Global Weekly: Checks and balances

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The US midterm elections are now behind us. Wall street and poll projections proved to be correct. The Democrats have gained control of the House of Representatives for the first time since 2010 and the Republicans maintain their majority in the Senate.

As a result, US President Donald Trump will now have two years where his judicial and administrative nominees should manoeuvre through the confirmation process. Democratic leaders are set to launch a number of investigations into the Trump White House, although it is very unlikely that this leads to an impeachment procedure. The Democrats will also have the ability to curb the Republican party on economic matters. This shift in power can also open the door to cooperation on some issues.

An economist of Bank of America Merrill Lynch US has noted that stock markets have historically thrived in scenarios with a Republican president and a split Congress, with average annual returns of 12% for the S&P 500.

The big winner could therefore be the overall stock market, as a hamstrung government leaves much of what US President Donald Trump has accomplished in place, but also keeps in check some of his more extreme actions such as trade battles.

Although Republicans and Democrats disagree on a wide variety of policy proposals, members of both parties have been supportive of infrastructure reform. Any progress on that front could be profitable for the industrials, materials and energy sectors. Congress and Trump could also find common ground on reducing drug prices, which could be a potential headwind for the health care sector.

For the time being, we maintain a slight overweight in equities with a bias towards the US. Regarding sectors, we are overweight energy and industrials. Overall, the election outcome and resulting influence on equity markets should have a positive impact on our equity position.

Treasury yields still rising

Due to the improved mood on equity markets, sentiment among investors was risk-on. Government bonds therefore suffered and the trend of rising yields remained intact.

The result of the US midterm elections could not stop the development of rising government bond yields – even now that the new democratic majority in the House of Representatives has the power to defeat president Trump’s further plans on fiscal spending.

A moderate further yield rise in the near term cannot be ruled out, as the US economy still shows a robust shape, keeping the Fed on track to its next rate hike in December. We believe bond yields are currently peaking, however, and could begin to decline in 2019 as we expect growth momentum to slow and Fed communication to begin signalling a pause after two more rate hikes next year.

In Europe, all eyes were on the volatility connected to the typical risk of Italy’s financial policy. The better-than-expected results of Italian banks after the stress test of the European Banking Authority led to some relief. The dispute with the EU about the fiscal rules, however, still seems to be an elephant in the room. For now, risk premium for 10-year Italian government bonds did not again exceed the threshold of 300 basis points. There is room for lower yields, if the outstanding conflict can be solved and with rating risks apparently being off the table for the rest of the year.

Spreads of European corporate bonds are still close to the highest level of this year, but have been able to make some improvements. Nevertheless, the unwinding of the ECB's asset purchasing programme could be a reason to stay cautious within this segment.

Emerging countries sent mixed signals this week. Mexican people have voted in favour of cancelling a USD 13 billion new airport project which is already under construction. Following this non-binding referendum would be costly for the government.

In Brasil, with president-elect Jair Bolsonaro heading the country, the attention will now shift to the composition of his administration, his policy preferences and prospects for forming a working coalition in the parliament. Market participants expect that the pension reform will pass early in Bolsonaro's presidency. If that is the case, this should pave the way for a sustained cyclical upswing in the Brazilian economy. All in all, we stay positive on emerging market debt and continue to consider it as an attractive buying opportunity.