Weekly Economic Focus: Strong US dollar drives equity markets lower 

By Alexander Forbes Investments on Nov 13, 2018 in Economic Insights

Last Tuesday’s US midterm Congressional elections produced a split, with Democrats taking control of the House of Representatives for the first time in eight years, and the Republicans increasing control of the Senate. These midterm elections produced what the US system was designed to do – to provide something for everyone and provide the necessary checks and balances to prevent any one of the three branches of government implementing radical policies as we have seen from the Executive over the past year.

The market consensus is that this outcome will not alter the current US policy path, implying that confrontational trade policy will continue, but a fresh tax cut and continued repeal of the Affordable Care Act is unlikely. Because of the hung Congress, we will likely enter into deadlock economic policy positions going forward, including spending ceilings, debt levels and positions on the US Federal Reserve (Fed) policy path. The fiscal cliff, debated a few years ago, is testament to this.

In Europe, the Italian government will resubmit its budget to the European Commission this week, after its initial submission was rejected due to lower-than-expected fiscal consolidation. A more stringent austerity path will increase tensions in Italy, yet without austerity, Italian debt problems will eventually have negative impacts on its growth. There are two points to take into account. First, Italy’s debt is the second highest in Europe after France and more than seven times higher than that of Greece, which would imply the contagion effects will be just as magnified as the 2011-2012 Greek debt crisis. Second, unlike Greece, 78% of whose debt was held by the foreign official sector, only 8% of Italian debt is held by the foreign official sector, which will mitigate the extent of contagion should Italy default on its debt (Figure 1 and Figure 2). These two aspects make it difficult to assess what the spill-over effects from Italy to the rest of the euro area and global markets would look like. However, it suffices to expect a significant volatility spike if Italy defaults, given its absolute debt levels and economic size within the euro area.

Trade negotiations will attract market focus this week following both US and Chinese authorities’ willingness to agree on a mutually beneficial trade deal. However, if we have learned anything from Trump’s approach to trade policy, it is that nothing is certain until it’s completed. We expect news flow from these discussions to impact markets negatively if there is no agreement, or positively if the two biggest economies reach a trade agreement.


US – Federal Open Market Committee (FOMC) points to a December hike  

The US FOMC kept rates unchanged at 2.25% at the November meeting. It noted that labour markets and economic activity continue to strengthen, while the inflation rate remains close to the Fed’s 2.0% target. The FOMC still expects to hike interest rates gradually over the next year, which according to its forecasts, shows one hike in December followed by three hikes in 2019.

The S&P 500 closed last week 0.7% higher while the technology-heavy NASDAQ was down 0.5%. Year-to-date (YTD), they are 3.2% and 7.9% higher, respectively. The US dollar index was up by 1.1% to 97 and the two-year and 10-year bond yields marginally declined to 3.11% and 3.18%, implying that the yield curve is a mere 7bp away from inverting.


Europe and the UK – Brexit negotiations and Italy’s fiscal issues continue

The major European markets declined last week. The Euro Stoxx, FTSE 100, CAC 40 and the DAX declined by 0.4%, 0.4%, 1.2% and 0.5%, respectively. However, they are all down YTD. Bond market performance varied by country. Bond yields on both the short end and the long end in Germany and the UK declined, while Italian bond yields rose, especially over the short term, due to debt problems.   


Emerging markets – Strong US dollar drives equity markets lower 

The MSCI Emerging Market Index declined by 1.6%, largely reflecting a 5.5% fall in Latin America where equity markets were down in Brazil, Mexico and Chile. Countries running significant twin-deficits – current account and fiscal deficits – saw their equity markets decline. Turkey led the pack with -3.6%, followed by South Africa and Russia with declines of 2.5% and 1.5%. Emerging market risk appetite generally fell, reflecting a degree of capital flight to safe-haven assets. With a hung US Congress, traditional economic wisdom is that it’s good for the US dollar and bad for the euro and emerging markets. This would imply that a short-term rebound is in store for US markets, but it will be short lived and will not lift the emerging market complex.


South Africa – Weak data underscore poor growth recovery

Economic data over the past week has been mixed. Mining production continued to contract in September and will subtract from 3Q18 GDP growth. On the other hand, manufacturing production rose in the month and will offset the decline in mining production. This week we expect retail sales to show a marginal contraction of 0.3% month-on-month, following an acceleration of 0.6% and 1.5% in July and August, respectively. For Q318, retail sales will contribute positively to GDP growth. Another less-prevalent indicator as far as market impact is concerned is wholesale sales, which we expect to post negative growth in September and 3Q18.  

We forecast GDP growth of more than 1.5% quarter-on-quarter, seasonally adjusted and annualised in 3Q18, up from -0.7% and -2.6% in 2Q18 and 1Q18, which means that the technical recession will come to an end. The big risk remains agricultural production, which was instrumental in the negative print we saw in the past quarter.

With that said, local asset class returns were in the red, except the tradable property index and cash, which returned 0.1% and 0.6% in October in rand terms. The JSE All Share returned -5.8% while the Top 40 retuned 6.7%. The Capped SWIX was slightly better but still in negative territory with -4.6%. Industrials were the biggest losers with -8.0%, followed by resources (-4.0%) and financials (-3.2%). This October recorded the second worst returns in 23 years.  


This week: Italy’s budget resubmission, US-China trade negotiations and US CPI inflation

Market focus will be on the implications of the US midterm Congressional outcomes on policy positions, particularly on trade. The initial assessment is that it’s unlikely to change the broad policy configuration. Italy will resubmit its budget to the European Commission after its initial submission was rejected because it did not comply with the required budget-deficit reduction path. China and US negotiations on trade will also take centre stage following indications from both Chinese and US authorities that they are willing to strike a mutually beneficial trade deal. US CPI inflation will also receive market attention given last week’s Fed statement that reinforced strong economic activity, improving labour markets and low unemployment. If the print beats expectations, US bond yields will rise and emerging markets will see a sell-off.

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Alexander Forbes Investments

Alexander Forbes Investments

Alexander Forbes Investments was established in 1997. We are a forward-thinking and trusted global investment provider, with roots in Africa. In pursuit of certainty we set out to understand our retail and institutional clients’ circumstances and risk tolerance to set clear goals. Our adaptive investment approach, called Living*Investing allows us to maximise opportunity and minimise risk at every stage of the investment cycle.

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