New market highs beget new market highs

After being faced with the prospect of a major slowdown in global activity in the wake of the Brexit vote, governments and central banks worldwide are now expected to do their utmost to reassure markets and provide stimulus.

Source: Bloomberg

This has led to an incredible rally in equities and industrial commodities. At the current juncture, the market expects the Fed to keep rates on hold until at least December, while monetary and fiscal easing is expected out of the UK and Japan. Of course, should those expectations fail to eventuate they could stop the rally short. The greatest unknown for markets is what will happen in mainland Europe. There is a pretty clear consensus that Italy’s banking sector needs a major capital injection, but the Italian government is abjectly refusing to see it happen according to the EU’s new bail-in rules. This is arguably the major pivot point for global markets: if the EU caves and allows a bailout amenable to the Italian government global markets are set to see an incredible rally, but if they don’t the European project could be torn apart and Europe could drive the world into a major global recession.

The rally in markets at the moment is strongly betting that the EU will cave and break their bail-in rules. Italy’s biggest bank Unicredit gained 13.45% overnight and a number of UK property REITs continued to see further strong gains. If the EU does cave then the biggest losers of the Brexit selloff – Italian banks and UK property REITs – could be set for some of the best outperformances.

No currency captures this changing global dynamic better than the GBP/JPY. The pound is gaining in the wake of the UK finally settling on a new Prime Minister and blissfully putting off triggering the Article 50 clause to formally leave the EU. While the yen continues to rally in the wake of Shinzo Abe’s strong result in the Japanese Upper House elections, which has opened the way for greater fiscal and monetary easing. These factors have helped see the GBP/JPY rally 6.5% in two days – an enormous move for developed market currencies – and there seems to be enough momentum behind the pair to push it to 145.

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The other major development overnight that hasn't had an impact on markets just yet is the decision by the UN tribunal that ruled that China had “no legal basis” for its expansive claims in the South China Sea. The decision has been met with unanimous derision and outrage in the major Chinese media publications and there is a not insignificant probability of these tensions flaring into actual conflict. Hopefully calm heads prevail, but the potential for conflict in East Asia has never been higher, particularly in the wake of Japanese elections on the weekend that could see Shinzo Abe further eradicate the pacifist clauses within the Japanese constitution.

Asian markets are all set to open higher following the strong performance in overnight markets. Iron ore gained 6.7% overnight alongside a range of other industrial metals. Oil also rallied over 5% but has pulled back somewhat after the US API inventories unexpectedly showed a 2.2 million barrel increase. Nonetheless, the materials and energy sectors are all set for a strong performance today.

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