"...and everything blows up in your face” Ironic, Alanis Morissette
There are times in financial markets when detailed economic and econometric analysis of potential outcomes leaves the market (temporarily at least) looking in the wrong direction. The election of Donald Trump was an obvious example, where consensus expectations ahead of time, that the protectionist, fiscally imprudent and controversial policies of the campaign, would be negative for stocks and the USD if they became a reality - those expectations were quickly and significantly dispelled. Yesterday was another example.
For a long time now we have outlined the view that the low rate, low inflation, low vol backdrop that had driven extraordinary equity gains and undermined the USD, was contingent on the absence of inflation. Indeed, the fact that the higher than expected average hourly earnings component of the January inflation report seemingly led to a significant capitulation of equity markets and a rebound in the USD appeared to validate this theory. It is perhaps not surprising therefore that financial markets attention to the release of the January (CPI) inflation data, was an acute focus.
Despite the fact that there was some uncertainty around the BLS revisions to the seasonal adjustments for January, the inflation data for January was significantly higher than expected. The knee jerk reaction was, not surprisingly, to sell equities and risk assets, and to buy the USD. This theme was quickly and sharply reversed through the course of the day.
Some have argued that the recent inflation acceleration overstates the underlying momentum. However, after years of flatlining it is hard to deny the reality of rising inflationary impetus in the US, just as a fiscal expansion collides with a tight labour market amid unsustainable debt trajectories. Against this backdrop, it is perhaps easier to understand the counter consensus resurgence of USD weakness after the inflation print. Rising equity markets, however, are less obvious.
With many moving parts to the story, we are inclined to draw few conclusions from yesterday’s price action (extended today). Suffice to say that volatility is historically at its highest point at the turn in a cycle.
Isn’t It Irenic… Don’t you think?
Yesterday officially marked the start of the (long overdue in our opinion) "Road to Brexit” speeches - where government is expected to lay out an expanded (and perhaps more importantly, positive) vision for the future EU relationship - with an effective call for unity from Foreign Secretary Boris Johnson.
Some may question his connection with the (increasingly disparate) youth and therefore the likely absorption of his message to this particular demographic. Many commentators have chosen to ignore his message, choosing rather to criticise or ridicule mr Johnson’s character "- as is their right”. You may even question the drawbacks of his extremely diverse lexicon (I had to look up a number of words from the speech - including ‘teleological’: seeing purpose in ends rather than stated causes, and ‘irenic’: aiming, or aimed at peace). However, it is difficult to question the need for those at the helm to provide a positive narrative to the aims and potential of the UK’s withdrawal from the EU.
The Foreign Secretary aimed to dispel three broad public concerns. (i) The strategic loss, or threat to European security due to Brexit. (ii) That the UK will become more insular or more nationalistic post Brexit. (iii) That there will be an economic loss due to Brexit. In riposte, Johnson reiterated the continued, unwavering commitment to European defense and security cooperation. He outlined a post Brexit UK that is not nationalistic, but international (istic), welcoming talent from across the globe, while not limiting trade focus to an area that comprises "just 6% of humanity”. Ultimately, Johnson espoused a model of managed alignment (and mutual recognition), essentially allowing for divergence in a managed way. Expressing the desire to do more trade with Europe, not less, while benefiting from additional trade with those countries outside the EU that will account for 90% of global growth over the next 15 years.
"Who would have thought...” Ironic, Alanis Morissette
"Heat not a furnace for your foe so hot that it do singe yourself” William Shakespeare
For most of 2017, and pretty much all of January, global financial markets were in risk seeking mode, fuelled by monetary settings that created an economic backdrop that was deemed not too hot, nor too cold, but just right. This Goldilocksy backdrop for risk assets was essentially a function of the low inflation, low interest rate, low volatility environment, where an increasingly stable and synchronous economic recovery drove higher equities and, by default, a weaker USD. However, the reaction of global financial markets to the higher than expected wage inflation component of the January US employment report highlighted the bearish implications of inflation and its threats to the Goldilocks theme.
Last week we argued that while we are increasingly convinced that volatility is experiencing a regime-shift higher (as we have stated a number of times recently), it is not clear that the (in our mind undoubtedly bearish) threat of inflation, suggested by the January average hourly earnings, is immediate. In this regard, the wider inflation gauge of tomorrow’s CPI will be keenly watched. In many respects, at least at this stage, inflation could turn out to be the baby bear signal. Yesterday’s announcement that the Trump Administration are proposing a USD 4.4 trillion budget that blows a further hole in the deficit (and the pursuit of austerity) and that they are soon to unveil a protectionist programme of ‘reciprocal taxation’ are two more bearish threats to the USD and risk assets.
Ultimately, we would suggest that the market will increasingly question the validity (and more importantly the side effects) of the late-cycle and debt-financed fiscal easing of the Trump Administration. Not to mention the implications of sharply higher Treasury issuance against a backdrop of a Federal Reserve unwinding its QE bond holdings. However, in the near term, we are inclined to believe that the sell-off in risk assets last week was more of a bump in the road than a turning point - in the immediate future at least. Admittedly, it was a very big bump, and ultimately a warning shot as to the vulnerability of risk assets to the eventual turn in the low inflation / super accommodative monetary policy backdrop that has prevailed for so long. All eyes on CPI.
"Cold is a state of mind” Bud Grant
So far this week there has been very little in terms of significant economic data. This morning’s UK inflation showed some resilience (in both headline and core), but this is still almost entirely a function of the pass through of previous (Brexit related) falls in GBP. While markets look ahead to UK retail sales data (Friday) and tomorrow’s US CPI data, both for January, sentiment is back at the forefront.
In that regard, in the UK there are some interesting points to note in relation to Brexit progress - or perhaps more specifically in relation to strategy, than progress. Firstly, from the EU27, there appears to have been broad discontent with the thinly veiled threats of Mr Barnier at last weeks’ press conference. It seems that the inclusion of a so called punishment clause in a draft EU document published last week has drawn disquiet over its content and lack of consultation from France, as well as Nordic and Eastern European countries.
"The time is always right to do what is right” Martin Luther King, Jr.
Furthermore, and perhaps most pertinently, the UK appears to be reaching a more concerted and united strategy in its approach, not only to the negotiations, but also in uniting both Cabinet and (to a greater degree) the country behind a plan to deliver the greatest possible post Brexit benefits to the UK. The two week ‘charm offensive’, collectively known as "the road to Brexit speeches”, will consist of a series of speeches laying out the UK’s position.
Tomorrow, Boris Johnson will deliver a domestically focussed ‘call for unity’ over Brexit and reportedly reach out to Remainers. Saturday 17th Feb, Theresa May speaks in Germany on post-Brexit UK-EU Security cooperation. TBC, David Davis will speak on "driving higher standards” and Dr Fox will deliver a major speech on "trading with the world”. Finally, culminating at the end of February, Theresa May will delivery a speech entitled "A future Partnership”.
"Some rise by sin, and some by virtue fall” William Shakespeare
Earlier this week we discussed the backdrop for global financial markets in the wake of the upside surprise to average hourly earnings (AHE) and the extended rally in US yields and subsequent capitulation of confidence / algorithm-induced flash crash / spectacular unwind of short-equity vol. trades that followed. Ultimately, we posed the question: "have we had a healthy correction within a continuing bull market theme, or is this the start of a deeper down move? And, more broadly, what are the implications for wider financial markets and for FX markets in particular?”
In many respects, in the near term it is not quite as simple as that. While we are increasingly convinced that volatility is experiencing a regime-shift higher (as we have stated a number of times recently), it is difficult to argue that the recent price action is a response to to the data. If we were to summarise the key trends of the past year or so, it is likely that they would all be a function of the low inflation, low interest rate, low volatility global economy, where an increasingly stable and synchronous economic recovery drove higher equities and by default, a weaker USD. The ‘game changer’ for this embedded theme of financial markets is the presence of inflation.
However, it is not clear that wage inflation is trending higher, nor that it will generate a ‘policy relevant’ rise in headline inflation (in this case, the Fed’s preferred measure of inflation - core PCE), at least in the near term. Furthermore, we will not get any further data to either corroborate or conflict until next week (CPI), and then early March (PCE and Feb. AHE).
How do you like them.. potatoes?
Yesterday, no sooner had NY Fed President Bill Dudley uttered the line, "so far the stock sell off is small potatoes”, the Dow Jones fell another 1000 points, its second such decline in a week. In financial markets timing is everything. Joking aside, the Fed’s (Kaplan and Harker, in addition to Dudley) ‘calm’ response to a significant correction in equity markets suggests that the central bank ‘put’ (or the level at which central bank policy - in its broadest sense - is eased to support market sentiment) is not close.
One last point worth raising at this stage is the impact on the Treasury market of the US fiscal deficit - widened sharply by the GOP tax cuts. A ballooning federal budget deficit will oblige the Treasury to borrow more than USD 1 trillion this year. Increased issuance is likely to add upside pressure to yields, which in turn likely adds to the negative impetus for equity markets. Despite this, in the near term, we are inclined to believe that equity markets will regain some stability, at least until the picture on inflation becomes clearer. Though bounces will also likely be limited by the damage to confidence of such substantial and consecutive shocks.
"Could this be the magic at last?” Take That, Could it be Magic
Adding to the complexity of this week’s trading environment has been the fact that there has been very little in terms of (significant) data to guide rational expectations and decision making. Instead, the diverse and less predictable combinations of positioning, algorithms and sentiment have played a dominant role.
The major economic focus of the week was the Bank of England’s ‘Super Thursday’ - simultaneous release of the policy meeting statement, minutes and the policy itself, as well as the Quarterly Inflation Report (QIR). While policy was unchanged, Super Thursday was notable for a several reasons.
Firstly, the Bank of England upgraded its growth forecasts for 2018 and 2019 to a respectable (and above equilibrium) 1.8% y/y. Furthermore, inflation is now expected to return to target at the 2 year policy horizon, instead of three - with real wages turning positive over the next quarter. In a further sign of economic strength, the Bank expect domestic inflation to firm as a "wage… and a productivity recovery appear to be under way” with "excess demand building in the economy from early 2020”.
Governor Carney was clear to point out that "the UK is in a crucial year for Brexit negotiations”, and in an almost uncharacteristically balanced statement on Brexit Carney stated "it is fair to say that in a years time it is likely that we will have a better understanding of the future trading relationship… it could be positive, it could be negative, it could be neutral…”
"Down, down, deeper and down” Down Down, Status Quo
From the middle of January, volatility across asset classes had started to rise. However, such modest rises from low historic levels did nothing to alter the positive risk sentiment across markets, amid continued good news from a strengthening global economy. In fact, the S&P 500 hit a record closing high of 2872.87 on Friday 26th January. By the time of the US January employment report, equities were already significantly lower. The sharply higher than expected average hourly earnings print exacerbated the selling, as the long buried threat of inflation, and thus of a steeper yield curve, tipped the equity investor scales from ‘greed’ to ‘fear’.
The resultant capitulation saw the S&P trade almost 10% lower than its highs of just over a week before, with algo’s and automated sell orders being blamed for the exaggerated decline (or to some a ‘flash crash’) on Monday evening. The big question in the markets now is whether we have had a healthy correction within a continuing bull market theme, or is this the start of a deeper down move? And, more broadly, what are the implications for wider financial markets and for FX markets in particular.
"One day the market forces will reverse” Marc Faber
Our initial thoughts for the equity market are a combination of both. In the near term, it is likely that the algo’s (whom are widely attributed to have been the dominant sellers) that sold are just as likely to buy if momentum returns to the topside (even if this is in the form of a bounce). Furthermore, it is also likely that, given the unrelenting rally in stocks over recent months (~7% in Q4 and and another ~7% to the peak in January), that there is a reasonable supply of investors on the sidelines willing to buy the dip. However, equity outperformance over recent years has likely been predicated on a (i) positive growth story, (ii) a buoyant consumer, (iii) low yields, (iv) low inflation and perhaps most importantly (v) low volatility.
Furthermore, we are increasingly convinced that volatility is experiencing a regime-shift higher. We are also very sympathetic to the view that inflation is likely to gain a more solid foothold in the US. If we do start to experience higher volatility and higher inflation, then we can extrapolate back through the list above, until arguably we get to a weaker equity market. Against a higher volatility backdrop, the fact that 2 year US yields are now above S&P dividend yields likely adds to this proposition.
What about the USD?
We have written on many occasions our views on what is likely required to create a backdrop that is supportive or constructive for the USD against the recent, extended theme of USD weakness. "The first is likely the emergence of more pronounced inflationary pressures that would require a rethink of the shape of the US yield curve and rebalance the recent moves in interest rate differentials back in favour of the USD. The second is the emergence of a negative external shock, or risk event, that likely drives safe haven flows back into the USD. Thirdly, and in many respects the most difficult to measure, is the emergence of significant repatriation flows as a function of US tax reform.”
… On Friday, we had the first sign in a very long time that wage pressures may be building in the US, as average hourly earnings data jumped to 2.9% y/y in January. On Monday, we had what could be described as "negative external shock” in the form of a stock market fall that equated to more than 1500 points of the Dow Jones Industrial Average, which sent shockwaves around the worlds’ equity markets. Perhaps the most surprising result of these events, however, is the remarkable stability of the USD.
The process that we describe above, where volatility and inflation ultimately reverse the fortunes of yields, growth and equities, is also likely to be pertinent for the USD. So far the bounce in the USD index has been minimal and disappointing, however, we expect the USD to begin to show some more convincing signs of life, as this narrative evolves.
The main event focus this week will be on the Bank of England’s Quarterly Inflation Report this ‘Super’ Thursday. We will comment in greater detail on Friday, suffice to say that with the UK data surprising to the upside and and with the MPC becoming more upbeat on the outlook, we think that there is a good chance that the QIR sets a more hawkish tone than expected. By extension markets may have further to go in their repricing of interest rate path in the UK, likely supporting GBP.
"Whatever you win, whatever you lose” Whatever You Want, Status Quo
"Secret to the end” Depeche Mode
Yesterday marked the end of an era. After the global financial crisis imparted unparalleled stress on the financial system it was Ben Bernanke that was responsible for the untested and aggressive monetary easing (through QE, operation twist and forward guidance). Janet Yellen, whose stewardship of the FOMC ended with last this week’s policy meeting, oversaw the transition of economic recovery - and subsequently expansion - through to the beginning of the ‘gradual’ process of monetary normalisation with a steady, capable hand. After being officially sworn in as Fed Chair on Monday, Jerome Powell will not only have some very large shoes to fill (metaphorically obviously) but he is likely to have to deal with a phenomenon that his predecessors consistently failed to achieve. Inflation.
The Fed left rates unchanged last night, as broadly expected and delivered a statement that could perhaps be described as a ‘gradual hawkish iteration’. A statement that draws a line under the stewardship of Janet Yellen, with no clear outstanding issues. Essentially, the statement describes an economy where "the labor market has continued to strengthen and...economic activity has been rising at a solid rate”. An economy where inflation is expected "to move up this year” and where the "medium term risks to the economic outlook remain balanced”. Over to you Mr Powell.
"It is always wise to look ahead but difficult to look further than you can see” Winston Churchill
There are however subtle signs of a an FOMC that is more attentive to the prospect of higher inflation over the policy relevant horizon. The assessment of business investment was upgraded from ‘picking up’ to ‘solid’ and also added that inflation expectations have "increased in recent months”. However, the statement does not mention the impact or implications of the US tax overhaul that is the centre of the market debate over fiscal credibility and the potential for higher wage and price inflation driving higher US yields.
In the near term we continue to view last nights developments as insufficient to arrest the decline of the USD. However, the risks are increasing. In its gradual hawkish iteration, the Fed stopped short of inspiring markets to consider the prospect of a 4th rate hike this year, indeed markets are not yet fully priced for the three hikes in the Fed dots. Again this could be changed very quickly by the reality of inflation. The next release of headline inflation is not until Valentine’s Day, but the average earnings component of tomorrow’s US employment report has the potential to bring a non-linear response.
"It’s not certain that everything is uncertain” Blaise Pascal
In the UK, PM May’s trip to China brought encouraging signs for the prospects for the UK’s future trading relations independent of the EU, with new business deals worth GBP 9 billion being signed. However, the general press continue to focus on the negative divergences in the Brexit negotiations without compensating for the fact that it is a negotiation.
There are clearly potential pitfalls and a number of ways that both sides could end up with a suboptimal result. However, if we rewind to the negotiations over the Brexit Bill the EU started off with a demand for somewhere in the region of EUR 60 billion (but numbers as high as 100 billion were often cited). The UK started with a proposal for EUR 20 billion, to which the press ridiculed the government as being obstinate and misguided. The negotiation settled in the middle. Today, similar riducule is being targeted at a government whose initial position does not match that of one of the EU’s existing (bespoke) trading relationships. Perhaps the recent rise in GBP (not just against the USD as some have claimed) is a realisation that this is part of the process.
Interestingly, the debate over whether services should be included in a UK-EU trade deal was highlighted yesterday with the release of data showing that the trade in services between the UK and the rest of the EU increased at a record rate. Official figures showed that the UK services imports amounted to GBP 5 billion with the UK exporting GBP 9.2 billion and highlight the importance of services trade to both the UK and the EU.
Furthermore, it was also announced that overseas investors interest in central London offices surged to record levels last year, up 26% to £16.4B, aided by the sale of two of the London skyline’s most Iconic skyscrapers. Hardly synonymous with a decline in the importance of London as a global financial hub. We retain our positive view of the ultimate negotiation outcome and the prospects for the UK economy and we maintain the view that GBP is cheap.
"No word was ever as effective as a rightly timed pause” Mark Twain
As the start of the new week draws January to a close, the sentiment in markets is a little more cautious. Last week’s theme was a clear acceleration of the USD decline that has essentially characterised the whole of January (and in many respects the whole of 2017). The driving force behind the change of tack this week is likely the market reducing or closing out short USD positions, many likely entered into at the tail end of a significant January move. This week’s USD rebound has retraced around a third of the accelerated move over the last couple of weeks. Ahead of this evening’s State of the Union address by President Trump, the January FOMC statement (no press conference) tomorrow, and the January US employment report on Friday, this week is likely key in shaping the near term prospects for the USD.
"To refrain from imitation is the best revenge” Marcus Aurelius
Before looking ahead it is perhaps worth a quick recap. The low of the USD last week came after the ECB meeting on Thursday after Mario Draghi refrained from making reference to the pace or magnitude of the rise in the EUR (essentially its rise has been limited to the the USD, its rise on a trade weighted basis has been much more modest) - an omission seen as a green light to continue buying the EUR against the faltering USD. Furthermore, while Draghi disappointed the expectations of some protagonists in maintaining the statement reference to an "extended period” of unchanged interest rates beyond the end of QE the descriptive narrative of the eurozone economy was more clearly a bullish iteration.
However, the subsequent release of a statement that "some ECB officials are said to prefer June for the next policy shift”, while of minimal impact on interest rate expectations, was a subtle reminder that there remains a more dovish contingent on the ECB governing council. More significantly, at the same time as the release of the viewpoint of "some ECB officials”, President Trump, speaking from Davos, played down the conflicting strong dollar policy comments of Treasury Secretary Mnuchin that we discussed last week (Freeeeeeeee… Free Fallin?).
Furthermore, in the UK, the weekend press was rife with tales of disquiet and disharmony from within the Conservative government and with projections of negative possible outcomes. GBP has thus been on the back foot this week so far, helping to drag the USD back to its feet. Going forward, this week will be key for the USD. Can it regain some poise and bounce further from current levels supported by broadly higher yields, or, are we likely to see a more protracted USD decline. We currently advocate the latter.
"A government that robs Peter to pay Paul can always rely on the support of Paul” George Bernard Shaw
We have written on many occasions our views on what is likely required to create a backdrop that is supportive or constructive for the USD. The first is likely the emergence of more pronounced inflationary pressures that would require a rethink of the shape of the US yield curve and rebalance the recent moves in interest rate differentials back in favour of the USD. The second is the emergence of a negative external shock, or risk event, that likely drives safe haven flows back into the USD. Thirdly, and in many respects the most difficult to measure, is the emergence of significant repatriation flows as a function of US tax reform.
As we move towards February we continue to see the three events that we outline above as less likely than a continuation of the established theme of higher equities, a flat yield curve and a weaker USD. As UK sentiment has ebbed in light of recent Cabinet disunity if not press reports of such, we fail to see the negative connotations for transition progress ahead of the March EU Summit. As we continue to see GBP as significantly undervalued and thus we are inclined to view the recent dip as opportunity not disappointment.