after which Mr Corbyn looked vanquished. Last week Labour had fought back with policies such as the proposed renationalization of the railways, the abolition of student tuition fees, and putting more police on the streets. The leak of Theresa May’s manifesto before it was ready to be launched was viewed as a serious error, detailing a plan to make the elderly pay for their own social care until their total assets fell below Pounds 100,000, with a cap on the amount they would have to pay being removed. This was promptly reversed, with Mrs May saying, ‘don’t worry, nothing has changed’. Unpopular changes to national insurance were also reversed. Then followed the Manchester bombing, which was difficult to interpret in terms of its effect on the election, with campaigning suspended for a short respectful period at that time. Now with the latest attack on London and a campaigning suspension it remains unclear how this will play out. The markets may be gripped by the fear of a no win situation in a ‘hung parliament’.

“Global and domestic investors in UK assets would take fright at a ‘hung parliament’ ”

Theresa May has campaigned on the main ticket that she and her colleagues are the correct team to successfully counter the aggressive negotiating position on Brexit being taken by the European Commission. The terms of Brexit are justifiably the immediate, defining overall issue in the campaign, however the Labour Party hasn’t particularly wanted to discuss Brexit, being more comfortable sticking to the usual discussion of the lack of funding in the national health service or the high average numbers of pupils in classes in state schools. Last week a YouGov poll in the Times, and apparently based on a new methodology, suggested the Conservatives may fall short of an overall majority (by 16 seats, to be exact). Various other polls published in recent days have indicated a ‘hung parliament’, with no single party having a majority. Early last week Mrs May told voters that if Mr Corbyn was elected he would be very unlikely to take on the EU in an effective manner, with the implication there would be dire consequences if he was in charge of it. As mentioned, Brexit negotiations scheduled to begin just 11 days after the proposed In recent months there have been some European elections in which opinion polls were accurate in determining the voters’ mood. UK opinion polls last year predicted incorrectly the outcome of the Brexit vote. Our indicators suggest the house view being a win for the Conservatives but with recent events it is hard to say now. A hung parliament would almost certainly be very bad news for the UK, as it would result in a large reduction in bargaining power going into the crucial Brexit negotiations – and (just as Mrs May had planned) the next UK general election would not normally take place until well after the UK has left the EU. If Mrs May ends up having to scramble about looking for political support in a hung parliament, that would be the exact opposite of what she had envisaged – and it would be taken very badly by the markets, with weak sterling being unable to support UK equity indices. In the immediate short term recent gains seen in Sterling may see a pull back as a result. Longer term the fundamentals of the Uk economy remain anchored and we maintain the longer term forecast of an exchange rate of 1.35-1.40 range for the British Pound versus the US dollar. 

“The People’s Bank of China has strengthened its currency on a tactical basis”

The Chinese authorities are continuing their efforts to reduce financial risks in their economy, with the cost of domestic borrowing continuing to rise. The authorities have issued new rules designed to discourage banks from using borrowing to invest in bonds, and/or the further growth of unregulated (‘shadow’) banking. The Chinese yield curve has become inverted (with short-term rates higher than those further out in time). Since the beginning of the year the yield on Chinese 10-year sovereign bonds has risen from 3.05%, to 3.63%. As mentioned in last week’s report, Moody’s downgraded China’s credit rating, partly due to a concern that its total debt is continuing to rise, as potential economic growth slows. The authorities appear to have tightened the credit squeeze already in place, in a renewed attempt to de-leverage as much of the Chinese economy as possible – although they must also be very mindful that any kind of crash must be avoided. In recent economic data, the official manufacturing PMI published by the National Bureau of Statistics came in at 51.2 for May, unchanged from April’s level (and above expectations of 50.0). The official data tracks larger entities, primarily SOE’s (‘State Owned Enterprises’), whereas the private sector Caixin/Markit Manufacturing PMI fell to 49.6 (vs. 50.3 in April), so registering a contraction in activity (below a reading of 50.0). The official services PMI came in at 54.5 for May, up from 54.0 in April. The offshore yuan/renminbi (‘CNY’) has been strong against the dollar recently, and not simply because the dollar has been weaker on its index. During the last three years we have only seen the People’s Bank of China (the central bank) depreciate the CNY, but now the PBOC appears to be making a U-turn, appreciating the currency. Indeed the offshore currency has had what is historically quite a large move, moving from $ = 6.8800 on the 23rd May, to 6.7500 last week (and vs. the official rate of 6.8100). In the view of our Asia FX & Rates desk in Hong Kong, the PBOC engineered the move after coming up with new mechanism for the daily official fixing. In our colleagues’ opinion, the PBOC wanted to appreciate the CNY before the likely US Fed rate hike later this month. The PBOC is thought to have understood very well that had they not made such a move – which may have allowed the official rate to weaken above the 7.0000 level if the dollar strengthens across the board upon confirmation of the rate hike, it would have been more difficult for them to prevent renewed cash outflows from the country. By pushing the spot rate lower while the dollar is still rather on it’s back foot, the PBOC has given themselves more room later for future dollar strengthening/yuan depreciation. The conclusion from our Asia desk is that the strengthening in the offshore yuan has gone too far, however, and that seeing 6.7700 (and possibly down to 6.7300) would be a good opportunity to go long the US dollar vs. the offshore Chinese currency on a tactical basis.

Italy back in focus

Italian government debt has been doing badly relative to its peers as investors consider the prospect of an earlier-than-expected general election. Italy is the EU’s third largest economy. Former PM Matteo Renzi has raised the possibility of an autumn vote – it does not have to be held before 23rd May next year The country has had an interim government since Mr Renzi’s resignation last December. Mr Renzi, of the centre-left Democratic party, is backing reform of the country’s electoral system that might lead to a snap election in months. He also said a vote coinciding with Germany’s September elections would “make sense” The populist/eurosceptic Five Star Movement (‘M5S’), and Silvio Berlusconi’s centre-right Forza party have also come out in favour of a move to a proportional system, The unexpected convergence of political opinion in favour of voting system reform suggests President Mattarella may dissolve parliament before the summer break, The existing government is still struggling with the restructuring of Italy’s oldest bank, Monte dei Pashchi and must maintain tough austerity measures to abide by EU budget rules Under the mooted electoral reform, parties may need to gain just a 5% threshold to enter the lower house of parliament and analysts have said this raises the prospect of a hung parliament – although it could also lead to a ‘grand coalition’ of pro-EU parties The scenario most spooking markets would be a rival eurosceptic alliance between M5S and the Northern League. One commentator said that much more groundwork is needed on the electoral system before a snap election can be held, First, the government has to be voted down in a no-confidence vote, then the President dissolves parliament and calls the election - suggesting 50- 70 days after parliament is dissolved Latest opinion polls put Renzi’s PD party slightly ahead of the anti-establishment Five Star Movement, which makes Italy the biggest risk for the eurozone in the eyes of investors

INVESTMENT SUMMARY

The Asset Allocation committee met last week and by and large remains larelgy unchanged in its strategy. The committee views it appropriate to remain ‘risk on’ led by an ‘overweight’ in European and US equities. The committee remains ‘overweight’ the US dollar and ‘underweight’ investment grade government bonds. Within this sub asset class the committee decided to further underweight the ‘conservative’ profile to bring the underweight in investment grade in line with the other profiles of balanced and moderate. It remains appropriate to be ‘overweight’ high yield bonds as well and playing long crude oil by being ‘overweight’ MENA equities that are viewed as cheap with respect to other global equity markets.

For any inquiries related to this article, please contact Alain Marckus or Clint Dove.

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Weekly Investment View – 4 June 2017

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