Exchange rates return to the spot light

2 December 2016

The past week brought some surprises as well as some interesting developments, which in combination served to underpin recent improvements in market sentiment, even if the UK’s stock market fell slightly over the course of the week. Interestingly it all still hangs together.

First the UK. Here, some progress in the planning of the EU exit negotiations made it all but clear that there just is not likely to be enough time available over the 2-year notice period of Article 50 to actually arrive at anything else but a Hard Brexit. Even the most hard-nosed Brexiteers appeared to accept that such a scenario without any transition arrangement may carry too much risk for the UK’s economy to seriously contemplate. When Brexit secretary David Davis hinted that the government may see merit in continuing to pay EU contributions in return for a temporary extension of preferential treatment of trade in services and goods, financial markets took this as a strong hint that they were correct in their suspicion that this divorce would be far more drawn out than 2 years. With more time, things can change and more importantly the status quo is extended into the future. And the status quo is not so bad right now, with the UK sporting the highest GDP growth rates this side of the Atlantic.

The subsequent further recovery of £-Sterling was evidence that the currency markets are currently the most vigilant opposition the UK’s government has, in that they seemed to signal approval of the development towards seeking an extension of the current UK-EU relationship framework. However, the £ strength became a headwind for the UK stock market. Just as the weakening currency had pushed it up as it increased the £‑value of overseas revenues and profits, the strengthening has to and did result in the opposite.

The other very notable news item was the surprise success of the OPEC oil cartel to agree to production cuts next year – by 3.4%. While by no means meaning that these will actually happen, oil markets nevertheless took it as a signal that the price war over market share is coming to an end. This should mean less price volatility next year, which should encourage a return of exploration investment planning stability which in turn returns some very welcome industrial demand to the global economy.

Predictably the oil price shot up - from $46 per barrel (bbl) to $54/bbl  - a whopping 17.4%. Given a price above $50/bbl turns much of the US shale oil industry back into profit, the price may have already overshot on the upside, because shale oil volumes can be turned back on in matter of months.

The higher oil price and the general upward price pressures that come in its wake, together with the improved industrial output prospects, immediately fed into rising inflation expectations. These had already moved up significantly since the summer and even more since the Trump win, in anticipation of fiscal stimulus measures which would be necessary to stem the rise of the global populism movement. The oil push re-accelerated the rise in yields and connected sell off in bonds as investors seek to protect their wealth from rising inflation. So while the fiscal argument appeared to run out of momentum, oil has given it another life.

Overall good or bad news then? Well, as the UK’s bank stress test results of the past week also showed, there are still clouds on the horizon, but at least there are now a number of the factors that recently undermined confidence (low-flation, low growth prospects, low yields) which are now moving in the opposite, improving direction.

This leads us back to political risks and here the focus will be on Europe over this weekend. At the time of writing, there was an expectation that the Italian constitutional referendum would fail and lead to Italian Premier Renzi’s resignation. This could spell trouble for the weak Italian banking sector, but probably only is the No side wins by a landslide, as this would open the prospect of a populist government next year. If the No margin is small, then we should expect just a continuation of the typical Italian muddling through politics.

The re-run of the Austrian presidential election may be more insightful in terms of whether the right-wing populism is spreading further of has gone past its peak with Trump’s election. This is because there the subject matter is less complex than in Italy – the electorate has a straight forward choice between a xenophobic right wing nationalist and a liberal candidate.

Given the experience of Brexit and the US presidential election I now doubt very much that outcomes in either will have far reaching negative market impact, as markets appear to have accepted extreme electoral results as the new normal. However, given the recent weakness of European stock markets despite significant economic and corporate growth improvements, a surprise return to more moderate voting has the potential to cause a bit of a market rally.