Markets Turn Cautiously Bullish Ahead of FOMC
Last week the ECB over-delivered, cutting main interest rates and expanding its massive bond buying program. However, Draghi added that he does not anticipate the need to cut rates further, triggering investor disappointment and sparking sharp downside reversal and a surge in the euro on Friday. Nevertheless, ECB’s more aggressive package of measures suggests support for European equities, thus leading Citi analysts to raise their end-2016 Stoxx target from 360 to 380.
In China, new yuan loans and aggregate financing—a measure of total credit issued—came in well below forecasts for February while real activity data is disappointing with both retail sales and IP YTD growth lower than expected. Against this backdrop, Citi analysts believe China’s policymakers may need to provide further aggregate demand support including fiscal and monetary.
This week’s FOMC meeting is priced by markets to be a “non-event” with no rate hike probable. Nevertheless, markets may be surprised by the FOMC discussion and new economic projections that imply interest rate normalization may continue at a pace much faster than implied by market pricing.
Global equities were up with the MSCI World Index rising 1.14%. In the US, the Dow Jones Industrial Average and the S&P 500 Index gained 1.21% and 1.11% respectively and the Nasdaq Composite Index increased 0.67%. European equities, as measured by Stoxx Europe 600 Index, inched up 0.13%. Meanwhile, Japanese equities retreated as strength in the yen weighed the market. (Nikkei 225: -0.45% and Topix index: -1.17%).
EM assets continued to outperform with the weaker US dollar. The MSCI Emerging Markets index finished higher 1.26% led by the MSCI Emerging Europe and the MSCI Latin America gaining 3.09% and 2.00% respectively. The MSCI Asia ex-Japan also posted a positive weekly gain of 0.73%. Australian equities rose 1.5% while shares in mainland China lost ground (SHCOMP: -2.22%).
Equities — We think the ECB’s latest policy actions are likely to under-pin a more positive period for risk assets, including European equities.
Credit — Both US and European investment grade corporate spreads remain attractive. We favour longer duration opportunities, as we have little concern over rising long-term rates.
Rates — Interest rates in core developed sovereign bond markets have drifted higher over the last few weeks, as the main drivers of headline risk (i.e. China, oil) appear to have stabilized.
Commodities — Gold trading has shown a clear bias towards risk-off buying and we expect these inflows to continue to drive price upside through 1H as macro uncertainty remains elevated. However, lingering risk-off sentiment may not be enough to provide sustained support.
Markets Drivers & Risk
Driver: This week’s FOMC meeting is priced by markets to be a “non-event” with no rate hike probable. We believe there may likely be no more than two rate increases this year, but the FOMC may put in a third one.
Risk: Nevertheless, markets may be surprised by the FOMC discussion and new economic projections that imply interest rate normalization may continue at a pace much faster than implied by market pricing.
Implication: Citi analysts believe that although the US economy remains on a moderate growth path, the downside risks associated with market-induced uncertainty are rising and sizable. Moreover, there is a risk that inflation expectations may become unanchored, which would imply a more aggressive monetary policy response to economic and financial shocks.
Driver: Last week, Draghi and the ECB surprised most market participants with a more aggressive package of additional policies. We think the ECB’s latest policy actions are likely to under-pin a more positive period for risk assets, including equities. With € IG corporate bonds now on the ECB’s “shopping list”, we see the ECB as a buyer of last resort returning to the market.
Risk: Subdued wage growth, second-round effects of recent fall in energy prices, and a still-high output gap are likely to keep consumer core inflation low for a longer period.
Implication: Citi analysts raise our end-2016 Stoxx target from 360 to 380 (end-16E & end-17E P/E of 17.1x & 14.9x, end-16E & end-17E DY of 3.4% & 3.7%). Additionally, European corporate bond spreads are likely to narrow over coming months as the ECB’s new policies are implemented. Narrower spreads may support outperformance from Financials, Autos, Construction and Basic Resources.
Driver: We anticipate a rebound due in part to expectations for government policy. However, it is unclear whether this will produce a real bottom. Citi’s forecast range for the near term is 1,175-1,525 for TOPIX (mean of 1,350) and 14,500-18,500 for the Nikkei 225 (mean of 16,500). Our end-March 2016 TOPIX forecast is 1,400, while our Nikkei 225 forecast is 17,500.
Risk: While we feel that the relative performance of Japanese equities in a resource-price rebound phase may not shine, we think the phase presents a good opportunity for sector rotation.
Implication: Sectors that find it easy to benefit from an upturn in crude prices include mining, trading companies, non-ferrous metals, and marine transport. Conversely, rising crude prices could negatively affect the transport, utilities, and rubber product sectors.