Here are the main questions facing investors and markets as a new trading week beckons.
Last rites for the Trump trade?
Barring an unlikely bout of Congressional rapprochement, the fiscal stimulus plans of President Donald Trump’s administration appear forlorn. The dollar, down 7 per cent this year, and US small-cap equities, off 6 per cent in the past month, have signalled this for some time. Now there are indications of unease moving the broader equity market. The S&P 500 has broken out of its early August torpor with three daily moves of more than 1 per cent in the past six trading days, with a slide of 1.5 per cent on Thursday, led by technology and financials.
A bounce in equity prices on Friday after news that controversial presidential adviser Steve Bannon was leaving the White House, faded, highlighting fragile sentiment among investors at the moment.
With the White House preoccupied by the president’s apparent reluctance to clearly condemn neo-Nazis, and beset by an investigation into the Trump campaign’s ties to Russia, markets face a further bout of drawn out political theatre as negotiations to raise the US debt ceiling loom next month.
More violent movement in market prices could have broader effects. “A sharp increase in volatility and a significant market correction in equities would inevitably and rightly move credit spreads wider,” says Chris Iggo of Axa Investment Managers. “Are equities overvalued enough to make a large market correction likely? Many would argue yes, but they have for some time.”
What do central banks think about asset prices?
The release last week of meeting minutes from the Federal Reserve and European Central Bank showed a focus on familiar issues. Stronger inflationary pressures are absent, even as labour markets improve and large amounts of monetary stimulus remain in place.
So low bond yields worldwide reflect a general view among investors that inflation is moribund.
Yet this may prove dangerous as central banks tweak their strategies, led by a Fed that appears set to pull back from reinvesting its bonds. With the big central banks holding a fifth of their government’s debt, fixed-income investors have clearly benefited from having a massive buyer in their market since the financial crisis. As have holders of equities and corporate bonds.
Joshi Dhaval, of BCA Research, says “the most accommodative central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. These central banks are set to dial back accommodation.”
Indeed, the Fed’s minutes revealed a telling line with officials noting, “vulnerabilities associated with asset valuation pressures had edged up from notable to elevated”.
Alberto Gallo at Algebris Investments notes among the reasons for a withdrawal of stimulus by central banks: “One is to build a policy buffer for the next crisis. Another is financial stability: normalising interest rates would prevent households and corporates from over-leveraging. There are also political considerations . . . QE introduced collateral effects to society, including wealth and geographical inequality.”
Mr Dhaval adds: “Central banks are realising that in the struggle to achieve 2 per cent inflation, persistent ultra-accommodative policy endangers the healthy functioning of markets and poses a risk to financial stability. At the same time, the continued undershoot of 2 per cent inflation is not such a terrible thing when the economy is growing well.”
Should currency markets brace for a Jackson Hole surprise?
The annual gathering of central bankers in Wyoming, hosted by the Federal Reserve Bank of Kansas City begins later this week with discussions and papers such as Fostering a Dynamic Global Economy.
A hot topic for markets is the prospect of the European Central Bank trimming stimulus and while ECB president Mario Draghi is scheduled to speak, investors may be left wondering for a little longer. With the ECB meeting on September 7, Mr Draghi may well decide to say little about tapering in the wilds of Wyoming.
That won’t stop the currency market from guessing when the jawboning will begin as the euro remains sharply higher for the year against its rivals.
Simon Derrick at BNY Mellon notes: “Given that ECB policy decisions have been behind a number of the more volatile sessions seen over the past three years it would therefore seem to make sense to listen particularly closely for any rhetoric on this theme over the next few weeks.”
This comes after last week’s release of minutes from the ECB’s July policy vote. Officials believed there was a risk of a firmer currency, curtailing efforts to meet an inflation goal of about 2 per cent as a richer euro makes imports cheaper and limits export growth.