Risk appetite improves, on the back of earnings growth and easing trade tensions, ahead of the US mid-term
US labor market conditions improved further in October, with stronger-than-expected job growth (+250k vs 12-month average of 211k | cons: +200k), the unemployment rate stable at a multi-decade low (3.7%), and wage growth accelerating (up by 0.3 pps to 3.1% yoy, the highest since April 2009).
Economic growth may ease from here (based on weaker business surveys and slowing GDP), but remains sufficient for further labor market gains. To contain an overshooting of the labor market, financial conditions may need to tighten further, and growth to slow. In the event, policymakers could remain calm regarding the tightening in financial conditions since the last FOMC meeting (September 25-26).
The Fed is expected to remain on hold at its meeting on November 7-8, in view of stable inflation data (core PCE unchanged for a 5th consecutive month at 2.0% yoy in September), and to resume rate increases in December. Recall that the Fed currently expects its policy rate at 3.00% - 3.25% by end-2019, implying 4 more hikes from current levels (2.00% - 2.25%). After better-than-expected labor market data, investors assign a 20% chance to that scenario, up 6 pps from a week earlier.
Regarding the US mid-term elections (November 6), consensus expects the Democrats to gain control of the House of Representatives, while Republicans are set to retain their Senate majority. In the event of a split Congress, the US administration could face increased opposition to its policy agenda (e.g. trade). Chances of further fiscal stimulus would rise if Republicans retained full control of the Congress, while the healthcare reform, seeking to reduce prices paid for drugs, would be a reasonable policy expectation under a Democratic party victory in both chambers. Overall, regulation-sensitive sectors (e.g. high tax companies or healthcare firms) may react strongly to either outcome.
The European Banking Authority’s stress tests, which covered 48 banks (70% of EU banking sector assets), suggested enhanced resiliency compared with a similar exercise in 2016. The test did not apply a pass/fail threshold, but its results will be among the inputs of the Supervisory Review and Evaluation Process (SREP) and for setting Pillar-2 Guidance. The adverse scenario (which imposed negative growth and real estate prices shocks) indicated a 395 bp decline for banks’ fully loaded common equity tier 1 (CET1) capital ratio from 14% at end-2017 to 10.1% at end-2020. Intra-bank CET1 level dispersion was significant (6.3% - 34%), with two UK banks (Barclays, Lloyds) and one Italian lender (BPM) recording the lowest performance (<7% FL CET1). European banks declined on Monday (-0.9%), while their Italian peers came under further pressure (-1.6%).
Global equity markets rebounded in the past week (MSCI ACWI: +3.1% | -4.5% ytd), as EM stocks rallied (+6.1% wow) to their strongest pace in 2½ years, due to strengthening risk appetite and a broadly unchanged USD. Despite soft economic data (ex-US), equities rose across the board as investors focused on strong corporate earnings, ahead of the US mid-terms. Risk appetite in European and Asian markets was supported by reports pointing to an improved prospect for a US/China trade agreement (even preliminary) by the G20 Summit. However, White House advisor Kudlow played down that prospect on Friday (S&P 500: -0.6% on Friday).