Thursday December 1

Equity indices were mixed today as oil prices continued their post-Opec meeting ascent. The S&P 500 fell 0.4% to 2,191 and the Dow Jones rose 0.4% to 19,191. The KBW Bank Index rose 2.2% while the Dow Jones Utility Average lost 1% on higher interest rate expectations. Economic data today showed that jobless claims rose more than expected. The PMI Manufacturing Index came in at 54.1 versus the consensus of 53.9. The ISM Manufacturing Index similarly hovered around the consensus of 52.3 with a reading of 53.2. Interest rates rose today as higher oil prices will be an upward pressure on inflation. The two year Treasury yield rose 4bp to 1.16%. The ten year Treasury yield rose 7bp to 2.45%. 2yr vs 10yr bear steepened to 1.29%. The dollar fell today against peers as the recent rally took pause. USD fell 0.7% against EUR to $1.0657. USD fell 0.4% against JPY. USD fell 0.6% against GBP to $1.2587 after a UK official suggested that the country may seek to make payments to the EU in exchange for retained access to the single market. Currencies from countries that are reliant on commodities, such as Australia and Canada are on the rise as well. WTI rose 3% to $50.91 while Brent added 3.5% to $53.63.

The selloff in some European markets leading up to the Italian referendum on Sunday is creating opportunities for some investors. Assets in countries such as Italy and Spain, especially banks, have been selling off dramatically as a result of risks that ultimately lead to the rise in euro-skeptic political parties. The Netherlands, France, and Germany all face similar elections next year, and euro-skepticism is getting more and more popular among voters according to polls. Some asset managers have taken the view that those fears are over estimated, and that the status quo will prevail. If that is the case then it is likely to see asset prices in affected countries rebound significantly. Eurozone stocks have underperformed US stocks throughout the year by a fairly significant margin. Even worse, Italian stocks have underperformed Eurozone stocks by more than 15%. Data shows that European equity funds have experienced outflows of $97bn so far this year. Some believe that US investors are driving these movements, which creates opportunities for European investors who can offer more of a “boots on the ground” perspective. Italian banks for example are down 50% year to date on aggregate. There may some buying opportunities there for quality banks that will emerge from the current distressed situation. In fixed income markets yield spreads between Italian – Germany and France – Germany have each reached two year highs indicating elevated risk. This could be a result of rising euro-skeptic parties in each of these countries. Currently the euroskeptic party in France is polling in second place, and in Germany in third place. However given that polls this year have been wrong about Trump and Brexit many are skeptical to trust those. For what it’s worth, polls are also projecting that Italian citizens will vote for the status quo on Sunday.

China is set to make it increasingly difficult for large corporations and other institutions to take their money out of China, which is creating headwinds for many companies. First, China is planning on increasing regulations and enforcing strict requirements on offshore acquisitions made by Chinese companies. This could affect sectors in US markets where the Chinese have been heavy buyers, such as real estate. Additionally they are reducing the amount of money that companies are able to transfer to their own operations in other countries, a practice known as “sweeping”. Before companies were allowed to “sweep” up to $50mm worth of yuan out of China at a time with ease. As a result of strict capital controls that number has suddenly decreased to just $5mm. When China sought to become a reserve currency with the IMF, it ensured that it would continue to make the yuan more transparent, freely and openly traded. When the IMF was considering making the yuan a reserve currency, “sweeping” was one of the reasons it was approved. However this new shift marks a turn from those pledges. An executive at a large multinational US company that has large deposits in China was told to prepare for “increased friction” when looking to take money out of the country, contrasting what he was told in prior meetings. Many companies hold deposits in China, however Apple is expected to hold the largest by far with an estimated total of $7.8bn.

Higher oil prices alleviates some pressure on banks. Many banks have exposure to the sector, and were harmed earlier in the year when prices plummeted. When prices dropped into the $20s and $30s, banks set aside significant reserves to protect themselves against losses in energy portfolios. Now that prices have risen and Opec has proved it is willing to cooperate, banks will likely begin to release those reserves. This will free up capital for them to make loans to other sectors, which is beneficial for the economy. Barclays estimates that US banks set aside a total of $6bn in reserves for energy portfolios, and defaults have actually been lower than they had predicted. Firming oil prices are a positive development for banks, and as a result financials rose and outperformed markets both yesterday and today.

Corporate debt has been in favor with investors since Trump was elected president, especially riskier sectors of the market. Even though fixed income portfolios around the world have lost a total of $1.7tn, it is expected that increased stimulus and lower taxes will benefit US corporations. Investors have shifted out of government debt and into corporate debt as a result of Trump’s anticipated policies. Since higher yielding corporate bonds get less of their return from interest rate risk, there is a somewhat of a buffer for investors in high yield as interest rates rise. For example for investors in Treasuries 100% of their return comes from interest rate risk. However for high yield only 20% of their return comes from that component of risk, and the majority comes from credit risk since they are bonds from non-investment grade issuers. As a result high yield tends to benefit relative to government debt during rising interest rates and increasing economic growth. One continued risk to these markets is that inflation rises faster than expected, forcing the Fed to raise rates more than they have telegraphed to investors. In which case fixed income markets would sell off indiscriminately most likely. Short term debt has outperformed long term corporate debt as a result of inflationary concern, with five years and in being the most in demand part of the curve.

Thursday December 1

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