"Reflation" equity trades have reversed course due to US policy uncertainty
The British PM, Theresa May, triggered Article 50 of the EU Treaty on March 29th, commencing the process of the country’s withdrawal from the EU, which is provisioned to formally conclude in two years.
However, the timeframe will be challenging, as talks regarding the country’s future relationship with the EU could be complicated and lengthy, and new trade agreements with the EU will need to be negotiated.
Thus, a transitional agreement could emerge (following the two-year deadline), allowing talks to be extended and avoiding uncertainty over trade impediments in 2019.
In the US, investors will monitor the administration’s next steps on economic policy, in order to better assess its ability to pass new tax legislation.
Recall that US Federal Debt as % of GDP stands at 77%, a level only previously witnessed shortly after World War II, while the CBO estimates that, under current law, it should reach 89% by 2027. At the level of general government, which adds the debt at the state and local level, the debt stands at 108% of GDP.
The Federal Deficit is projected to reach 5.0% of GDP in 2027 from an estimated 3.2% in 2016, mainly due to higher interest payments and health care spending (see graph). Thus, the US administration has limited fiscal room under its pledge that, overall, the interventions on tax policy will be fiscally neutral.
ECB officials during the past week reduced the probability of an imminent change in the sequence of forward guidance (ending QE and then increasing interest rates). The weakness in March CPI data for the euro area, albeit likely transitory, corroborates that view (see Economics section).
Global equity markets were up slightly on a weekly basis (MSCI World: +0.5% wow), due to positive economic data and as investor concerns have eased regarding euro area politics. The Eurostoxx overperfomed, rising by 1.7% wow.
For Q1:2017, global equities increased by a strong 6% (MSCI World in USD terms). However, “Reflation” trades have lost significant ground and/or have plateaued lately (small vs large caps, value vs growth, cyclicals vs defensives – see graph below) due to increasing concerns over the Trump’s administration capacity to proceed with its pro-growth agenda.
Oil prices rose, as investors gradually turned more confident regarding an extension (likely by 6 months by end-2017) of the agreement between OPEC and some non-OPEC producers to curb production by 1.8 mb/day and due to news of oil supply disruptions in Libya. The WTI was up by 6.9% wow to $50.6/barrel and, as a result, US HY spreads, which are dominated by the energy sector, narrowed by 15 bps wow to 392 bps.
The combination, during the past week, of dovish ECB comments and several Fed officials maintaining a hawkish view, caused the euro to decline by 1.3% wow versus the US dollar to $/1.065.