Markets – The Week Ahead

The Week Ahead: 3 things to watch

At the start of a new week, geopolitics, economic data, an ECB meeting, and the stock market rally in the US are all in focus. Political risk has risen once again, with the demise of President Assad in Syria. He has been overthrow, which is a blow to President Putin’s prestige, according to the BBC. Added to this, there are reports that Israeli forces have crossed into Syria, which could see an escalation in the proxy war between Iran and Israel. The immediate risk is that the fall of Assad leaves a power vacuum in Syria, and stock index futures are lower at the start of the week.  Syria does not have oil, and the end of the Assad era may not impact the oil price too much. The oil price is up 0.4% at the start of the week, however, the Brent crude oil price fell more than 1% on Friday, even though Opec extended its production cuts yet again. This suggests that events in Syria may not impact the oil price long term.

The other main geopolitical event at the weekend was comments from President elect Trump who said that Ukraine could receive less military aid once he takes office. It is unclear if this would be due to him brokering some sort of truce between Russia and Ukraine, rather than leaving Ukraine high and dry. He also said that NATO needs to pay its bills as a condition of the US remaining a member. It is worth watching European markets, and defense stocks in particular, to see how his words impact sentiment.

After hitting another record high at the end of the week, stock market futures are broadly lower on Monday. The Santa rally could take a breather at the start of the week as the market digests the latest geopolitical events, however, we think there could be more to come. In the past week, the biggest drivers of the stock market include momentum, upward earnings revisions, liquidity, and growth. This is a broad array of market drivers right now, which is also supportive of stock markets in the lead up to the final weeks of the year. However, there are three tests for sentiment this week, including US CPI, an ECB meeting and UK monthly GDP figures.

1, US CPI

This week’s US CPI report will be important to seal the deal on a Fed rate cut when they meet next week. The market is expecting a 0.3% increase in monthly headline inflation, the annual rate is expected to tick higher to 2.7% from 2.6%. The core rate of price growth is expected to remain steady for November at 3.3%. We think there would need to be a large upside surprise for a December rate to be derailed, the market is currently pricing in an 85% chance of a cut according to CME’s Fedwatch tool. CPI can have a big impact on markets, however, in recent months the market impact in the one hour after the release has been small, with an average response in the S&P 500 of -0.1% in the 60 minutes after the release. The upper bound is 0.39%, and the lower bound is -0.6%, over the last 12 months.

The CPI report is one of the last economic jigsaw pieces before next week’s Fed meeting. If inflation is in line with expectations, we do not think that it will derail hopes of an interest rate cut. A large upward surprise would shock the market, and we could see stocks sell off into the Fed meeting, especially as valuations are rising. Overall, once the key risk events are out of the way, including the CPI report and next week’s Fed meeting, as long as there are no negative surprises, then we could see an extension of the rally in the S&P 500 to 6,200 and beyond.

2, ECB meeting  

It feels like we are either waiting for a central bank meeting, or one is taking place as we lead up to the Christmas holidays. This week it is the turn of the ECB, who will announce their policy decision on Thursday. Economists are expecting a rate cut of 25bps, to 3% for the main deposit rate. There are also cuts expected for the main refinancing rate and the marginal lending facility. A cut is virtually guaranteed, the question is, will the ECB shock the market and cut rates by 50bps? Although economists surveyed by Bloomberg do not think that they will, the market is not ruling out the possibility, with 37 bps of cuts currently priced in.

The decline in German factory orders and industrial production for October, highlights how the growth engine of Europe’s economy is in desperate need of a decline in interest rates. But will this be enough to boost the German economy? An end to the Russia/ Ukraine war may have a bigger effect, especially if it brings down gas and energy prices for the long term.

The one area where Germany has a big advantage over other European countries is its bond market. Its bonds remain attractive vs. other European countries, most notably France. Although the French – German 10-year yield spread declined last week, after the collapse of the French government, the yield spread remains a hefty 77bps, and we do not think that the yield spread will narrow much further.

The issues with France and Germany support a 50bp rate cut, but it is unlikely in our view, as several ECB members prefer a gradual approach. The ECB staff will also release their latest economic forecasts, which could reflect the deterioration in the growth outlook for the currency bloc and the disinflation process, which is expected to remain intact, even with rising wages. If the central bank says that inflation risks are to the downside, then we could see the euro tank. EUR/USD has traded in a tight range between $1.05 – $1.06 in the past month, a dovish assessment by the ECB could see this pair break the November low of $1.0418, which would be a significant break of support and would open the way to parity.

3, UK GDP

Monthly GDP will be the key release in the UK this week. The market is expecting a return to modest growth for October. The start of Q4 is expected to see growth ‘bounce’ back to 0.1% from -0.1% in September. The economy has struggled in H2, however, there is hope that the economy may have strengthened in Q4. The decline in growth in Q3 was partly due to a fall in IT and communication services, which may have reversed in October. There could also be a bounce back in production. There are positive signs about private demand, and government spending is also likely to have propped up growth, so the risks could be to the upside.

The pound was the second-best performer in the G10 FX space last week, and GBP/USD rose close to $1.2750. It opened a touch lower on Monday, as geopolitical concerns boosted the dollar. However, if risk sentiment recovers, we think that the pound could extend recent gains and $1.30 could be on the cards. An upside surprise to October GDP could give GBP/USD a push in that direction.

What’s driving the Nasdaq ?

Looking at the Nasdaq 100 in more detail, it rose by 3% last week, led by some big gains for Super Micro Computer, which gained an extension from the Nasdaq to file its delayed financial reports. Lululemon rose by a stunning 25% after the company reported strong sales of its bread and better products including leggings, and it raised its full year net revenue guidance. Tesla also rose by another 12%, in the past month the stock has surged by 36%. Big gains for these three stocks tells us something about current market trends: firstly, the market is reacting positively to strong earnings numbers, secondly, the market is sensitive to any good news, even if it’s from a company like Super Micro Computer, who have experienced compliance challenges this year. Momentum remains a strong driver of tech giants this year. Tesla is only 5% away from its record high, and the prospect of its breaching the record close of $414.50, its high from 2021, is looking like a possibility. Tesla is receiving a boost from expected regulation changes in self-driving technology, along with Elon Musk’s position in the heart of Donald Trump’s administration. There is a lot of chatter around Tesla right now, and that could drive further gains. The options market is also frenetic with demand for call options for Tesla stock well above its current trading price of $389, soaring.

It’s worth noting that the Tesla stock price is not rising on the back of earnings. It is the ultimate growth stock right now and it appears to be driven by other rules compared to the broader market. Thus, it is hard to call a top in its share price. At some point Tesla will sell off, and we will have to see if that is used as a buying opportunity.

The US stock market continues to suck in money from investors. Rotation has happened from big to mid-cap stocks, and now back to some of the large tech stocks. The important point to note is that money is not leaving the market, it is just being moved around. This could leave the market at risk of getting frothy, however, with a strong fundamental backdrop and a good outlook for corporate earnings there could be further to go in this Santa rally.

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