Oh dear, Keir!

Not a good week for the UK government….

In the wake of last week’s Federal Reserve rate cut, the US yield curve has continued to steepen, with short dated yields edging lower, just as longer dated yields have moved in the other direction. We see this as a rational development in the context of a central bank showing a reaction function, which is seeking to prioritise growth over inflation in our eyes, and we believe that this trend has further to run.

Meanwhile, as we head towards next week’s key US employment data, we ask ourselves what sort of data thresholds we think we should see, in order to skew markets towards expecting a zero, 25bps or 50bps cut at the next Fed meeting in November. From this standpoint, were we to record an outcome above 200k jobs added and a drop in the unemployment rate, this might suggest to us that the FOMC may want to stand pat.

Similarly, a higher unemployment rate with a monthly job gain of less than 50k jobs could suggest a 50bps move is again on the table. That said, we continue to believe that the economic trajectory in the near term looks relatively healthy, and we believe that concerns with respect to any weakness in the labour market may currently be overstated, as highlighted in weekly claims data.

With the US election still looking very 50/50, so a sense of political uncertainty is currently compounding the backdrop of some economic uncertainty. With the dollar close to a 2-year low on a trade-weighted basis, it might seem that the FX market has skewed a bit more towards the likelihood of a Harris win, whereas the equity market remains more hopeful of a Trump win.

It strikes us that this race may run to the wire and may be decided more by turnout rates than marginal voters switching allegiance at this time. From this point of view, you could say that the US looks like a politically stable democracy, in that the overwhelming majority of voters who voted Republican or Democrat in 2016 and 2020 are likely to repeat this pattern in this election. This appears quite different compared to the situation in Europe, where voting patterns have seen a large share of voters switching sides.

Elsewhere, events in the Middle East have taken a worrying turn towards escalation, with Israel seeking to crush Hezbollah and its ability to launch missiles towards its southern enemy. Meetings with analysts and policymakers have suggested to us that Netanyahu may have calculated that he has something of a free hand to push the conflict, this side of the US election. It appears that Iran is eager to avoid a major conflict.

Meanwhile, the Biden administration will be very wary of any censure of Israel ahead of the November vote, in case it costs them in the polls. Moreover, if there is larger retaliation from Hezbollah or Iran, inasmuch as this draws the US into a conflict, then this may benefit Trump as a more ardent Israeli supporter, relative to Harris. A bigger conflict could represent upside risk to oil prices, though generally speaking, it seems likely to us that problems in the Middle East will continue to be contained.

In France, the government’s travails continue to build, with Macron’s approval ratings sinking to new lows. New economy minister, Antoine Armand, has announced that he is excluding Le Pen’s RN party from consultations to form the upcoming Budget. Yet with Prime Minister Barnier relying on support from RN to avert a ‘no confidence’ vote, it strikes us that the days of the current administration already appear to be numbered. Indeed, one wonders if he will last much longer than the UK’s Liz Truss, or the famous lettuce, which outlasted her….

Moreover, with France running a fiscal deficit over 5% of GDP and subject to excessive deficit procedures by the EU, there is a need to deliver fiscal restraint or face censure from Brussels. However, it is hard to see Paris being able to deliver this over the coming months, against the backdrop of a dysfunctional government.

Pressure on Macron himself is likely to continue to build. As we reflect on this, the more Macron’s decision to call Parliamentary elections this past summer reminds us of David Cameron’s historic gaffe in announcing the Brexit referendum in 2016.

At the moment, it appears difficult to plot a constructive path forward in France, and it may be necessary for a crisis to build and come to a head, before an agreement can be reached. In this context, we expected further pressure on OAT spreads, though any move should be capped below 100bps relative to bunds, as long as Macron does not announce his own resignation in a fit of pique, over the months ahead.

European PMI survey for September were relatively downbeat, due to weakness in French and German data. The economies of southern Europe are performing much better, though it seems this is only likely to ensure that growth in the EU as a whole remains close to 1% in the quarters ahead.

Consequently, the ECB is under pressure to deliver more monetary easing, having played down prospects of an October cut at its recent policy meeting. With the Fed having delivered a larger move, the euro testing $1.12 and little movement towards a bigger EU fiscal push, a more dovish stance from Lagarde next month now looks likely to us.

Elsewhere in Europe, it has been notable that the German government appears to be railing to prevent a takeover of ailing Commerzbank by Unicredit of Italy. Although we would not want to bet against Orcel, the public reception from policymakers in Berlin has not been constructive up to this point. In many respects, this nationalistic agenda is disappointing and exactly what the EU doesn’t need, if progress is to be made towards a capital markets union and a more competitive and integrated future.

Indeed, Berlin’s actions can be viewed as another nail in the coffin of the Draghi plan, which called for the EU to come together under grand visions to tackle the structural issues overshadowing the bloc today and constraining its ability to compete relative to the US and other large emerging economies. This is disappointing, though perhaps unsurprising against a political backdrop across the continent, which is moving in a more nationalist and populist direction.

Ultimately, a crisis could cause attitudes to change. Indeed, there are some in Brussels claiming a crisis in the EU is present today. However, the reality for the time being is that the EU looks set to remain a low growth economy, whose purchasing power and global significance will slowly fade over the course of time.

The UK Labour Party conference has seen the cabinet seek to talk up the country’s economic prospects, after facing criticism for a narrative of doom and gloom and an upcoming Budget that is set to be painful. Certainly, it is notable that Starmer’s approval rating is now as low as Rishi Sunak’s and any early honeymoon now seems like a distant memory. Poor communication has given the impression of a party not ready for power, after a 14-year break from office.

At the same time, a drip feed of sleaze accusations linked to senior MPs receiving gifts from wealthy donors has also undermined trust in a group who were very quick to point their finger at the Conservatives for many of the same sins. UK growth has been holding up a bit better than in the EU, thanks to the UK economy being service based, having long lost much of its manufacturing capabilities.

That said, Brexit remains a drag, government finances are stretched, and inflation remains more entrenched than elsewhere. Consequently, there seems very little scope to support the economy through fiscal or monetary easing over the months to come.

In China, policy easing saw robust gains in Chinese equities over the past week on improved sentiment. It appears that more aggressive Fed accommodation may have been a factor leading Beijing to be more assertive.

Further easing of restrictions with respect to property purchases were well received, though the reality is that China is in a full-blown property bear market at the moment, and it will be difficult to avert this. There may be a sense that Xi himself is seeking to prioritise measures to stimulate the economy and in the short term, it won’t be surprising if this lifts the mood. However, we think it is right to remain more downbeat on China on a medium-term view.

In Japan, the LDP leadership election today has seen former defence minister Shigeru Ishiba selected to become prime minister in an unusually close race against Sanae Takaichi, who led in the first round of voting. Takaichi had positioned herself as a monetary policy dove, which had seen JGBs rallying and the yen weaker over the past several days when it looked like she was set to triumph. Subsequently, markets have snapped back in the opposite direction on Ishiba, with the yen rallying intraday from 146.5 to 143 in the space of a few minutes.

Ultimately, we feel the desire to build consensus may mean that policy outcomes don’t alter too much in Japan and so some of these short-term moves may be unwarranted. However, we think that a snap general election in November is likely as Ishiba seeks to validate his mandate. Consequently, this pushed further BoJ policy tightening back to January, in line with our previous suggestions.

Overall, we remain confident that the Japanese economy is on track, and we will see further normalisation in monetary policy in the quarters to come. Inflation remains above 2% and wage growth is becoming more entrenched. In a scenario in which the US economy slows a lot further in the next few months, it is possible that this could stymie BoJ policy normalisation, though this is not our expectation.

For now, JGB yields have rallied in line with moves in other markets, but we don’t see this as sustainable. It is also worth noting that the over-valuation of 10-year JGBs is also a function of JGB purchases and the past policy of Yield Curve Control. BoJ purchases will decrease dramatically in the months ahead, as QT winds down and this is an additional factor to expect 10-year rates to normalise relative to longer dated 30-year bonds, which continue to trade above 2%.

Looking ahead

As we move into the final quarter of 2024, it strikes us that the investment landscape looks as uncertain as it has done for some time, when trying to look much beyond a 3-month time horizon. In the short term, we have some confidence that the US economy remains in decent shape and that a dovish Fed may help benefit sentiment with respect to risk assets.

Similarly, we would express confidence in a steeper yield curve, absent an upside data surprise that causes short dated yields to price out FOMC easing in November. Meanwhile, there is a sense that the US election is starting to loom large, and it is hard to discern the outcome with any confidence.

We are inclined to view a Trump win as likely to be more inflationary, adding to curve steepening and also bullish for the dollar. Risk assets may rally on a Trump win, though we are inclined to think that this would be an opportunity to materially de-risk if this occurs, as we see a Trump presidency as generically bad for fixed income in general.

Conversely, we look for a weaker dollar and a softer response from equities and credit, should Harris win. Meanwhile, an outcome which is not quickly conclusive could be messy and, following the turn of events in 2020, one hopes that this can be avoided, with a clear winner leaving no lingering doubts. Ultimately, we are aware that this election will be decided by as few as 100k voters in just a few states, and so it seems likely that this will go the distance.

Back in the UK, Starmer must be relieved to have a large majority and the luxury of not needing to go back to the polls until 2029. That said, the leader’s stumbles have given an impression of a blundering administration. Indeed, one wonders how Biden would have been treated in the press, if he had been the one to call for the ‘return of the sausages’ instead of hostages!