It will come as no surprise that politics has been the driving force behind the weak investor sentiment of late. Surprisingly, economic fundamentals have actually been developing more positively than many would have expected this year, as demonstrated by China’s PMIs overnight (slightly beating expectations).
However, President Trump’s indiscriminate twitter gun has clearly enflamed tensions and elevated risks. So far, Trump’s well publicised aim has been largely focused on China but with Mexico being the latest country to come under scrutiny – this latest threat calls into question the fate of the United States-Mexico-Canada Agreement, which the three countries hammered out last year as the successor to the North American Free Trade Agreement.
Whilst the Chinese tariffs announced so far may only have a small direct effect on growth and inflation in both major economies, there is a little more concern around the Mexican tariffs given its trade exposure to automobiles and parts; the rising costs for the US auto industry could be crippling, having a bigger negative impact on US growth.
Moreover, the second-order dynamics via financial markets and confidence will be more significant and less predictable. It also begs the question – who’s next? With Europe, Canada, Japan all waiting in the wings to potentially face the wrath of tariff threats.
And if we know one thing, markets do not like unpredictability…
Away from the US, a familiar theme of politics above fundamentals is being echoed. In the UK, Brexit headlines has dominated sentiment for the last 2 years; as highlighted in last week’s big picture, there are now no fewer than 13 candidates for the PM job. In Germany, Angela Merkel’s coalition (SPD) has resigned, raising new doubts about the durability of the Chancellor’s ruling coalition with the center-left party. In Italy, the right wing League party’s anti-EU rhetoric in particular has gone up a notch after its victory in European parliamentary elections, with its chief Matteo Salvini insisting that Rome should cut taxes to boost growth, rather than abide by “obsolete” EU fiscal rules that could choke the economy.
This has clearly shifted the landscape for markets in May, igniting concerns about global growth. There was a uniform risk-off move across the complex – the highlights include Bunds going from 0% to a multi-century record low of -0.202% and the S&P500 (-6.2%) having its 3rd worst month in the last 92 behind only December and September last year which saw declines of -9.0% and -6.8% respectively. Clearly, Asian stocks were most acutely affected with the MSCI Asia ex-Japan (AxJ) Index is down 10% from its April peak, though it’s still up 3% for the year.
Oil markets had been the laggard of the risk complex, however it appears the US-Mexican feud, continued geopolitical tensions around Iran and Venezuela coupled with rising inventories have clearly caught the oil market off guard.
Positioning and flow indicators have showed large outflows from equity (-$10bn) and HY (-$3bn) funds, but inflows to other bond (+$10bn) and money-market funds (+$12.9bn) – demonstrating the typical flight to safety trade although it is important to note that as summer approaches, seasonality also plays an important role (the “sell in May and go away” effect).
This is further supported when looking at realised volatility levels, as depicted by the chart above; interestingly all is still orderly and there are no signs of panic. This also clearly explains the recent lack of FX sensitivity to news-flow or data.
However, last week’s repeated US yield curve inversion (when long-term rates fall below short-term rates — typically a precursor to a recession) saw the 3-month Treasury bill’s yield cross above 10-year note yields in the widest divergence since the 2008 financial crisis.
If this continued downward pressure to US stocks persists, recent history has suggested that the FED will unleash their dovish monetary policy shift and it appears the money markets are betting as such, with over 50% being priced in for a July rate cut – USD will inevitably have to react accordingly.