Shenanigans in the White House and a political crisis in Brazil spark markets into life
After months of declining volatility, a turn in risk sentiment saw a flight to quality trade across global markets in the past week. The ‘fun’ started over the weekend, when Donald Trump predictably made a mess of the decision to fire the head of the FBI, James Comey, and then allegedly revealed classified intelligence to the Russian Foreign Minister and Ambassador in a meeting at the Oval office. Coming on the back of weaker US economic numbers last week (Retail Sales and CPI Inflation), the furore escalated and equity prices slipped from their highs after seeming to be impervious to the ongoing shenanigans surrounding the White House. The VIX measure of S&P 500 volatility jumped more than 50% and US Treasuries rallied as investors heavily discounted prospects for future Federal Reserve (Fed) tightening.
Notwithstanding this, our focus is primarily on whether this latest storm and the recent data releases have changed our fundamental view on the US economy. Here the answer is that it has not. This week’s labour market data (claims at historic lows) and a strong Philly Fed survey reinforce our confidence that the underlying structural economy is robust and that as long as the S&P does not experience a much more severe down move, we see nothing to suggest that the Fed will deviate from their normalisation of rates. At the March meeting, the FOMC dots suggested five more hikes until the end of 2018 and we believe that this path will remain unchanged in June, with the Committee hiking at this meeting and signalling a gradual path. This will take the Fed Funds rate back towards a neutral rate above 2% in the year ahead, with the economy close to full employment and with inflation close to its target. In this context, we believe that the pricing at the front end of the US curve is more asymmetric than ever, with market prices discounting no more than two hikes between now and the end of next year.
As always, it is important to ignore the hype and hysteria that is a feature of the news cycle and focus on the nuggets of information that are really important.
Elsewhere, the tone in markets was also impacted by news flow in Brazil, where a sting operation has resulted in President Temer being taped, seemingly condoning payments to a convicted politician in order to keep him quiet in the course of the ongoing corruption investigation. For Brazil, this would normally not be news, but it comes at a crucial time for the passage of the critical social security reform. The pension fund reform bill was due to be put to a vote in Congress in the coming weeks and much of the positive sentiment generated in Brazil in recent months has been built on its successful passage. The event drove volatility another leg higher with Brazilian markets hitting downside circuit breakers and broader emerging market (EM) related assets initially hit hard. However, it has been encouraging that the price action has been two-way and there has been little evidence of panic selling.
As we look ahead, we continue to voice the view that Capitol Hill remains more important with respect to the US legislative agenda than the White House. Trump appears to be a bit of a circus – but even were he to exit the stage, the prospect of Pence would probably be viewed even more bullishly by business and financial markets. In the short term, we see the announcement of a Special Counsel to take control of the investigation into potential collusion with Russia is a constructive step. Robert Mueller is a hugely respected figure by both Democrats and Republicans and will have free reign to provide a decisive ruling on whether there is a case to answer on collaboration between the executive branch and the Russian state. This will not be a quick process, but it’s our expectation that it will calm the overhyped hysteria.
Moreover, if distractions can be contained, Congress is now focusing on proposals for the Budget and the business of crafting tax reform. We stick to the view that they are very motivated to get traction on this before the political cycle kicks in for the mid-term elections in 2018 and that by September we should have managed to reach an agreement with regard to tax cuts at a minimum. As always, it is important to ignore the hype and hysteria that is a feature of the news cycle and focus on the nuggets of information that are really important. In that context, we see little reason to change our current views. In this sense, the recent spike in volatility is welcome as we believe it provides us with great opportunity potential to take advantage of mispriced assets.