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Blog Posts — January 9, 2018

2018: a repeat performance?

by Christoph Schon, CFA, CIPM

2017 provided ample fodder for Axioma’s weekly commentary and quarterly Insight webinars. Looking ahead, 2018 promises a similarly bountiful harvest.

Over the past 12 months, stock markets on both sides of the Atlantic posted record high after record high, fuelled by expectations of lower taxes in the US and strong economic performance in continental Europe. As a consequence, the euro was one of the biggest winners of 2017, gaining 14% against its American rival. The pound was also a winner, recovering part of its post-EU referendum losses with a lift of 9.5% on the prospect of higher short-term rates and perceived progress in the Brexit negotiations. That said, safe-haven currencies—including the Swiss franc and the Japanese yen—showed smaller gains of only around 4%, indicating that the 10% average depreciation of the USD over the past 10 months wasn’t all due to dollar-specific issues.

10-year government bond yields in the United States and the United Kingdom began and ended the year more or less at the same levels. Long rates remained depressed by doubts of the feasibility of the proposed tax reform and persistently low inflation in the US, along with uncertainty around the future of the UK economy, its future trading relationship with the EU and the stability of Theresa May’s government. At the same time, the Federal Reserve Bank kept increasing rates at the short end, which resulted in the flattest US Treasury curve in a decade. The Bank of England, too, raised its base rate for the first time after 8.5 years of ultra-low refinancing conditions.

In contrast to their Anglo-Saxon rivals, longer-dated German Bunds saw their yields increase, with the 10-year rate rising by a quarter of a percent. Like the strong euro appreciation, this was driven by the solid economic performance in the Eurozone—especially in Germany. Increases could have been higher, though, had it not been for the fact that Europe’s most powerful economy has still not been able to form a new government in the now almost 4 months since the general election.

German coalition talks: is a new election in the cards?

We expect most of these themes to continue to drive markets in 2018. Germany’s biggest parties—acting Chancellor Merkel’s centre-right Christian Democratic Union (CDU) and the centre-left Social Democratic Party (SPD)—have now revived their talks about a possible reissue of their recent coalition, despite the fact that SPD leader Martin Schulz had repeatedly ruled out this option during the election campaign and in the weeks afterwards. Though the continuation of the so-called “grand” coalition seems to be the most convenient—if not the only—option to end the current interregnum, it is far from certain whether the SPD grass roots will ratify this once negotiations have succeeded. So, there is a significant chance that German voters may be asked to the ballot boxes once more, although there is no guarantee that the next result will be significantly different from the status quo, as recent opinion polls indicate. Such a scenario can be expected to be bad news—not just for Germany—but for the Eurozone as a whole.

General elections in Italy and Hungary: more success for right-wing populists?

Further potential bad news for the European Union is on the horizon from the upcoming general elections in Italy and Hungary, scheduled for March and April/May, respectively. Support for populist, euro-sceptic parties is growing in both countries. The Hungarian Fidesz Party, led by current Prime Minister Viktor Orban, is set to increase its majority to over 50%. Together with the projected 15% for the nationalist Jobbik party, this is would raise right-wing support to almost two thirds. In Italy, the EU-critical Five Star Movement is also leading opinion polls. Although they are still some way away from coming to power, this is nevertheless a warning sign that anti-EU populism is on the rise again.

United Kingdom: more Brexit uncertainty ahead?

What happens in continental Europe is also likely to impact the EU27’s strategy in the ongoing Brexit negotiations. Growing unrest in the remaining member states may induce EU negotiators to take a tougher stance towards the United Kingdom, in order to discourage other countries from leaving the bloc, too. At home, Prime Minister Theresa May continues to face challenges from her own cabinet ministers, Tory backbench rebels and the House of Lords, who tend to oppose Brexit and are looking for a greater say in ratifying the final deal. This uncertainty, in turn, weighs on economic sentiment, as well as the EU’s current stance of limiting any free trade agreement to goods only, if the UK insists on limiting free movement of citizens. This would notably exclude the all-important financial services sector and could result in an arrangement similar to the one with Switzerland.

United States: lower taxes, low inflation and an inverted curve?

On the other side of the big pond, the ongoing investigations into alleged Russian interference with the 2016 election are likely to continue to overshadow Donald Trump’s presidency, feeding concerns about a possible impeachment. The stock market gains at the end of 2016 and over the course of 2017 were fuelled to no small degree by the expectation of lower taxes and infrastructure investments promised by the new administration. Any setbacks or hurdles to these plans would likely weigh on USD and on US Treasury yields. Another factor keeping long-term interest rates down is the persistently low inflation, which Fed officials keep citing as a major concern. Yet, the US central bank remains on its path towards higher short-term rates, with the median forecast slightly over 2% for the end of this year. Longer estimates currently project a peak of over 3%. With 30-year Treasuries trading around 2.80% at the moment, this would result in the much-dreaded inverted curve—usually considered a harbinger of a recession. Given the ongoing uncertainty about the future of the Trump administration and the fact that the conflict with North Korea is far from resolved, long Treasury yields could well remain at the current low levels for some time.