Politics dominated the past two weeks – weekly update 4 June

A look back over macroeconomic and market events for the two weeks ending 1 June 2018. Politics dominated, firstly with an anti-establishment stand-off in Italy, followed by the US imposing tariffs on several allies. The economic backdrop was more mixed with some disappointment in Europe but reasonable numbers out of the US.

Italy avoided a bitter return to the polls

Italy avoided an acrimonious return to the polls as the President approved the proposed coalition government formed of the radical left Five Star Movement (5SM) and radical right League parties. Both parties achieved significant gains in the March general election, but with no party gaining an overall majority, there have been several months of negotiation to try and form a government.

Last week Italy seemed to be heading towards a constitutional crisis when the President vetoed the selection of finance minister, spooking investors in peripheral Eurozone government bonds and equities. However by Friday with cooler tempers, an alternative, less anti-Eurozone, candidate was found and the President approved the incoming cabinet. Although this caused a minor relief rally, the prospect of an anti-establishment government in the Eurozone’s third largest economy is still likely to lead to a stand-off between Rome and Brussels. As part of the agreement, Giuseppe Conte, an academic with essentially no political experience, will become the Prime Minister with the two party leaders both becoming vice-premiers.

The 5SM leader, Luigi Di Maio, also becomes minister for labour and economic development, while the League leader, Matteo Salvini, becomes interior minister, giving them both control of their ideal policy areas. The two parties share a common trait in their anti-establishment politics, but otherwise their positions and philosophies are worlds apart, so ruling is likely to be fractious. Plans for tax cuts and increased welfare payments will be popular with the electorate but will blow out the deficit, breaching Eurozone rules and potentially unsettling investors. Italian politics still has plenty more news flow to generate.

Global trade war heated up again

Still on politics, the global trade war heated back up last week, as the US declared the imposition of steel and aluminium tariffs on key allies, effective from last Friday as the exemptions for the EU, Canada and Mexico were allowed to expire. The announcement that the exemptions would be allowed to lapse was only made on Thursday, just as the Italian situation resolved, and likely holding back more of a rally. All of the affected countries have vowed retaliatory action, and we covered some of the key EU targets in a previous note, while the G7 meeting over the weekend also took the rare step of rebuking the US.

The tariff imposition – implausibly on national security grounds – is yet another example of the strong-arm negotiating tactics of the Trump administration. These latest tariffs also come as the EU grapples with the issue of the US withdrawal from the Iran nuclear deal, which risks further tensions around secondary sanctions. While a full-scale trade war would be a serious headwind to our investment outlook, we don’t read too much in to the current bluster and will wait to see how the negotiations develop.

On that theme, the latest round of negotiations between the US and China ended on a sour note over the weekend, with no further headway and no joint statement, which seems likely to lead to fresh tariff threats from the US. On a more positive note for humanity, the US-North Korea denuclearisation talks are currently back on, though the gulf between the two sides’ core objectives remains vast.

Eurozone PMIs disappoint

Eurozone PMIs disappointed, but inflation surged. The Eurozone Composite PMI reading fell a whole point, from 55.1 to 54.1, against forecasts for no change, with both the Services and Manufacturing components dragging. Although this is still comfortably within the ‘expansionary’ range, the speed of the decline from recent highs clearly signals a cooling of momentum. Against this, there was a significantly stronger uptick in inflation, as Eurozone CPI jumped from 1.2% to 1.9% year on year (yoy), ahead of the 1.6% forecast, while the core measure, which strips out energy and food, rose from 0.7% to 1.1% (1.0% forecast).

Energy was the main driver of the increase on the back of the recent rally in oil prices, but there was also a notable increase from the services sector. This latter element could be enough to help European Central Bank President Mario Draghi take a more hawkish tone at the upcoming meeting, despite the question marks over economic growth and global trade tensions.

US non-farm payroll showed that 223,000 jobs were added in May

The US non-farm payroll release showed that 223,000 jobs were added in May, ahead of the 190,000 forecast, and with average hourly earnings rising 2.7% yoy, from 2.6% (2.6% was expected). Underemployment fell from 7.8% to 7.6% and unemployment dipped from 3.9% to 3.8% but this latter result was probably mostly caused by the 0.1% dip in the participation rate (to 62.7%). So overall an upbeat message, though other economic indicators were a little more mixed: the Composite PMI from Markit rose quite impressively from 54.9 to 55.7, but Durable Goods Orders contracted more than expected from an upwardly-revised 2.7% month on month (mom) to a -1.7% contraction in April (-1.3% was forecast). They were mixed overall, but the economic picture looks pretty stable, with no reason to see the Federal Reserve changing from its current trajectory.

Last week’s other events

• The Spanish parliament ousted Prime Minster Rajoy following a high profile political scandal. The Socialist Party’s Pedro Sanchez becomes Prime Minister, but leading a minority government with just 84 seats out of 350 (he does not even hold a seat himself). Given the divergent policies and priorities for the supporting parties, it is difficult to see much legislation being passed, and fresh elections are expected, though Prime Minister Sanchez has yet to suggest when these would be
• UK CPI inflation slipped from 2.5% to 2.4% yoy (forecast was for no change), whilst Core CPI, which strips out food and energy, slipped from 2.3% to 2.1% (2.2% expected). Retail Sales growth accelerated from 1.1% to 1.4% yoy, well ahead of forecasts for 0.2%, but still a fairly meagre number in absolute terms. Manufacturing PMI rose from 53.9 to 54.4 (53.5 expected)
• Eurozone Economic Confidence slipped from 112.7 to 112.5 (112.0 expected), whilst Consumer Confidence fell from 0.4 to 0.2 (0.5 was expected). Unemployment was unchanged at 8.5% (markets expected 8.4%)
• Japan saw Manufacturing PMI fall from 53.8 to 52.8. The All Industry Activity Index was 0.0% mom, from 0.4% previously and expectations for 0.1%. Retail Trade growth increased from 1.0% to 1.6% yoy (no change was expected)

The markets

It has been an eventful week for markets, with the Italian crisis driving investors into core sovereign bonds and away from peripheral Europe, as well as negatively impacting equity markets – especially those markets close to/with exposure to Italy.

Equities

US equities were the only market to make a positive return over the two weeks, shaking off Italian worries to trade mostly flat, with the S&P 500 returning 0.9% for the fortnight. UK equities were only marginally down, with the MSCI United Kingdom slipping -0.9% overall. With Continental Europe at the epicentre, European equities (MSCI Europe ex-UK) shed -2.3% for the fortnight, meanwhile the TOPIX index of Japanese equities fell -3.6%. The MSCI Emerging Markets index fell -0.8%.

Bonds

Core sovereign bonds retrenched on the back of safe haven flows, with 10-year German bund yields falling 19 basis points (bps) during the fortnight to 0.39%, having closed as much as 32 bps at 0.26% at one point. UK 10-year gilt yield yields were down 22 bps to 1.28% by the close on Friday, whilst the equivalent US Treasuries were 15 bps lower to 2.90%.

Commodities

Oil slipped from its recent highs during the fortnight, with Brent crude closing at US$76.79/barrel. Interestingly, gold was little impacted by the political turmoil and was barely changed on the fortnight, still below the US$1,300 mark at US$1,293/ounce. Copper was marginally stronger at US$3.10/lb.

Currencies

Yen strengthened across the board, gaining 2.0% against sterling. Sterling slipped -0.9% against the US dollar and was flat against the euro. Sterling closed on Friday at US$1.33, €1.14 and ¥146.

The week ahead

After a busy couple of weeks, it’s a particularly quiet week ahead. Early morning on Tuesday China reports the private Caixin Services PMI as does Japan, with the UK reporting Services PMI later in the morning, followed by Eurozone Retail Sales (1.8% from 0.8% yoy expected). On Friday, Japan and China will also report their latest trade data. Whilst the data release schedule may be quiet, however, there are still plenty of political tensions that are likely to occupy the newswires for the week ahead. The daily breakdown is as follows:

Monday: Japan updates on its monetary base in the early morning, with UK Construction PMI (52.0 from 52.5 expected) and Eurozone factory-gate pricing also out in the morning. In the US, Factory Orders are out (-0.5% mom from 1.6% expected).

Tuesday: The busiest day for data releases. Just after midnight, the British Retail Consortium reports Like-for-Like Sales, with Japan and China (Caixin) reporting Services PMI a couple of hours later. Later in the morning, UK Services PMI is expected to come in at 53.0 from 52.8, and Eurozone Retail Sales are also reported (see above). In the afternoon, the US reports JOLTS Job Openings and the Non-Manufacturing Composite PMI from the Institute for Supply Management (57.6 from 56.8 expected).

Wednesday: The only releases of any note are Japanese Labour Cash Earnings (1.3% yoy from 2.1% expected), and Eurozone Retail PMI in the afternoon.

Thursday: Japanese official reserves are updated early in the morning, with UK House Prices from Halifax also reported. We also have the latest revisions to Eurozone GDP later in the morning, whilst in the afternoon US Jobless Claims and Consumer Credit will be out.

Friday: Finishing the week, both Japan and China will report their latest trade data, and Japan will also present revisions to the first quarter GDP print, Banking Lending activity and the latest Eco Watchers business surveys, which will neatly wrap up a quiet week for data.