The week ahead: US CPI, tensions in the Middle East and the start of earnings season

The market is dealing with multiple narratives as we move into the fourth quarter. Firstly, geopolitical tensions and the risk of further direct strikes between Iran and Israel, secondly, the continued impact of China stimulus, and after Friday’s monster payrolls report, the prospect of a strengthening US economy that spurs inflation and does not allow the Fed to cut rates as quickly as had been expected. The Fed has said that it will focus more on the employment side of its mandate now that inflation is moderating, however, the employment side appears to be taking care of itself, instead the Fed may have to watch out for stronger wage growth.

US economic data surprises on the upside yet again

We have gone from hard landing to soft landing, now we might be in the era of ‘no landing’ for the US economy after the 254k jump in payrolls last month. The payrolls report has led to worries about the US economy overheating, which is why 10-year US Treasury yields surged at the end of last week, rising by 27 basis points last week to their highest level since early August. The 2-year Treasury yield posted one of its biggest weekly jumps since 2008 and rose by 37 basis points. In our NFP preview last week, we spoke about the rising trend in US economic data, and the payrolls report has boosted the Citi’s US economic surprise index. Throughout September, US economic data surprised on the upside, the rate of upside surprises is now at its highest rate since May. This suggests that the US economy picked up steam at the end of Q3, which leaves it in a strong position as we move into the final months of the year. This is boosting stock markets around the world. US stocks recovered losses on Friday, Asian stock markets have surged on Monday and European futures are predicting a stronger open today.

Will the Fed roll back on rate cut hopes?

The long-lasting impact of Friday’s payrolls report is that a 50bp cut from the Federal Reserve in November is now highly unlikely. The market appears to have settled on a 25bp cut. The market has also priced out nearly 2 rate hikes over the next year, with just over 6 rate cuts now expected, at the start of October, the market expected nearly 8 rate cuts. The strength of the labour market data also calls into question the Fed’s decision to cut by 50bps last month and questions the Fed’s decision to focus on the employment side of its mandate. We think that the Fed will go back to worrying about inflation over the coming months, since average wage growth ticked up to a 4% annual rate last month, the highest rate since May. This week’s US CPI print is crucial for market sentiment, in our view. The report, released on Thursday, is expected to show annual headline CPI moderating to 2.3% from 2.5%, the core rate of inflation is expected to remain steady at a 3.2% annual rate. The risk is to the upside after the recent bout of stronger than expected economic data, as the economy appears to have reaccelerated in late Q3. If we do get a larger than expected reading for inflation later this week, it may trigger a wave of risk aversion as US Treasury yields surge and as further interest rate cuts get priced out. It would also be dollar positive in our view.

Dollar on course for best week in two years

The dynamics of the FX market are shifting rapidly. The dollar index had its best week in 2 years, while the yen sunk and had its worst week since 2009. The yen fell 2.3% vs. the USD last week and was the worst performing currency in the G10 FX space. The pound was another big loser and fell nearly 2% vs. the USD. The rise of the greenback in recent weeks is a symptom of investors’ fears about escalating tensions in the Middle East, the upcoming US election and a US economy that is too hot for the Fed to cut rates. The weak dollar had been the overriding theme in FX markets since the middle of this year, and many thought that this would continue, however, the medium-term direction of the dollar going forward might be dictated by the economic data, especially future payrolls reports.

Will the selloff in the Pound continue?

The pound had a dismal week and fell nearly 2% vs. the USD. EUR/GBP also rose nearly 1% last week. Is this the end of the pound recovery theme, or is it merely a technical adjustment? The pound remains the best-performing currency in the G10 FX space so far this year, but this week will be a test to see if the market has fallen out of love with sterling. The dramatic fall in GBP/USD last week was driven by fundamentals and a narrowing in the UK – US yield spread. The 10-year yield spread fell by 9 basis points, while the 2-year yield spread has fallen by more than 20 bps since the end of September. This is a massive move, and highlights how quickly rate cut expectations can change, and the impact they can have on the FX market. The focus this week will be on the UK’s BRC September reading for retail sales. There is some expectation that a consumption ‘boom’ can help boost growth at the end of Q3 and into Q4, as the savings rate has been rising and consumer spending has stalled in recent months. The other big data point to watch will be the August monthly GDP reading. After a subdued reading in July, pound bulls will want to see some signs of life in the UK economy to help boost the chances of a decent reading of Q3 GDP. The market is expecting a slightly better reading for August compared to July, with GDP expected to expand by 0.2% on the month. The 3 month-on-month rate is expected to moderate to 0.3% from 0.5% growth in Q2. This is a dismal rate of quarterly growth, which will do nothing to boost the government’s reputation after it said in the election campaign that economic growth was one of its main targets. Overall, we think that this week’s economic data will be crucial for the direction of the pound going forward.

Will the government hint at a more business-friendly budget?

It is early days for the government, and they must play a part in turning around the UK’s economic fortunes. This week the government will host an investors summit in London that will feature some of the biggest names in global business. The hope is that the government will be able to attract some big-ticket investment on the back of this conference. However, for this to happen, we think that the government will have to commit to small and inconsequential changes at this month’s Budget, including to Capital Gains Tax and to carried interest charges. There has been some speculation that the government will water down original plans to charge these taxes close to the highest rate of income tax at 45%. If there are any hints that this month’s budget will be more business friendly, we think that it will be positive for UK asset prices, and it may help the pound to stage a recovery after a bruising week.

How markets could be impacted by events in the Middle East

GBP/USD has opened the week stable around $1.3115, after finding support at $1.3080 on Friday. The start of the week could be tricky for the pound as Middel East tensions may threaten to boil over on the anniversary of the Hamas attack on Israel. Israel targeted more sites in Lebanon on Sunday night, but the bigger risk for markets would be an Israeli strike on Iran’s nuclear facilities or on its oil fields. In this extreme scenario, oil would likely surge more than $10, and fears about an escalation in tensions could lead to greater demand for safe havens like the dollar. So far on Monday, these tensions have not reached boiling point, and the oil price is lower, Brent crude is trading below $78 per barrel. Gold was an unreliable safe haven last week, even as geopolitical risks flared up. Gold was mostly flat, as a rising dollar weighed on the price of the yellow metal. Thus, if the dollar remains in demand, the gold price may struggle.

Chinese stocks surge yet again

Chinese markets surged once again on Monday, as markets reopened after a national holiday. The CSI 300 rose by a further 8% and is at its highest level since April 2023 after an astounding rally in recent weeks. Everyone is waiting for the rally to end, but after under-performing for most of the last 4 years, there is room for Chinese and Hong Kong stocks to play catch up for some time.

This is a period of change for financial markets. China stimulus has altered the picture for global economic growth and Asian stock market allocations, interest rate expectations have shifted significantly, and geopolitical risks have surged as the threat of war between Iran and Israel materializes. Stocks in Europe and the US underperformed stock markets in China and Hong Kong for a second week. The S&P 500 and the Nasdaq eked out small gains last week. They were saved by a late rally on Friday, spurred by the better-than-expected US payrolls report. European indices sold off sharply last week, the Eurostoxx 50 index fell by more than 3.8% last week on a currency adjusted basis, the Cac was lower by nearly 5 % and the FTSE 100 was down by more than 2.4%, although UK oil majors were the best performers in the FTSE 100, BP rose more than 7%, while Shell was up by more than 6% as the price of oil surged. The UK’s energy sector means that it is more protected from the downturn in stocks triggered by Middle Eastern tensions compared to other European indices. However, US stock markets are the most cushioned from oil price increases, since it is a net oil producer, unlike Europe, which is a major energy importer. Looking ahead, the stronger outlook for the US and China economies is positive for stocks as we start a new week, and we could see US stocks attempt to claw back losses they have suffered since the start of October.

The start of Q3 earnings season: The bar is lowered

Events in the Middle East are a major risk for financial markets yet again this week. However, investors also need to be aware of economic data and corporate data. It is the first big week for corporate earnings in the US, with the major US banks including JP Morgan, Wells Fargo and Blackrock all reporting Q3 results on Friday. Earlier in the week, Pepsi and Delta Airlines will also report Q3 results. This earnings season comes after the S&P 500 has rallied more than 20% so far this year, adding $8 trillion to the US index. However, analysts have scaled back their expectation for earnings growth, and Q3’s growth rate is expected to fall to its lowest level in four quarters. Analysts expect a 4.7% increase in US earnings, down from nearly 8% in July. On the positive side, this means that the bar is lower, however, there are some key risks ahead, including geopolitical tensions and fears about the economy potentially weighing on consumer sentiment. Profit margins will be watched closely, as will the performance of Russell 2000 companies. The market will want to see if small and medium cap stocks in the US can keep up with large cap stocks, if they can then the stock market rally could continue to broaden out. It is worth noting that although the equal-weighted S&P 500 is tracking the market cap weighted index closely, the market cap weighted index has outperformed over the past month. If earnings reports mostly come in line with expectations, then the Fed may take over once more as the most powerful driver of stocks.