It’s a data heavy week with an Opec + meeting thrown in for good measure. We are also at the end of the second quarter and moving to the start of the second half of the year, the question now is, what will drive markets for the rest of the year, will there be more spectacular returns for asset markets or could Covid variants and the Fed ruin the party?
Risks start to rise as we move to H2
As we stare into the start of the third quarter a few interesting developments have been taking place. The reflation trade is changing. The outperformance of value stocks, those considered to be economically sensitive and cheap compared to their peers across other sectors, started to see their lead against growth stocks start to shrink from mid-May as doubts started to rise about the strength of the US economic recovery and the prospect of long-term inflation biting at corporate profits. The market’s focus has shifted in the latter part of Q2, fiscal and monetary support cannot be guaranteed going forward, the prospect of tax rises are on the table as the market ponders how Covid relief will be paid for, inflation is rising sharply which is leading some to question whether central banks around the world will say that interest rates could come sooner than expected to combat price pressures. For now, these unknowns are causing pockets of volatility, but not an outright panic, for example, European stocks are set to make a fifth straight month of gains as investors keep the faith that the economic rebound will remain on course. But there is no doubt that risks are rising, but will it put investors off?
The Fed giveth and taketh away…
Looking at stocks first, stocks tend to be sensitive to changes in both monetary and fiscal policy. We think that changes to fiscal policy will be slow and gradual. Although there will be less fiscal stimulus in the next 6 months, some Covid funds across the US and Europe will continue to trickle through to the real economy, especially after President Biden announced his $1 trillion + infrastructure fund last week. We do not think that changes to corporate tax rates are likely in the short term, thus the global minimum corporate tax rate is a low risk for stock investors in the second half of this year in our view. Instead, a shift in monetary policy is a bigger risk. Earlier in June, the markets were briefly dented by the Fed’s dot plot, which showed that interest rates could rise a whole year earlier than previously expected. While the dot plot is only a signifier of when Fed members think rates will rise, it was a wakeup call to markets that Fed support won’t be available indefinitely. So far, the ECB and BOE have kept to their dovish stances, but that could change if growth and inflation trajectories stay the same.
US Payrolls key for market sentiment
The market will be watching the US June labour market report closely this week. The NFP report is released on Friday and analysts are expecting US job growth to be between 600-700k. The unemployment rate is expected to dip further to 5.7% from 5.8%, as the rate of hiring is expected to pick up now that certain roadblocks have been lifted, including the end of unemployment benefits in some Republican states, and higher vaccination rates across US states which previously may have deterred some people from actively trying to find work. Wage growth is also in focus, the market is expecting a 3.6% increase in wages for June, which could be indicative of a tight labour market with employers competing to hire staff, which is pushing up wages. If wage increases are higher than this and if wage growth tops 4%, then we could see risk sentiment drain from the markets at the end of this week. The risk is that higher wages will hurt corporate profits or lead to entrenched inflation, that defies the view of many global central bankers that price pressures will be transitory. Thus, dangerously high levels of wage growth may put pressure on central banks to tighten monetary policy sooner rather than later.
OPEC + unlikely to disrupt oil market progress
Elsewhere, the oil price is also in focus this week. After a stunning 45% rally in crude prices so far this year, will Opec + allow greater production causing the oil price to back away from recent highs? Some analysts have been calling for triple figure oil due to Opec supply constraints and the reflation trade. We would argue that the oil price is lagging behind some sectors of the stock market where there is growing scepticism about the strength of the global economic recovery, however, Opec is an important driver of where the oil price goes next. Overall, we expect Opec + to boost production by 500,000 barrels per day. This is unlikely to dramatically impact the oil price, the last time Opec + changed production targets they increased output by 2 million barrels. US/ Iran negotiations may have hit a road-block after US airstrikes in Iraq and Syria overnight. This could delay the return of Iranian oil onto international oil markets. When or if this happens is likely to have a much bigger impact on the oil price than the latest Opec + meeting at the end of this week.
Rising commodity prices likely to hurt manufacturing growth in Q3
Commodity markets have been on a tear higher this year, with copper prices surging alongside the oil and soybean price. It is worth noting that the price of lumber and copper has moderated sharply in recent weeks, for example, the price of copper has fallen for delivery in December, suggesting that the market expects prices to moderate in the coming months. Earlier on Monday, profit growth in Chinese industrial firms slowed yet again in May, as surging prices for raw materials squeezed profits and weighed on Chinese factory activity last month. We expect rising commodity prices to slow manufacturing activity in the US and Europe in the coming months, which could also limit upside pressure on commodity prices in the second half of this year. Whether or not weaker commodity prices help to reduce upward pressure on inflation in the coming months, we will have to see.
Elsewhere, Eurozone inflation data for June is released this week and is expected to show that prices have moderated slightly in the currency bloc, with 1.9% expected. This is the ECB’s target rate and suggests that the ECB will be under no pressure to modify policy in the coming months, which could weigh on EUR/USD this week.
Why AUD/USD is our FX trade to watch
Our other FX trade to watch this week is AUD/USD, which is in focus as parts of Australia are back in lockdown as a third wave of the Delta Covid variant takes hold in the country. From a technical perspective, AUD/USD had been above its 200-day sma at the end of last week, although it has fallen after the Covid outbreak news early on Monday, this pair fell sharply but has since stabilised around the 0.7550 level, supported by the 200-day sma. Short-term resistance lies at 0.7600, but attempts to break this level have been thwarted so far. Overall, we think that the Aussie could be in consolidation mode and may move sideways now that 0.7550 – the 200-day sma – has been confirmed as decent support. The next move for this pair could be dependent on the US NFP report on Friday, and what this might suggest for the future of US monetary policy.
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