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S&P 500 retests support

By David Morrison  |  02/07/2018 15:22
Emerging markets continue to sell off, China’s Shanghai Composite remains in a ‘bear market’ and this week will be disrupted by US Independence Day with Non-Farm Payrolls on Friday

As we go into the second half of 2018, the S&P 500 is retesting key support around 2,700. Partly this is a result of a $30 billion drop in the Fed’s balance sheet over the weekend as the US central bank continues to reduce its bond holdings as it no longer reinvests maturing debt. However, this comes against a backdrop of Fed rate hikes as inflation picks up and growing worries over the global economic outlook. Investors have become increasingly concerned by the escalating tariff rhetoric coming from the US and the tit-for-tat responses from China, the European Union, Canada, Mexico and others on the receiving end of Trump’s attacks. Perhaps of even greater concern was a report that the US president is prepared to leave the World Trade Organisation.

Meanwhile, fears grow that German Chancellor Merkel faces a split of her fragile coalition government over immigration policy. It appears that last week’s EU summit agreement on migration (such as it was) is not enough for Horst Seehofer, leader of coalition CSU and German interior minister. Herr Seehofer threatened to resign over the weekend in a move which would severely weaken Chancellor Merkel’s position and that of her government. He has since backed off meaning the immediate threat has passed. But the CSU remains concerned ahead of regional elections in October where there's a growing risk that the right wing AfD may upset the balance of power in Bavaria. 

On top of this, Monday saw China’s Shanghai Composite fall further into bear market territory (down 20% from recent highs) after it closed 2.5% lower overnight. The Chinese renminbi continues to come under pressure and is now at its lowest level in close to a year. On one hand this will make Chinese exports cheaper and go some way to offsetting tariffs. But it also makes it more difficult to repay dollar-denominated debt which is a serious problem for China and emerging markets. As can be seen, ongoing US dollar strength is hitting emerging markets resulting in steep declines for the Argentine peso, Brazilian real, Mexican peso, South African rand and Turkish lira, amongst others.

Meanwhile, the US yield curve continues to flatten. One of the main bond market barometers is the spread between the 10 and 2-year Treasuries. Last week this fell to 31 basis points, the lowest level in over 10 years. At the same time the 30-year/10-year is hovering around 12 basis points and is very close to inverting – an occurrence which typically signals that a recession will follow. But even without inversion, the flatter yield curve weighs on the profitability of the banking sector as financial institutions borrow short to lend long and need the comfort of a wide spread to counter lending risks. As this spread narrows banks are less willing to lend, crimping business expansion and making it difficult for corporations to refinance existing debt.

Last Friday the Fed’s preferred inflation measure, Core PCE, rose to 2.0% annualised, finally hitting the US central bank’s target. This suggests that the Fed will be happy to hike rates two more times before the year-end. This should keep the dollar supported but could present a headwind for equities and emerging market currencies. If the yield curve continues to flatten and there’s no backing down from Trump’s tariff rhetoric then we can expect volatility to pick up.

Looking ahead, trading volumes are likely to decline ahead of Wednesday’s US Thanksgiving holiday. But things should pick up on Friday when we have the release of US Non-Farm Payrolls for June. These are expected to pull back to 200,000 following the prior month’s larger-than-anticipated rise of 223,000. The Unemployment Rate is expected to remain steady at a 17-year low of 3.8% while Average Hourly Earnings (another indicator of inflationary pressures) are also projected as being unchanged from the prior reading of a +0.3% month-on-month rise.
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