US stocks hit record highs, but could Powell dent the rally later today?

European stock indices are under pressure on Tuesday and the Cac 40 is the weakest performer in Europe as more details emerge about what a left-wing alliance government could look like. Although France has no clear leader right now, the prospect of a far-left party calling the shots and increasing both taxes and spending is worrying investors, and thwarted hopes of a post-election recovery rally in French assets and the euro. The Cac 40 is still down more than 5% since the election was called, Société General, is down more than 11% since the election was called, highlighting the large political risk premium still attached to French assets.

Political risk premium could haunt French assets  

Volatility for the Eurostoxx index had collapsed after the first round of voting in France, but it is rising again, as the market tries to guess who will govern France, one of few European countries that does not have a track record of coalition governments. French bond yields have stabilized and the 10 -year French bond yield fell on Monday, however, the spread between French and German yields is still wide. Although it has fallen back to 63bps, this is still 20 basis points above where the spread was before the election. It is hard to envisage this spread returning to normal anytime soon, and there may be a permanent premium attached to French bond yields on the back of the political turmoil that France is now experiencing, with far left and far right parties gaining prominence.

BP takes knock from lower fuel demand

The FTSE 100 is bucking the trend in Europe, and is higher on Tuesday, however, the energy sector is a drag on the index, and BP is currently down more than 2% and is one of the weakest performers in the UK this morning. The decline in BP comes after it preannounced lower refining margins in Q2 and higher maintenance costs that could lower Q2 earnings by $500mn - $700mn. It also plans to write down the cost of its German refinery by more than $1bn. It flagged the issues with its Gelsenkirchen refinery in Germany earlier this year, and now it plans to significantly scale back refining operations in the country due to high costs and declining demand for fuels. While hydrocarbons are still going to be an important part of the fuel mix for the foreseeable, there is no doubt that oil companies and refiners will see volatility in their results going forward, as demand for traditional fuels fall as renewables grow in popularity. BP’s stock price is unchanged this year, and it is hard to see UK oil companies extending gains since the outlook for fuel consumption is constrained. BP will release its full Q2 results on 30th July.

FTSE 250 to continue to outperform

Elsewhere, the FTSE 250 is taking a breather today after a decent rally in the past week of nearly 3%. UK mid-caps have received a medium-term boost from the outcome of the general election in our view, and the new government’s focus on growth. We continue to think that the FTSE 250 can stage an extended rally and may continue to outperform the FTSE 100 in the medium term.

Could Powell strike a hawkish tone on Tuesday?

With election risk in the US and UK out of the way, and signs that President Biden will stay on as the Democratic Presidential candidate, the focus will now shift to US inflation data released on Thursday, and that could shift the dial for US interest rate cut expectations. The market currently expects headline inflation to fall to 3.1% from 3.3%, with core inflation expected to remain steady at 3.4% last month. Ahead of the inflation report, Jerome Powell, the chairman of the Federal Reserve, will testify to the US Senate later on Tuesday. This is the usual semi-annual testimony, and we expect Powell to give a good assessment of the economy, stating that there are signs that the US economy is slowing without crashing. The Fed chair may also have to resist calls from Democratic Senators to cut interest rates, thus, there is a chance that he may sound slightly hawkish later today. However, the data will govern the timing of rate cuts in the US, so if inflation is cooler than expected, then that is likely to trump Powell’s testimony this week.

The FX view

The prospect of a less dovish Jerome Powell today is helping to boost the US dollar on Tuesday, which is the third best performer in the G10 FX space today. The mild rebound in the dollar is weighing on the pound, which is backing away to $1.28, which looks like good support for now. We continue to think that sterling could extend its recent rally, but the FX market is taking a pause on Tuesday.