24 April 2017
Author: Johan Jooste, Chief Investment Officer, Bank of Singapore, Member of OCBC Wealth Panel
With round one of the French presidential elections out of the way, a prime source of event risk has gone away. For a change, the pollsters got it right. That leads us to assume that round two will follow form as well, and that the right-wing populist threat of Ms Le Pen will not materialise.
Exit opinion polls point to Macron and Le Pen progressing to the second round of the French presidential election on 7 May. This is not the most EUR-positive outcome of Macron versus Fillon (Centrist vs Centre Right), which eliminates the EMU exit risk. But it is nevertheless a relief that the most EUR-negative outcome of Le Pen vs Melenchon (Far Right vs Far Left) is avoided because both candidates oppose EU/EMU orthodoxy.
Frexit risks remain low because of the difficulties in getting parliamentary support to call for a referendum on EU.
That said, we view markets to be in a consolidation phase. Upside is capped partly by geopolitical risk and Trump’s inability to make any economic reforms. But more importantly, the direction of markets has been determined by economic momentum. While the rise in markets was largely due to the improving economic cycle from November last year, the consolidation now is due to economic momentum moderating.
The big question is how much markets will move as the economic cycle moderates. There is no fool-proof method to predict how much markets correct during periods of economic moderation. One way is to look historically at how the S&P 500 performed when growth moderates.
In Chart 1, we plot the experience of the past 7 years using the widely-accepted Citi US Economic Surprise Index. The finding is that large market drawdowns of more than 10 per cent are uncommon (see Table 1). The only time that there was a large market sell-off due to this measure of economic slowdown was in 2010.
We conclude that while the moderation in growth is likely to persist for the next few quarters, the downside to markets from this source only is limited. Combined with our view that valuations are stretched to the point where it is pricing in more or less all the good news, leads us to maintain our broadly cautious stance in equity markets.
Currency update: Don’t chase the GBP rally. Initial GBP bullish reaction to an early UK election looks overdone. The early elections should result in a larger Tory majority and might strengthen PM May’s bargaining position ahead of the Brexit negotiations. But we doubt it would lead to a softer Brexit stance or make EU give UK a better deal.
Indeed, the EU leadership will likely stick to its strategy of making an example of the UK and try to discourage any other members from leaving.
We are not keen to chase the GBP rally, but would accumulate if GBPUSD dips to 1.20 and below.
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