Investors face a test of nerve as the second quarter beckons.
The rally in US stocks and the dollar sparked by the election of Donald Trump is looking stretched, amid doubts about the president’s ability to deliver fiscal stimulus for the economy that can justify lofty equity valuations. The shifting mood has spurred money into emerging markets and European stocks, with EM currencies enjoying a stellar March and fund flows into Europe hitting their highest level in over a year. Signs of firmer growth in China has also lifted markets, notably commodities. However, with an output squeeze by Opec encouraging the US shale industry to produce more, the outlook for the oil price is particularly uncertain.
Against that backdrop, here is how analysts and asset managers view the risks and opportunities in the next three months.
The next stage of the Trump trade and US rate policy
Optimism over the ability of the White House and the Republican-controlled Congress to deliver on pro-growth plans, such as big tax cuts, are being questioned following the failure of proposed healthcare reforms.
Investors’ caution is evident in the best performing sectors of the S&P 500 this year, with tech and healthcare — markers of the Trump trade — leading the pack, but defensive stocks, such as utilities, outpacing the big beneficiaries of Mr Trump’s agenda like financials.
As investors watch Congress and the White House parry over legislation, economic data and first-quarter earnings as well as guidance from corporate America will help shape sentiment. Companies will begin reporting in early April.
“If we don’t get tax reform does that mean the market is a sitting duck?” says Jurrien Timmer, director of global macro at asset manager Fidelity. “To my mind it does not . . . Markets are very resilient and it is not all about Washington.”
Another key player in Washington is the Federal Reserve. After a policy tightening last month, the central bank surprised the market by maintaining a cautious outlook for the coming year.
Together with doubts over Trump’s capacity to execute his agenda, the Fed’s caution has been enough to send US Treasury yields lower and the dollar has eased. But some worry markets are looking complacent over Fed policy. Any sign of inflation gathering pace, and the labour market tightening further, may well spur a reassessment of the current view that the Fed will tighten policy just twice more this year. After all, in late February the bond market was not expecting a March move.
EM assets experienced a strong first quarter of the year, both in terms of real economic growth and inflows of investment capital. GDP growth among all emerging economies rose to an average 4.4 per cent in the first three months of the year, up from 4.1 per cent in the fourth quarter, according to an unofficial “tracker” compiled by Capital Economics, a research firm. Not only does this level mark a three-year high, there are also signs that momentum is spreading from China to Latin America and eastern Europe.
Any upsurge in US trade protectionism, particularly with China, has the potential to damp EM exuberance, analysts said. But for now, investors are ramping up their exposure to the developing world, cheered by the fastest trade growth for seven years and ebbing EM inflationary pressures. Sovereign bond issuance by emerging markets hit an all-time quarterly record in the first quarter, while flows of portfolio capital into EM stocks has been strong.
French presidential election
The stakes are high for the euro heading into the first round of the election on April 23, and investors will be watching the polls with all the more trepidation after the shock of Brexit and the election of Mr Trump. A victory for Marine Le Pen’s National Front is seen as less likely, given the contest takes place over two rounds of voting.
“If Le Pen wins through to the Elysée Palace in May it would pose an existential threat to the euro,” says Stephen Macklow-Smith, head of Europe equity strategy at JPMorgan Asset Management.
“But we think the barriers to her doing so are very high. In the first round, against a fragmented political spectrum, she will do well, and possibly even top the poll, but in a second round run-off she is likely to lose out to a centrist candidate . . . I think the chances of a euro break-up in 2017 are zero.”
1. Mario Draghi, ECB president, calls euro strength a “serious concern” and “all instruments” would have to be considered to stimulate economy
2. ECB announces it will buy €60bn of bonds each month from March in programme of quantitative easing
3. Matteo Renzi, Italy’s prime minister, loses referendum on constitutional changes tied to reform agenda, raising chances of early elections
4. Prosecutor opens preliminary investigation into possible misuse of public funds by French presidential frontrunner François Fillon, a boost to the far-right Marine Le Pen
Since its March meeting, expectations that the ECB will be able to lift rates before the end of the year have grown, and attention will focus on any signs of a more hawkish mood on the governing council and a scaling back of its bond-buying programme.
ECB president Mario Draghi’s room for manoeuvre is likely to be constrained by the proximity of the French election — first-round voting takes place four days before the April 27 ECB meeting. Adding to that sense is a retreat from the high levels of inflation that has helped fan market expectations of a tapering.
“To move from tapering to a first rate hike requires higher inflation rates, a pick-up in wages and a further strengthening of the economic recovery,” argues Carsten Brzeski, chief economist at ING.
“The possible exit sequencing — whether there will be a rate hike before or only after the end of QE — is likely to remain a subject of market speculation for a while.”
Brexit-watchers should split this quarter into three — four weeks of calm, the must-watch April 29 EU summit and then a period of market turbulence as investors digest the first skirmishes in negotiation.
The key early questions are: how red are each side’s red lines, particularly the thorny issue of sequential negotiations? And by extension, is the market’s big fear, the “no-deal” scenario, possible?
Watch out for the unity of the Conservative party to come under strain, and plenty of debate about transition or extending the two-year deadline, as French and German elections eat into negotiation time. There is “lots to negotiate”, but “little time” say Citi analysts, echoing plenty of others.
The pound should continue trading erratically without breaking the $1.20-$1.27 range, while gilt yields stay low and UK equities are driven by other factors such as global growth, the oil price and merger and acquisition activity.
Data will provide the pound’s next major test. Is the economy continuing to resist Brexit-related uncertainty and, if so, how will the Bank of England respond? Negotiation headlines will matter, but not as much as the BoE’s inflation report on May 11 and its next meeting in the middle of June.
Opec and the oil price
Oil spent the first quarter testing the limits of the so-called “shale band” — the idea that crude is trapped between the price at which US frackers get squeezed and the level at which they flood the market.
That band is increasingly narrow, with less than $10 a barrel separating Brent’s high of $58.37 and low of $49.71 in the last three months. Opec, whose efforts to prop up the market through supply cuts have been blunted by the shale industry’s rebound, will be hoping stronger demand in the run-up to summer will provide them a much-needed boost.
The cartel meets on May 25 to agree whether to double down on the supply cuts agreed with allies like Russia late last year. Opec wants to see bloated inventories of crude and products globally start to decline so they can show shale alone can’t replace their supplies. Don’t bet on the band snapping before then.
Reporting by Joe Rennison, Michael Hunter, Roger Blitz, James Kynge and David Sheppard