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Market Insights – May 7th, 2018

Weekly financial & economic analysis.

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Essentials

The US dollar continues to gain ground. The diverging trend between US and eurozone economic data, together with ever widening yield spreads in favour of the dollar, is most likely behind the greenback’s sharp rally.The US dollar continues to gain ground. The diverging trend between US and eurozone economic data, together with ever widening yield spreads in favour of the dollar, is most likely behind the greenback’s sharp rally. US crude oil prices reached their highest levels since 2014 after Donald Trump again stated that the USA might withdraw from the Iran nuclear deal. These geopolitical tensions are good news for Saudi Arabia, which is hoping prices will remain buoyant in the run up to the privatisation of Aramco. The eurozone’s economic surprise index dipped to a recent low, on the back of weaker economic data so far this year. We think this is temporary, particularly since the global economy is in good health and the euro has lost ground recently.  

A surprise slowdown in Eurozone infla-tion

Investors have been wary of an upturn in inflation for some time now. Their fears were heightened earlier this year by signs of an ageing macro cycle, espe-cially in countries like the USA, which saw their economies pick up more quickly. The US economy has been ex-panding for almost ten years now and has created new jobs every month since October 2010. In the past, such a long period of growth has always ended up triggering a surge in inflation, prompting the Fed to put on the brakes. Investors are therefore betting on an upturn in inflation, spurred on by the ultra-loose monetary policies still in place across the globe. These policies have involved printing money – and sometimes still do. Economists think that inflation will start rising in the USA as wages inevitably pick up in an economy nearing full em-ployment (unemployment stood at 3.9% in April, its lowest level since 2000). Yet, despite a slight uptick in January, year-on-year growth in hourly wages remains very steady, coming in at 2.6% in April. This rate of growth is a long way from the levels needed to make inflation a linger-ing problem in the USA. But what can be said for the eurozone? The ECB is getting ready to start bringing monetary policy back to normal, but inflation has once again moved further away from the bank’s 2% target. In April, growth in prices slowed to 1.2% year over year, falling short of economists’ forecast of 1.4%. What’s more surprising is that core inflation, which excludes more volatile  energy and food prices, dropped even more sharply to 0.7% year over year. Again, it’s hard not to put this trend down to structural changes in the economy: digitisation and globalisation have no doubt held inflation back. In this climate, a severe tightening of monetary policies or a sharp rise in long-term bond yields is difficult to imagine. In fact, US ten-year Treasury yields seem to be resisting the psychological threshold of 3% in spite of the onslaught from speculators. Despite the old “sell in May” adage, we think that investors will return to the stock markets, prompted by prospects of a solid macro cycle that will be further extended by weak inflation.

South Korea: calm waters ahead

The recent meeting between the leaders of North and South Korea was a first in many ways. While talks have been held in the past, a North Korean leader has never before entered the demilitarised zone. The main takeaways from the meeting are that both sides would like to replace the armistice with a peace agreement and denuclearise the Korean peninsula. But that’s nothing new: previ-ous summits have ended with similar intentions. But refusals to allow inspec-tions by international nuclear experts have always put a spanner in the works. Pyongyang’s announcement that it would shut down one of its main nuclear test sites is therefore a very encouraging sign. The next step will be the meeting with Donald Trump, which will probably be followed by a four-way summit in-volving China. The financial markets’ reaction has been positive but by no means euphoric as investors await more concrete progress. Risk premiums on South Korean debt have dropped, and shares on the Seoul Stock Exchange have outperformed slightly. We remain bullish due to the synchronised macro cycle but are not (yet) increasing our weighting. If the talks go well, we will increase our exposure to stocks that would benefit from a more open Korean peninsula (such as infrastructure stocks) and those that were side-lined by Bei-jing when tensions between South Korea and China escalated around the de-ployment of the THAAD missile system.

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