Stocks fell to finish the week lower however still increased over the course of the week. The S&P 500 fell 0.2% to 2,181 and the Dow Jones lost 0.2% to 18,867. Over the course of the week those indices were 0.8% and 0.1% higher respectively. Today telecom and energy led indices while consumer staples and health care underperformed the most. Equities could be reaching a ceiling as strength of the US dollar is coming back into focus and could be a big headwind going forward. Today was a heavy day for Fedspeak. James Bullard is leaning towards a December rate hike, as is Esther George and Robert Kaplan based on statements made today. Accordingly Treasury rates rose. The 2 year yield rose 2bp to 1.07%. The 10 year yield rose 5bp to 2.35%. Accordingly 10yr vs 2yr bear steepened to 1.28% which is the steepest since the end of 2015. The market for Fed funds futures is currently pricing in a 98% chance of higher interest rates in December. The US dollar was stronger across the board against peers. USD rose 0.4% against EUR to $1.0588. USD rose 0.7% against JPY to Y110.91. USD rose 0.6% against GBP to $1.2342. The Mexican peso fell 1% against USD to P$20.6435 even after the central bank there raised interest rates by 50bp. Since Trump’s election victory funds that track financial, health-care, biotech, and industrials companies all experienced record inflows. At the same time emerging market funds have experienced record outflows. WTI prices today rose 0.3% to $45.58. Brent rose 0.9% to $46.89.
The dollar’s strength poses challenges for emerging markets. The Mexican peso has lost 11% against USD since the election and the Brazilian real is down 6.3%. This creates problems for US companies who look abroad for revenue growth. From the perspective of emerging markets it prompts capital outflows. Partially as a result of the stronger dollar, the Goldman Sachs Financial Conditions Index currently reflects the tightest financial conditions since the start of the year. The index looks at interest rates, foreign exchange, stock prices, and credit spreads. Right now stock prices and credit spreads would contribute to expansion, but foreign exchange and interest rates are leading to tighter monetary conditions. Investors have poured money towards bets that the US dollar will appreciate. That has led to an appreciated USD and a difficult environment for emerging market nations that need to repay debts in dollars. Emerging markets so far year to date have issued a record $409bn in USD debt. As a result several emerging markets have intervened in markets to support their domestic currencies. Indonesia throughout last week sold USD and bought their own government bonds to support the rupiah. China has been guiding the renminbi lower but is cautious to prevent too dramatic of a slide. Mexico raised interest rates to try and stem the peso’s decline. Malaysia is trying to attempt speculation in the ringgit market after it has fallen 4% against USD. American companies such as Cisco and Coca Cola have already started to incorporate currency headwinds into their earnings guidance. As such domestic companies have outperformed international companies since the election. Corporations that earn more than 90% of their revenue domestically are up 5.2% whereas companies that generate majority of their revenues internationally are up just 2.2%.
William Dudley of the New York Fed says that inflationary expectations are reasonable and that the Fed is on track to meet its inflation target of 2% within the next few years. Tailwinds that will propel inflation include above trend growth, solid wage gains, as well as Trump’s policies. The 10 year breakeven rate is up to 1.95% which is the highest level since mid-2015. The 5Y5Y forward rate is up as high as 2.48% which is the highest since mid-2015 as well. He also believes that infrastructure spending will improve productivity, which is a key driver to Ray Dalio’s theory of the economic machine. Dudley expressed hesitance regarding whether or not it would be a good idea to roll back Dodd Frank, however he did admit that there was room for improvement with the bill.
The next global political event that markets will be paying attention to is the Italian referendum that will take place on December 4. Italian Prime Minister Matteo Renzi has proposed a constitutional overhaul that will make the political and lawmaking system more efficient, and make the Italian government more stable. A “yes” vote would accept the changes, and a “no” vote would deny the changes and Renzi has pledged to resign if the “no” camp wins. Analysts expect that a no vote would be bad for the Italian financial sector, weaken the euro, and push up Italian bond yields. The “no” camp is currently in the lead but with 20% undecided voters. As such the yield on Italian 10 year bonds has risen nearly 50bp year to date to 2.03% and the spread between the Italian and German 10 year bonds is currently higher than 1.8% indicating a higher risk premium. CDS spreads have widened to around 170bp from 97bp at the start of the year. Renzi says the current system favors instability and “backdoor dealings.” If he steps down following a “no” victory, it could lead to an antiestablishment party gaining power. The 5 Star Movement (the leading antiestablishment party that is gaining momentum) wants to renegotiate Italy’s debt and hold a referendum on euro membership. Analysts note that Italian stocks aren’t pricing in much risk having fallen just 1% since the start of November. Deutsche Bank analysts believe that the index would fall around 20% if the “no” vote prevails. Italian banks are in distress, and both plan on enacting recapitalization plans after the referendum. These include issuing stock, selling assets, and drastically cutting costs. UniCredit’s CDS are now even more expensive than Deutsche Bank’s for the first time since the start of the year.
Companies around the world have issued $6tn in corporate bonds this year which is a record amount year to date. They are looking in at looking borrowing costs at historically low levels, in anticipation of possibly higher rates with the Trump administration’s fiscal policies. Rising yields over the last two weeks have resulted in more than $1.5tn in losses for fixed income investors around the world. Given the recent selloff the total amount of negative yielding debt around the world has fallen to $11.8tn down from $13.5tn in September. This comes as monetary policy has shifted from the primary driver to fiscal policy. In spite of the backup in rates spreads have remained steady indicating that investors are still sticking to credit risk in spite of better returns on government debt. Corporations who expect the selloff in rates to continue will likely rush to issue debt over the next few months.