FINANCIAL NEWS HIGHLIGHTS OF THE WEEK
- Investors perceived this week’s political developments in the U.S. as likely to delay the implementation of pro-growth policies. As a result, they risk assets sold off midweek in favor of gold and treasuries. Risk appetite appeared to make a comeback toward the end of the week along with some reversal in earlier trends, particularly among American equities.
- Underneath the political noise, the economy continued to emit mostly positive signals which included a rise in industrial production and capacity utilization, and falling jobless claims. Homebuilding appeared to be a soft spot at first glance, but the details reveal a better story.
- The Fed will keep an eye out for financial market stress, but is likely to continue focusing on signals from the economy. So far, the outlook for the second quarter remains solid, with growth currently tracking north of 3% annualized. As such, odds are still in favor of a June hike.
CUTTING THROUGH THE POLITICAL NOISE
To say that political events dominated headlines this week may be somewhat of an understatement. The U.S. administration found itself in hot water once again over allegations of misconduct. Mounting political pressure reached a boiling point with the appointment of a special prosecutor to probe Trump-Russia ties. Financial markets perceived these developments as likely to delay the implementation of pro-growth policies such as tax reform and infrastructure spending, and quickly sold off risk assets. By midweek global stock markets followed the rapid decline in American indices (Chart 1). The trade-weighted U.S. dollar gave up all of its gains recorded since the U.S. election. In commodities, oil retained its upward trend and is poised to end the week above $50/bbl, buoyed by news that Russia and Saudi Arabia may extend their production cuts along with a report from EIA showing falling U.S. inventory levels.
Political turmoil was not limited to the U.S.. The president of Brazil was accused of bribery, sending both the national stock market and currency plunging 9% and 7% respectively the day after news broke. Under such global disorder investors poured their money in safe heaven assets, with gold gaining around $25/oz on the week and sending U.S. Treasury yields lower. However, risk appetite returned by the end of the week with some reversal in earlier trends, particularly among American equities. The heightened volatility was reflected in the VIX index, which spiked to a month high at midweek but subsided quickly thereafter.
Underneath the political noise, the economy continued to emit mostly positive signals. Industrial production rose 1.0% in April – the biggest monthly gain in more than three years. Capacity utilization also rose to 76.7% – the best level since late 2015, boding well for future business investment. Weekly jobless claims fell unexpectedly, with levels now resting near decade-lows seen as further signs of a tightening labor market. Lastly, homebuilding appeared to be a soft spot at first glance, but the details revealed a better story. The headline was pulled down by the volatile multifamily segment, while the single family segment retained its upward trend (Chart 2). The latter is a much larger and better indicator of economic conditions, and its advance is reflective of continued progress in the labor market. We expect this trend to continue as rising wages support household formation and demand for new homes. 
Looking at the big picture there are two main points worth highlighting. First, investors will continue to pay close attention to political events because the implementation of pro-growth policies remains the cornerstone needed to validate today’s rich stock valuations. Intuitively, this suggests potential for further volatility in the weeks and months ahead. Second, the Fed too will keep an eye on such developments, not because it has placed much emphasis on the pro-growth policies to begin with, but rather because a market downturn could weigh on the real economy. Unless it sees concrete signs of this occurring, it is likely to continue focusing on underlying signals from the economy, particularly those related to inflation where recent readings have disappointed. So far, the outlook for the second quarter remains solid, with growth currently tracking north of 3% annualized. As a result, market participants will continue to price in a June Fed hike, with odds from CME Group currently pegged at 74%.
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