Weekly market wrap

By David Morrison  |  01/06/2018 14:29

This article looks at the latest US Non-Farm Payroll release, US tariffs and the Italian coalition government
 
Look-ahead

Now that US Non-Farm Payrolls are behind us, it’s set to be a quieter week as far as economic data releases are concerned. Nevertheless, on Monday we have Australian Retail Sales and UK Construction PMI while Tuesday brings a rate decision from the Reserve Bank of Australia along with UK Services PMI and the US equivalent, the ISM Non-Manufacturing PMI.

We could see further fall-out from the US decision last Thursday to go ahead with tariffs on aluminium and steel from the EU, Canada and Mexico. This may unsettle markets going forward, although investors were quick to take advantage of an equity sell-off to dive back in on the buy side on Friday morning. Adding to positive sentiment, it looks as if Trump will meet with North Korea’s leader Kim Jong-un, even if this doesn’t take place on the 12^th June as originally planned.

Overview

Friday’s Non-Farm Payroll number was much stronger than expected, coming in at +223,000 on expectations of an increase of 190,000 in May. The Unemployment Rate dropped to an 18-year low of 3.8% against a forecast of 3.9%. But US stock index futures initially pulled back from their pre-announcement highs, reacting to Average Hourly Earnings which rose by 0.3% month-on-month (2.7% year-on-year) above the 0.1% (2.6%) expected suggesting that a further pick-up in inflation was on the cards. The news also saw the dollar spike higher while precious metals sold off.

There were some other important US data releases last week. Friday also saw the release of the US ISM Manufacturing PMI. This came in at 58.7 which was better-than-expected and a solid improvement from the prior reading of 57.3. This is an important data release as it is an index based on a survey of purchasing managers in the manufacturing sector. It is forward-looking, and this strong number will feed through into second quarter GDP, offsetting recent fears that US economic growth is slowing.
Earlier in the week first quarter GDP was revised down to +2.2% from +2.3% annualised while Core PCE (the Fed’s preferred inflation measure) came in at +1.8% year-on-year, unchanged from the prior month, and still below the Fed’s 2.0% target.

Putting this all together, weaker data gives traders an excuse to row back on their expectations for Fed rate hikes for the rest of this year. Considering minutes from the last FOMC meeting, Committee members are evenly split between raising rates by an additional two or three times in 2018. The market expects a 25 basis-point rise at the next meeting on June 12th-13th. But the big question is whether the Fed will go on to hike in both September and December, or pause in the third quarter and then reassess the state of the US economy? As things stand it’s difficult to know. In favour of a pause, the Fed has made it clear that it is prepared to see inflation overshoot its 2% target and may be in no rush to hike aggressively even as inflation indicators tick higher. In addition, there were signs that US economic growth may be rolling over as evidenced in last week’s downward revision to first quarter GDP. But Friday’s strong ISM Manufacturing PMI argues against this if it foreshadows a growth pick-up in the second quarter. On top of this, Fed Chair Jerome Powell has indicated his willingness to ‘normalise’ interest rates. If inflation and GDP growth head higher, investors should prepare themselves for a rise in borrowing costs as well.

As far as Europe is concerned: on Friday markets shrugged off news that Spanish Prime Minister Mariano Rajoy lost a confidence vote and was replaced by opposition Socialist Party leader Pedro Sanchez. Mr Sanchez is considerably better looking than Mr Rajoy, but perhaps more significantly is, like Rajoy, pro-EU so won’t be rocking the boat.
The same can’t be said of Italy’s new government with the two coalition partners, Northern League and Five Star, solidly Eurosceptic. The new coalition wants the European Union (EU) to lift rules that limit public spending. This would increase Italy’s national debt which currently stands at 130% of GDP – well above the EU’s 60% limit. There’s also talk that the coalition wants the EU to write off a chunk of Italian debt. The coalition is also understood to be looking at issuing securities which look suspiciously like a currency parallel to the euro. This has raised fears that Italy would at some point abandon the single currency completely.  

FOREX

In the middle of last week, the US Dollar Index pulled back from 2018 highs on profit-taking and as the euro strengthened as the panic sell-off in Italian debt reversed sharply. But buying interest resumed on Thursday as investors sought out a ‘safe-haven’ currency after the US confirmed that the EU, Canada and Mexico would face tariffs on steel and aluminium with effect from June 1st. Canada and the EU have promised retaliatory tariffs, although it is unclear if this will escalate into an all-out trade war.

But overall, the euro had a better week after a compromise was reached between Italy’s President Sergio Mattarella and the leaders of the two main Italian Eurosceptic parties, Matteo Salvini of the Northern League and Luigi Di Maio of the Five Star Movement. It was confirmed that Giuseppe Conte would be sworn in as Prime Minister and a governing coalition would be formed, negating the need for another General Election. The job of economics minister goes to Giovanni Tria. Professor Tria has been critical of the European Union’s governance but supports Italy’s continued membership of the Euro zone. This contrasts with the previous candidate Paolo Savona (controversially vetoed by Mattarella) who has been highly critical of the single currency.

Italy is now governed by two Eurosceptic parties who will look for concessions from the European Union (EU), such as the writing off billions of euros-worth of Italian debt or increasing budget deficits. If the EU refuses, then there will be a showdown which could lead to threats by Italy to bring in an alternative currency or leave the euro all together - even if that isn’t in the country’s best interests. But if the EU gives in to Italian demands, this will place enormous strains on the single currency which the European Central Bank (ECB) will struggle to control – despite ECB President Mario Draghi’s promise to “do whatever it takes” to save the euro.

Last week the EURUSD fell to within a few cents of 1.1500 and hit its lowest level since last summer. It subsequently recovered, but looks vulnerable to further weakness. However, investors were encouraged to buy euros after Euro zone inflation came in stronger than expected. The news reignited speculation that the ECB is preparing to release a timetable for ending its Asset Purchase Programme. However, it’s worth remembering that at +1.1%, Core Euro zone CPI is still well below target while recent data (such as Services and Manufacturing PMIs) have pointed to a patchy, if not weak, economy across the currency union.
 
Crude oil
 
Both Brent and WTI steadied last week after a dramatic sell-off ahead of May’s long holiday weekend. The pull-back was triggered by a report from Reuters that Saudi Arabia and Russia were considering an output boost of around 1 million barrels per day (bpd). This would be done by reducing the OPEC/non-OPEC production cut agreement from 1.8 million bpd to 800,000 with the OPEC meeting later this month being the venue for an announcement. An increase in supply would help to offset production lost as Venezuela struggles with its economic meltdown and as US sanctions against Iran kick in once again. Both countries are OPEC members. Meanwhile, US production hit a fresh record high of 10.47 million bpd. This has contributed to the premium of Brent over West Texas hitting a three-year high at over $11 last week, doubling in less than a month.

Chart-wise, WTI is trading near the bottom of an upwardly-sloping trend channel which began to form last summer. It is also finding support around $60. Brent has broken above the top of its own trend channel and should find support around $75 unless its premium over WTI drops back significantly.
 
 
Key events next week

Monday -             AUD Retail Sales; GBP Construction PMI; USD Factory Orders

Tuesday -             CNY Caixin Services PMI; AUD RBA Cash Rate and Rate Statement; EUR Final Services PMI, Retail Sales; GBP Services PMI; USD ISM Non-Manufacturing PMI, JOLTS Job Openings

Wednesday -     AUD GDP; CAD Trade Balance, Building Permits; USD Crude Oil Inventories

Thursday -           AUD Trade Balance; EUR German Factory Orders, Euro zone Revised GDP; USD Unemployment Claims

Friday -                 CNY Trade Balance; EUR German Trade Balance; GBP Manufacturing Production, Inflation Expectations, Industrial Production; CAD Unemployment Rate; USD Final Wholesale Inventories
 
 
 
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