FTSE 100 makes another record as pound withers

Another day, another record high for the FTSE 100. The high so far this morning is 7,480, with volatility at extremely low levels and the oil price continuing to benefit from the Opec-effect, 7,500 is the next logical target. Considering it took five months for the FTSE 100 to jump 500 points, if momentum is maintained over the summer months then we could see 8,000 in this index by October.

Why are the markets so high?

There are a lot of reasons why stock markets shouldn’t be so high: global cyber-attacks, North Korea missile tests along with legislative gridlock in the US. However, when stock markets continue to rise, it’s worth analysing the strength of the drivers to try and gauge whether the rally can live to see another day. Right now there are two clear drivers of stock markets: politics and central bank policy.

Politics and stocks: a beautiful relationship

Looking at politics first, the markets reacted with glee to the election of Donald Trump last November, European indices are now doing the same with Emmanuel Macron in France. His victory in last week’s election solidifies the euro and eradicates the threat to the West’s organisational structure from nationalist parties who wanted to break up the Eurozone. This is a powerful tonic for markets, especially when Europe’s economy is starting to pick up and the ECB is toying with the idea of tapering at some stage later this year. Markets may continue to bask in Macron’s victory, but it could be cut short in mid-June when we get the National Assembly elections. If Macron’s newly formed En Marche! Party cannot get enough members into parliament to push through Macron’s radical agenda, then the Macron rally could lose some of its lustre. However, the next month could be strong for European equities, as political risk recedes.

Central banks are still king for financial markets

Central banks are also driving the markets, with the Fed expected to raise interest rates next month, and the ECB continuing with its enormous stimulus package. The soft patch of economic data for the US in Q1 this year means that the Fed could put the brakes on its rate hiking efforts for a few months after the expected June hike. A little bit of tightening isn’t going to hurt this stock market rally, but too much of it will, thus, a hike from the Fed in June and then a pause would probably be the best outcome for global stock markets. In contrast, a strengthening European economy is giving rise to expectations that the ECB will have to announce some form of taper perhaps as early as this summer. But that is good for stocks also, as it would suggest a confidence in the Eurozone economy that would also be welcomed by investors. Thus, this rally may still have further to go.

The Vix: a loose cannon

The one thing to watch is the Vix index, which hit a rock bottom level on Monday at 10.40. This index could drift lower, potentially to a sub-10 level, but this index doesn’t tend to stay low forever, and tends to mean revert. Thus, while I can see a supportive fundamental picture for stocks right now, the subdued nature of the Vix is worrying, and it is worth watching this index closely in the coming days and weeks.

UK inflation not enough for the pound

A quick word on UK inflation, prices were stronger than expected with headline inflation rising to 2.7% in April, up from 2.3% in March. Air fares were the main contributor to the increase last month, due to the late timing of Easter. Rising prices for clothing and electricity also pushed up this rate. However, a fall in motor fuel prices limited some of the upside. The core rate also surged to 2.4%, from 1.8% in March, which is the highest level since 2013. So why didn’t the pound break above 1.30 versus the USD?

We mentioned in our note yesterday, that a rise in prices for April was expected after the Bank of England brought forward its expected peak for CPI to the end of this year in last week’s Inflation Report. Thus, larger increases in CPI now may mean that price increases will be subdued in the summer months. This is one reason why the pound has been kept in check. The other reason is that today is the euro’s time to shine, after EUR/USD broke above 1.10 earlier. This is helping to lift EUR/GBP, which is above 0.8850, and is also adding to the downward pressure on the cable rate. We will have to see if UK wage data and retail sales later this week can be enough to drive GBP/USD above 1.30, for now there is a shyness ahead of this level.