#Market Strategy — 05.06.2018

Between Economic Relief And Political Concerns

Xavier Timmermans

Stronger-than-expected job creation in the US and the formation of a new government in both Italy and Spain reassured the markets, which rebounded strongly on Friday.

Last week was particularly turbulent, with the markets fearing a new euro crisis due to the political gridlock in Italy as well as fears of the consequences of President Trump's customs tariffs. Last Tuesday's trading session was marked by a 2.7% fall in the Italian stock market and a spectacular rise in Italian bond yields. Over the week, the Stoxx Europe 600 index limited its fall to 1.1% and the Italian MIB index to 1.3% while the S&P 500 gained 0.5%.

US employment report

The US economy created 223,000 jobs in May and unemployment fell to 3.8%, its lowest in 18 years. Average wages rose by 2.7% year-on-year, down from 2.6% in April. Over the last 12 months, on average 190,000 jobs were created per month. On this news, the dollar strengthened and bonds fell, with US 10-year yields falling to 2.91%.

Populist government in Italy

The formation of a government with the anti-establishment Five Star Movement party and the extreme right-wing party, the League, ended the longest political crisis since the war. This prevented new elections which investors had feared would become a referendum on euro membership.

The relief of the markets is probably only temporary, as the two parties in the coalition intend to meet their extravagant electoral promises. Sooner or later, the new government risks running up against the rules of monetary union and confronting the European authorities. It will not take much budgetary slippage for investors to become fearful, as Italian debt has already reached 130% of GDP. Italian bond yields fell slightly but remain high. Investors still demand a political risk premium.

Customs tariffs

Last Sunday, the third meeting of US and Chinese negotiators in Beijing resulted in no agreement. Will the world's two largest economies move towards a $50 billion confrontation on 15 June?

China’s official news agency is talking of tangible progress without saying more. But it warns the US administration against any punitive customs tariffs that would derail negotiations that are supposed to last throughout the summer. The new threat of tariffs last week surprised and displeased the Chinese as it seems to contradict the truce announced two weeks ago by Mr Mnuchin.

It appears that a part of Trump's entourage is less inclined to conclude agreements quickly but aims to counter China's long-term strategic ambitions. If this argument prevails, it could bring further damage to the markets.

Europe was also surprised by President Trump, who went ahead with his tariffs on steel and aluminium while it hoped to negotiate an exemption. Retaliatory measures are likely to follow.

A step towards the internationalisation of Chinese stock markets

233 Chinese stocks listed on the continental stock markets ('A' shares) are now included in the MSCI Emerging index. This is an important step towards the opening up of Chinese stock markets to international investors, even if for the time being, these 233 stocks represent only 0.8% of the index compared with 30.5% of Chinese shares listed in Hong Kong and the US.  If 100% of ‘A’ Shares are included in the MSCI Emerging index, they would represent 16%, taking China's slice to more than 40%. This should occur over many years.

Looking ahead

Despite all these political uncertainties of threats of a commercial war, the S&P 500 index was positive in May and the MSCI World All Country is still above its 200-day moving average. Will it last? Part of the answer will stem from the usual economic data at the beginning of the month. The strength of the economy remains the best counterweight to political fears, as US labour market data have revealed once again.