In an eventful overnight session which saw a historic transition in Saudi Arabia, an unexpected Republican victory in the Georgia Special Election, China’s inclusion in the MSCI EM index and Travis Kalanick’s resignation, S&P futures continued to fall, alongside stock markets in Asia and Europe, while oil prices extended their drop despite a larger than expected draw reported by API on Tuesday. The USDJPY continued its recent slide, dropping just shy of 111, while GBPUSD tumbled as low as 1.2589, the lowest since May announced the UK election, only to reverse and recover all gains ahead of the Queen’s speech on Wednesday.

Despite the much hyped inclusion of 222 mainland Chinese shares in the MSCI EM index starting May 2018, which will by only 0.73% to include Chinese A-shares, the Shanghai composite closed a modest 0.5% higher, as the initial euphoria fizzled following calculations that buying pressure from the MSCI shift would be muted. MSCI estimated the change, due around the middle of next year, would drive inflows of between $17 billion and $18 billion. China’s market cap is roughly $7 trillion.

The index provider also set out a laundry list of liberalization requirements before it would consider further expansion. “We suspect that it will be a long time before this happens,” wrote analysts at Capital Economics in a note. While China’s weighting in the MSCI Emerging Markets Index may ultimately rise to 40 percent or so, this rise is likely to be slow,” they added. “The upshot is that any initial boost to equities is likely to be small.”

“Inclusion is unlikely to result in a significant shift in the underlying flow picture,” Goldman Sachs economists led by MK Tang write in note. “While short-term sentiment could be favorable, over the longer term we continue to expect the CNY to move in a managed path, gravitating gradually towards a weaker level against the USD due to fundamental forces.”

More notably perhaps, the offshore yuan dropped, shrugging off MSCI’s decision to include mainland shares in its benchmark stock indexes while China’s Ten-year sovereign bonds fall, with the yield rising the most in 6 weeks after the PBOC drained CNY 40bn in liquidity, even as S&P said it sees a “real possibility” of a China downgrade, for one simple reason: China continues to drown in debt.

European shares fell for a second day as crude continued to edge lower. Haven demand spurred the yen and gold, which was poised to advance after five days of losses. For once oil’s woes had little impact in Saudi Arabia, where a palace reshuffle and good news from MSCI Inc. boosted equities. Shanghai stocks also advanced after the index provider added China’s domestic shares to its emerging-markets gauge.

Another key overnight development, was the Saudi Royal reshuffle in which King Salman stripped the current crown prince, his nephew Mohammed bin Nayer, of his post, and replaced him with his son, Mohammed bin Salman.  While speculation remains on what was the cause for the historic shakeup, with the ongoing collapse in the price of oil and resulting sharp saudi deficits cited as the most likely one, the local market took it in stride, with the Saudi Tadawul All-Share index rallying 3.3% after the news.

Back to markets, Australia’s S&P/ASX 200 Index slumped 1.6%, erasing its gain for the year, as energy shares tumbled. BHP Billiton and Rio Tinto both slid at least 2.9 percent. While the SHCOMP eeked out modest gains, Hong Kong’s Hang Seng Index fell 0.6% perhaps due to rebalancing.

European shares fell for a second day as crude extended its drop further into a bear market. Safe haven demand spurred the yen and gold, which was poised to advance after five days of losses. The ongoing weakness in crude and other commodities threatens to crush arguments from US central bankers that weak inflation rates will be transitory, adding to concerns of a Fed policy error that could unintentionally crimp the global economic recovery, according to Bloomberg. The Stoxx Europe 600 lost 0.7% with bank stocks leading the way.

All eyes remained on oil, where signs of a growing glut of supply and rising Libyan output sent Brent crude futures skidding back to $45.50 as European trading gathered momentum. The slide in energy costs boosted bond prices and flattened yield curves as investors priced in lower inflation for longer, while safe-haven flows underpinned the Japanese yen.

“Brent now the lowest since mid-November: remember that whole reflation thing? No, neither does the market,” Rabobank analysts told clients in a reference to Brent crude futures, which have slid almost 10 percent this month, and over 20% since the recent highs. Oil had shed 2% on Tuesday, taking U.S. crude futures into a bear market, a red flag to investors who follow technical trends.

The moves in rates were just as dramatic, with the spread between yields on U.S. five-year notes and 30-year bonds shrank to the smallest since 2007 as investors wagered the Federal Reserve might have to delay further rate hikes. Thirty-year German debt yields bonds also tumbled back toward two-month lows, adding to a more than 20-basis-point drop over the past month and ahead of what will now be a closely watched sale of 30-year debt in Berlin later.

“The plunge in oil prices ignited a bull flattening on the German and U.S. curve,” analysts at UniCredit said in a note adding that it suggested “reflation trades are finally deflated.”

The recent setback for crude and commodity prices as well some equity markets is partly over doubts of Trump’s promised multi-trillion dollar stimulus program, which had raised hopes of boosted inflation and growth, and has been a huge disappointment instead.

In currency markets, the flight from oil and into long-dated government bond benefited the safe-have yen which climbed to 111.120 per dollar. The U.S. currency was holding its own elsewhere though – oil and the greenback often move inversely. Against a basket of currencies, it was steady at 97.736 having touched a five-week peak overnight. The euro stood at $1.1146 after hitting a three-week low, while the dollar eased a touch on the yen to 111.17. Sterling was still in the firing line initially sliding back under $1.26 but since rebounding sharply and recoupong all losses.  It took a spill after Bank of England Governor Mark Carney hosed down speculation that he might soon back higher interest rates, saying he first wanted to see how the economy coped with Brexit talks.

Oracle scheduled to report earnings later on Wednesday, while numbers on existing home sales will be published on the macro side

Market Snapshot

• S&P 500 futures down 0.3% to 2,431.00
• STOXX Europe 600 down 0.8% to 386.28
• MXAP down 0.5% to 154.46
• MXAPJ down 0.9% to 500.76
• Nikkei down 0.5% to 20,138.79
• Topix down 0.4% to 1,611.56
• Hang Seng Index down 0.6% to 25,694.58
• Shanghai Composite up 0.5% to 3,156.21
• Sensex down 0.2% to 31,222.18
• Australia S&P/ASX 200 down 1.6% to 5,665.72
• Kospi down 0.5% to 2,357.53
• German 10Y yield fell 1.4 bps to 0.248%
• Euro down 0.04% to 1.1130 per US$
• Italian 10Y yield fell 4.4 bps to 1.62%
• Spanish 10Y yield fell 2.2 bps to 1.363%
• Brent Futures down 0.6% to $45.76/bbl
• Gold spot up 0.2% to $1,246.00
• U.S. Dollar Index up 0.01% to 97.77

Top Overnight News from BBG

• Theresa May will make her first attempt to engage with Britain’s new political landscape as she publishes a legislative program heavy on Brexit and likely to be light on anything controversial
• U.K. first secretary of state Damian Green tells BBC radio there’s still every possibility of Conservative Party deal with DUP; government currently lacks overall majority in parliament with legislative program due later on Wednesday in Queen’s Speech
• Saudi Arabia’s Deputy Crown Prince Mohammed Bin Salman was named to replace his cousin as heir to the throne in a shake-up that consolidates the 31-year-old leader’s power in the world’s biggest oil exporter
• Emmanuel Macron’s justice and European affairs ministers quit, bringing to four the number of members of his cabinet who have left in recent days amid various ethics investigations
• Chinese stocks were little moved by their addition to MSCI Inc.’s benchmark indexes as investors weighed the symbolic importance of inclusion against the limited impact on short-term inflows
• Republican Wins U.S. House Seat in Georgia After Close Race
• Oil Slide Hits Stocks; MSCI China Impact Is Muted
• Housing Finance Overhaul May Come Before Dodd-Frank, Warner Says
• Saudi Crown Prince Seen Keeping Oil Policy Aimed at Higher Price
• Uber CEO Travis Kalanick Quits Under Pressure From Investors
• BMC Software, CA Said to Weigh Deal to Combine, Take CA Private
• Sears Canada Is Said to Prepare to Seek Creditor Protection
• Sinopec, JD.com Discuss Cooperation on Logistics, Finance
• Sharp Says FY 2016 Sales to Apple Fell 18.8% Y/y to 542.1b Yen
• Mithra Completes Recruitment for Added Estelle® Safety Study

Asia equity markets traded mostly negative following the downbeat Wall St. close, where energy lagged after WTI crude briefly slipped below USD 43/bbl to hit a 9-month low. ASX 200 (-1.6%) underperformed with the index dragged by weakness across commodities, while Nikkei 225 (-0.4%) was dampened by a firmer JPY. Shanghai Comp. (+0.2%) and Hang Seng (-0.6%) were mixed with the mainland bourse kept afloat following MSCI’s inclusion of China A-shares in its Emerging Market index, which in turn also dampened stocks in South Korea due to expected outflows from the decision. 10yr JGBs are mildly higher with mild demand seen amid weakness in stocks, while the BoJ were also in the market for JPY 1.03fin of JGBs ranging from 1yr-10yr maturities.

Top Asian News

• Toshiba Picks Bain-Japan Group as Preferred Chip Unit Buyers
• Freeport Indonesia Workers to Extend Strike for Third Month
• Australia Law to See Online Retailers Pay More Sales Tax
• Vanke’s Wang Exits After Tussle Over China’s No. 1 Developer
• China Stocks Win MSCI Entry as $6.9 Trillion Market Goes Global
• MSCI Sees $17b of China Inflows Under Current Inclusion Plan
• Singapore June COE Second Open Tender: Summary (Table)
• Allianz Seeks to Bulk Up in Asia in Wait for China Permit
• China Steel Rebar Extends Drop as ‘Off-Season’ Demand Takes Toll

EU markets trade in the red, a continuation from yesterday’s US session. Energy continues to struggle, with WTI futures looking to once again attack the USD 43.00/bbl level. Financials lead the downside however, not helped by earnings downgrades this morning, with prudential (-16%) the clear laggard in FTSE 100. Fixed Income markets are evident of the risk off sentiment — Gilts and Bunds continue to tick higher as global uncertainties continue. Spreads to the Bund have been mixed, with the lOy Spain trading well, 0.50bps tighter to Bunds, contrasting with a 0.50bps widening for BTPs. UK PM May stated that the Brexit needs to be delivered in a way the commands maximum public support, while May added they will work with parliament, businesses and devolved governments to ensure a smooth and orderly exit.
30 UK Conservative MPs are reported to have told PM May they will not accept a Brexit without a deal. The DUP was reported to have threatened to walk away from talks with the Conservative party over forming a government. Last night there was speculation that the Conservatives could even open talks with the Liberal Democrats’ 12 MPs about supporting the Tory Government if the DUP talks fail.

Top European News

• Gecina to Buy Eurosic for $2.8 Billion to Add Paris Offices
• Provident Financial Falls 20% After Warning on Consumer Credit
• Credit Suisse to Bolster Leveraged Finance Business: FT
• Australian Regulator Postpones Decision Date on Bayer, Monsanto
• Novo Nordisk’s Victoza Heart Benefit Claim Backed by FDA Panel
• May Faces New Political Reality With Brexit-Heavy Program
• Macron Loses Two More French Ministers as Bayrou, Sarnez Quit
• U.K. Budget Deficit Narrows in Fiscal Boost for Hammond
• Italy’s Gentiloni: U.K. Not Very Strong at Start of Brexit Talks

In currencies, FX markets again influence by the political mess in the UK, where we have a minority government scrambling for seats. The DUP have threatened to walk away from talks according to the media, but insiders suggest talks are ongoing, so earlier speculation that Theresa May and her band of not-so merry men will turn to the LibDems is premature. Nevertheless, GBP remains under pressure, as yesterday’s catalyst of gov Carney’s distancing from hawkish sentiment at the MPC has seen 1.2600 relinquished, but all too briefly as yet. EUR/GBP grinds higher to test 0.8850, but has stopped short of this level by some 5 ticks or so as yet. Elsewhere, we have seen a modest pullback in the USD in line with the Treasury curve, where the key 10yr rate is now just under 2.15%. USD/JPY is testing moderate support ahead of 111.00, but this is all inside familiar territory and suggests a period of range bound trade ahead. This goes for EUR/USD also, but we sense the demand in EUR/GBP is adding an artificial bid here as the lead EUR rate looks prime for a deeper setback after the sold resistance seen ahead of 1.1300, and now at 1.1200. EUR/CHF heavy in the mid 1.0800’s supports this view.

In commodities, West Texas oil fell 0.2 percent to $43.41. Futures tumbled more than 2 percent on Tuesday, touching the lowest since August. Gold rose 0.2 percent to $1,245.98 an ounce after falling for five straight days. Oil had shed 2 percent on Tuesday, taking U.S. crude futures 20 percent off recent highs and thus into official bear territory, a red flag to investors who follow technical trends.  “Brent now the lowest since mid-November: remember that whole reflation thing? No, neither does the market,” Rabobank analysts told clients in a reference to Brent crude futures, which have slid almost 10 percent this month. The weakness in crude and other commodities threatens to dent arguments from U.S. central bankers that weak inflation rates will be transitory, adding to concerns of a Fed policy error that could unintentionally crimp the global economic recovery.

Looking at the day ahead, it’s a quiet day for data with only US existing home sales for May out this afternoon. Away from the data the BoE Chief Economist Andy Haldane is scheduled to speak at midday today while the Queen’s speech will be the other big focus.

US Event Calendar

• 7am: MBA Mortgage Applications, prior 2.8%
• 10am: Existing Home Sales, est. 5.55m, prior 5.57m
• 10am: Existing Home Sales MoM, est. -0.36%, prior -2.3%

DB’s Jim reid concludes the overnight wrap

It it seems apt that Oil was one of the major market movers yesterday. WTI fell -2.19% yesterday to close at $43.23/bbl (although did hit an intraday low of $42.75/bbl). That means it has now fallen a little over 20% from its highs back in February (using close-to-close prices – closer to 23% using intraday pricing) and therefore slipping into the definition of a bear market. Rather than there being one specific catalyst yesterday the move just appeared to be an extension of the slide that we’ve seen for the last few months now with markets questioning the impact of the OPEC-led output cuts and also a reinvigorated US shale market. Risk assets were hit hard too as a result. The S&P 500 (-0.67%) suffered its biggest decline since May 17th while the Stoxx 600 (-0.70%) was down a similar amount. EM currencies sold off while sovereign bond yields fell in tow. 10y Treasuries ended the day 3.2bps lower at 2.157% while 10y Bunds were 1.9bps lower at 0.258%.

Oil is now back to levels last seen on September 16th last year and even though we’ve rallied hard since February 2016, Oil has only been lower than this for 6% (188 days) of the time since the start of 2005. That is mostly made up of 44 days in 2008/09 and 112 days in late 2015/ early 2016. So these are pretty stressed levels relative to the past decade or so. Given that Oil has returned back to start of 2005 levels we thought we would publish our usual monthly asset performance chart from this date to put the lethargic performance of Oil in some  context over the last 12 and a half years. Keeping it in USD  hedged terms only for simplicity sake, of our usual asset classes we monitor the biggest winners have been the Shanghai Comp (+286%), Gold (+189%), Hang Seng (+177%), S&P 500 (+163%) and EM Equities (+160%). So while Oil is net flat it’s not stopped equity markets rallying incredibly over that time. US and EUR credit indices have returned anywhere from +34% to +109% and DM bond markets have returned +38% to +61%. In fact outside of currencies only 4 assets have fallen in the last 12 and a half years (and therefore unperformed Oil). Those include the FTSE MIB (-10%), European Banks (-34%), the Broad Commodity Index (-38%) and Greek Equities (-68%). Clearly the financial crisis and peripheral European concerns of the last decade are the big themes there.

Away from Oil the other notable news yesterday came last night after markets closed with the announcement that China’s A-shares will be included in MSCI’s benchmark indexes for the first time following three previous failed attempts. The index complier plans to add 222 large cap China A stocks which will mean they occupy an aggregate weight of 0.7% in the emerging markets index. According to the FT that is a larger number of stocks and overall percentage than MSCI had previously proposed. Stocks will be added in two stages in May and August next year. Significantly this marks a fairly major landmark for China in as far as integrating into the global financial markets.

The announcement has seen Chinese equity markets firm up this morning which is helping to offset falling energy stocks. The Shanghai Comp is currently +0.13% after being up as much as +0.45% while the CSI 300 is +0.52%. In contrast the Hang Seng (-0.30%) is in the red along with the Nikkei (-0.23%), ASX (-1.35%) and Kospi (-0.56%). Oil is little changed while US equity index futures are also pointing towards a slightly weaker open. As we go to print headlines are also hitting the screens noting that Saudi Arabia’s King has replaced the Crown Prince, replacing him with his son Mohammed bin Salman.

Moving on. With the calendar fairly thin again today expect there to be a reasonable amount of focus on the Queen’s speech at 11.30am BST in the UK. With no deal reached yesterday it appears that an agreement between the Conservatives and the DUP parties will not be made in time for it. So it’s likely that the government will today present its legislative programme with no guaranteed majority. Several days of debate is expected to commence following the speech with votes then expected to go ahead on June 28th and 29th. The Telegraph ran a story last night suggesting that DUP MP’s are threatening to walk away from a deal entirely. So it’s very fragile situation.

Of course this all comes with the first week of Brexit negotiations getting underway and for which more and more details will emerge in weeks to come. Brexit was a big focus in Governor Carney’s Mansion House speech yesterday with the Governor stating that he wants to see how the economy reacts to the reality of Brexit negotiations. Carney also talked about “mixed signals on consumer spending and business investment” along with the “still subdued domestic inflationary pressures, in particular anaemic wage growth”. So pretty dovish overall particularly in light of the more hawkish BoE meeting last week. Sterling tumbled -0.85% yesterday to close at $1.263 and is now below the big election night spike lower, and at the lowest since April. It’s worth adding the Chancellor Hammond also spoke yesterday at the Mansion House and reiterated that the Government will “remain committed to the fiscal rules set out at the Autumn Statement….to a balanced budget by the middle of the next decade”. In other words no indication that the Government will be changing course any time soon but he did acknowledge that the election shows that Britain had become weary of austerity so maybe higher taxes are planned for some. He also spoke about prioritising jobs and the economy in Brexit talks which was different to the campaign trail rhetoric from his leader.

Away from the BoE it was also a busy day over at the Fed. The Chicago Fed’s Evans spoke again and said that he was a little nervous on inflation but overall still positive about the US economy. He also suggested that the Fed could wait until December before deciding whether or not to tighten again. Vice-Chair Fischer acknowledged that low rates have contributed to rising house prices in certain countries while the Boston Fed’s Rosengren voiced some concerns about financial stability risks as a result of a long period of low rates.

Meanwhile House Speaker Paul Ryan delivered his eagerly awaited tax speech but it ended up being pretty short on exciting details for markets. Ryan emphasised that the current administration is “”going to fix this nation’s tax code once and for all” while also saying that “we need to get this done by 2017”. It’s worth noting that Ryan avoided the much debated border adjusted tax issue although in a TV interview just after did also note that the BAT isn’t dead but that officials are also working on possible alternative proposals.

Before we wrap up, in terms of the limited macro data out yesterday, in the US the current account deficit for Q1 revealed a deficit of 2.5% of GDP during the quarter which is little different to that seen on average over the past eight years. In Germany a drag lower from energy prices saw Germany’s PPI fall -0.2% mom in May and a little bit more than expected.

Looking at the day ahead, it looks set to be another quiet day for data with only UK public sector net borrowing data for May due out this morning and US existing home sales for May out this afternoon. Away from the data the BoE Chief Economist Andy Haldane is scheduled to speak at midday today while the Queen’s speech will be the other big focus.