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Market Insights – May 28th, 2018

Weekly financial & economic analysis.

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Essentials

The financial markets – and particularly those in Europe – reacted strongly to the political uncertainties in Italy and Spain, which won’t be resolved overnight. In the meantime, Spain’s economy is doing much better than Italy’s, and this should soon be factored in by the markets.

The rise in US yields and the dollar’s appreciation have weighed on emerging currencies. The Turkish lira is one of the most vulnerable, and the country’s upcoming elections haven’t helped either. The markets are worried about a win by Mr Erdogan, who could bring in some rather unconventional monetary policies.  

After oil prices reached a recent high of USD 72 a barrel, some oil-producing countries such as Russia and Saudi Arabia ramped up production in order to rein in prices. The announcement had a brutal effect, with oil prices plummeting more than 5% in just a few days. We nevertheless think they are now nearing a zone of support.

The safety of gold

Following a short stint above the symbolic 3% threshold, US long-term yields seem to have slackened. It indeed looks like the Federal Reserve wants to continue tightening monetary policy very gradually, even if that means letting inflation inch slightly above its 2% target. This is what can be gleaned from the minutes of the Fed’s last meeting. What’s more, pessimism about US yields is at a record high, and bonds have rarely been so scarce in both private and institutional portfolios. The rise in US yields has also helped to push up the greenback and is starting to weigh on the more fragile emerging markets. A sharp increase in dollar-denominated yields tends to be bad news for emerging economies, which often replicate the Fed’s monetary policy. In prior macro cycles, an overly sharp rise in US yields has caused cracks to appear in some emerging markets, and even triggered major crises in some countries. Most recently, the Argentine peso and the Turkish lira have come under so much pressure that Argentina has had to seek help from the International Monetary Fund and Turkey’s central bank has had to ramp up interest rates. The situation in Turkey warrants the most attention given the size of the country’s economy, its large trade deficit and high debt levels. Generally speaking, fundamentals are still solid in most emerging economies, which are growing at a higher and faster pace than developed economies. In addition, commodity prices have picked up, which provides a boost to net exporters of natural resources – and therefore most emerging markets. After being punished recently, emerging currencies could start to gain ground if US yields and the dollar level off. But given the volatility that tends to come at the end of a macro cycle, gold is still a safe option – and could also be pushed up by a softer dollar. We have increased our holdings by buying on gold’s recent dip.

A potential dollar correction

Global news continues to boost safe-haven currencies like the Swiss franc and the yen, primarily against the euro. Major developments – like the arrival in power of eurosceptic parties in Italy, Turkey’s inability to restore confidence in its currency and the crisis in Venezuela – have all made investors more cautious recently.

In Europe, economic data have disappointed, with the purchasing managers’ index coming in below expectations and growth in German exports slowing. The eurozone’s economic surprise index is also at its lowest level since 2011. The euro’s 15% gain in 2017 could well be behind this trend, which could result in the ECB holding off on bringing monetary policy back to normal.

Indicators suggest that investors are very bearish on the euro but overly bullish on the dollar, and charts for the currency pair indicate that a relatively important support level has been reached. The euro might therefore experience a temporary rebound in the short term.

While President Mattarella’s refusal to appoint a eurosceptic as Italy’s finance minister provided some relief for the euro, it is likely to prolong the country’s political saga.

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