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As we reach the end of the third quarter, there are a number of key themes that could have an impact on global markets.
The US Federal Reserve (Fed) is well ahead of other major global central banks in tightening monetary policy, both raising interest rates and running down its balance sheet, while US tax reform and dollar repatriation by large US firms adds to the scarcity of dollars abroad. This has helped to strengthen the US dollar.
The European Central Bank (ECB), Bank of Japan and Bank of England have been slower to tighten policy, but a stronger dollar has global ramifications as the US remains the world’s lynchpin economy. More expensive money makes investors warier of risky assets.
Equity markets entered a new, more volatile phase after the sell-off in February 2018, and we expect this to continue. Tighter dollar funding has hit emerging markets (EM), where borrowers face a rise in the cost of servicing dollar debts. EM assets look likely to remain under pressure in the short term.
This provides the fundamental backdrop against which markets have had to digest a range of political risks. Escalating tensions over global trade have become a major source of investor uncertainty, with markets clearly reacting to shifts in the tone of the debate between the US and China. It is tempting to conclude that a trade war harms everybody and therefore policymakers will rationally draw back from the most damaging increases in tariffs and other trade restrictions. But it is becoming clear that the US has lost patience with the trade deficits it incurs under the current system and is serious about securing meaningful adjustments. We expect uncertainty over trade will continue to dog markets until and unless some broader agreement is reached, in particular between the US and China and between the US and the Eurozone.
Markets have had to digest a range of political risks.
Oil prices have risen since the low point of around $30 a barrel in early 2016, almost tripling towards $80 a barrel, as the OPEC cartel of oil producing nations has been fairly successful in enforcing production curbs in an environment of strengthening global demand.
We think oil prices will be further supported by the Trump administration’s re-imposition of sanctions on Iran and reduced supply from Venezuela, struggling with a deeper economic crisis.
Higher oil prices act like a tax hike on consuming countries and are a headwind to growth. The impact on the US is likely to be swamped by the real tax cuts taking effect there but the Eurozone and Japan will face more of a drag, while higher oil prices will be another factor dragging down consumer emerging market economies including China and India.
The Brexit process remains a fundamental short-term driver for UK markets. Sterling and UK equity markets tend to react negatively to signs that negotiations are heading for a “harder” Brexit that moves further away from existing trade arrangements, as this is seen as likely to be more economically harmful. The UK government has spent the summer months trying to establish support for its desired approach.
We expect the debate will continue to be a key driver for UK markets until greater certainty on the outcome emerges. That may allow the Bank of England to return to raising interest rates, perhaps more quickly than the market is currently pricing in.
The Eurozone has been unable to shake off home-grown political risks, as concerns over the stability of the German government coalition arose almost as soon as worries over the formation of a Eurosceptic Italian government faded, which themselves came hot on the heels of tensions over Catalonian independence. How much European integration is desirable, and what form it takes, seem likely to be questions that will continue to roil Europe’s domestic and international politics and markets
It is sometimes interesting to think about what hasn’t changed, and in that light we think the ongoing stability of most longer-dated government security yields is worth mentioning. Most notably, US 10-year Treasury yields have drifted down even as the Fed has hiked rates and the market looks ahead to wider deficits (and more bond issuance), flattening the yield curve.
A flatter yield curve It is sometimes interesting to think about what hasn’t changed, and in that light we think the ongoing stability of most longer-dated government security yields is worth mentioning. Most notably, US 10-year Treasury yields have drifted down even as the Fed has hiked rates and the market looks ahead to wider deficits (and more bond issuance), flattening the yield curve. We think ongoing asset purchases by the ECB and the Bank of Japan are helping suppress yields. But global central bank net purchases will probably turn negative around the end of the year as the ECB winds up its programme. We remain on guard against the possibility of a sharper rise in yields, which could hit equity and credit markets.
Andrew Colquhoun, senior asset allocation manager, discusses why a stronger dollar and higher price of oil are key factors for the rest of the year.