"Let every eye negotiate for itself and trust no agent” William Shakespeare
The first week in December draws to a close today with perhaps the data highlight of the week - the US employment report for November. However, the relative absence of economic data highlights this week have been more than offset by an, at times unpredictable, action packed global political backdrop.
After PM May managed to snatch defeat from the jaws of victory earlier this week, several days of discussion and a ‘milk train’ to Brussels has ultimately resurrected the agreement and re-opened the door to phase 2 of the Brexit negotiations. Critics would argue that the final agreed text is so open and so broad that it is a wonder that it took so long for all sides to agree. From our perspective, this is much less relevant than the prospect for a new progressive trade relationship. Indeed, just as the EU has laid out its vision of an ever closer union (or a Federal States of Europe if Martin Schultz has anything to do with it), perhaps now is the time for PM May and the UK to set out their vision of the UK’s goals and aspirations as a global leader in free trade and innovation.
While many commentators still point to potential pitfalls and sticking points in the negotiations we maintain a positive outlook to the potential for a quicker and more comprehensive trade deal than central market expectation. Combining with our view that it remains significantly undervalued, we maintain our positive outlook on GBP
"My optimism wears heavy boots and is loud” Henry Rollins
In the US, amid the constant stream of diverse distractions (a large proportion of which also emanate from President Trump) the market is trying to digest the optimism of near term growth boost from the fiscal stimulus. It is not yet clear that the medium term growth impact will be significant for the US, at least when its impact is weighed against that of the increased deficit over the period, however, there is growing optimism that the Tax Bill will lead the market to rethink the speed and extent of 2018 Fed rate hikes. A number of institutions have upgraded their forecasts for the number of incremental (25bp) 2018 rate hikes from the Fed to 4.
Trying to envisage a situation where the US economy will outperform expectations at a magnitude beyond that which would necessitate 4 rate hikes seems an unlikely task, even at the most receptive stage of the fiscal stimulus impact. However, the real issue is not the expectations of economic forecasters, or indeed the published expectations of the Fed itself. The real issue is the aggregate weighted view of the market, a market that has been significantly below, the shallow expected rate path of the Fed over the past couple of years… and have by and large been correct in doing so.
The Trump tax plan, may well have a limited long term growth impetus, however, it is another factor (along with the increasing wage inflation pressure likely sub 4% unemployment in the US) that should drive market expectations to meet the Fed, as opposed to the Fed ceding down to the market. If we then add in the convincing argument for the potential USD repatriation as a function of the Tax Bill, then the prospects for the USD become even rosier.
"He who talks more is sooner exhausted” Lao Tzu
Earlier this week the eurozone economy was shown to have grown at an annual rate of 2.5% in Q3, its fastest rate since Q1 2011 and above the average level of growth seen since before the financial crisis. Furthermore, optimists point to broad strength in the PMI data as a sign of a further uptick in growth in the near term. However, we are becomingly increasingly cautious about the near term backdrop for the eurozone, and thus the near term prospects for the EUR.
Despite the broad positive growth backdrop in the eurozone, German domestic demand slowed markedly in Q3, and recent industrial production and trade data have also disappointed expectations (despite encouraging data from export competitors such as China, who released very strong trade data overnight).
On a more technical note, the relatively high level of the EUR (at least compared to early 2017) and the continued long bias of market positioning offer a potential downside vulnerability. However, the USD funding squeeze that has driven the EURUSD cross currency basis swap to its most extreme level in around a year is likely to offer more immediate EUR selling pressure. Interest rate differentials such as the 2 year EURUSD rate differential which is pushing its highest level since 1997, and the 1 year 5 year forward rate (an indicator of the terminal or equilibrium rate level) both point to a EURUSD rate closer to 1.1500 than its current level
Essentially, we see an interesting divergence between general consensus views and our views of relative currency movements, in the near term at least. Our favourite major currency remains GBP and while we are increasingly positive on the USD, we are increasingly negative on the EUR outside of the more immediate impact of this afternoon’s US employment report and the acute market focus it brings.
"Delay is preferable to error” Thomas Jefferson
Last week closed with a sharply higher baseline volatility in equities and risk assets, as the Mueller investigation brought further revelations into misgivings related to Russian involvement in the 2016 US election (so far stopping short of direct misgivings from the President). This volatility was exacerbated by the positive connotations of further progress in tax reform - albeit at the very last minute (as the process moves towards reconciliation of the House and Senate bills). While this week started with a more positive risk sentiment backdrop, the positivity has moderated with the help of a number of disappointing developments.
On the data front, the theme this week has been almost universally one of modest disappointment relative to expectations - Eurozone investor confidence dipped, UK and US (dominant) service sector activity fell back, Eurozone retail sales fell in October, US trade deficit widened. While none of these data disappointments are likely significant enough to alter medium term confidence or forecasts of a broad global economic recovery, enthusiasm has perhaps rightly waned. From our perspective, this theme of modestly underperforming data prints and modestly declining equities and risk assets on the week likely exaggerates the focus and impact of the US employment report on Friday.
"Progress is not possible without change, and those who cannot change their minds cannot change anything” George Bernard Shaw
Political developments this week have also mirrored the data in modestly disappointing expectations with varying degrees of significance.
In the US, a view from the US Tax Policy Centre, supported by research from Moody’s, has cast doubt on the implications for higher growth from the Trump tax cuts, arguing that historically tax changes have had surprisingly (to President Trump at least) minimal impact on underlying growth rates, while aiding a substantially higher debt-to-GDP ratio over the next decade.
The dominant political theme however has likely been the progress (or perhaps more pertinently the unexpecHeld DUPted halt to progress) of the negotiations with respect to agreeing ‘sufficient progress’ to move to the mutually beneficial stage of the negotiations - trade. For a while on Monday it seemed that the wording of the sensitive Irish border treatment had been agreed by all sides until the DUP voiced a last minute disagreement - seemingly on the grounds of an implied regulatory divergence between the UK and Northern Ireland.
Today David Davis has sought to assure the DUP, UK and EU that any attempt to retain regulatory alignment between the EU and Northern Ireland would also apply to the whole of the UK - and that it does NOT require membership of the Single Market - a derived implication that as has concerned many participants on all sides of the debate.
While this is an unfortunate and in many respects embarrassing development for the May government, it is likely more of a bump in the road than a dead end. Progression to phase 2 at the EU Summit on the 14th of December is still our central expectation. Indeed, we retain a constructive and positive expectation for the speed and comprehensiveness of the trade talks, as they become active.
"Yesterday is not ours to recover, but tomorrow is ours to win or lose” Lyndon B Johnson
Yesterday I attended a conference where a UK MEP gave some views and opinions about the mood in Brussels and the likelihood and possible direction of progress towards a new trading arrangement. While the concept of regulatory equivalence was highlighted as something that the UK can NOT rely on going forward, the prospect of a ground-breaking new deal covering trade and services (setting new terms which the WTO may eventually follow) is more likely than current expectations. Such a progressive view is not only supported by the unique position that on day 1 the rules governing both sides will be identical, but also that the goodwill towards the UK from within Brussels is far greater than the current press, Barnier rhetoric and external facade suggests.
Furthermore, on the subject of ‘central clearing’, there was a surprisingly clear view that relocation on the basis of ‘primacy to the Central Bank of issue’ sets a dangerous precedent, effectively giving the CB (and thus ALL individual National Central Banks in the case of Europe) a veto over risk management. The real issue is not location, but oversight. Thus, it is likely that, in the absence of an economic argument for moving capital and ancillary services and infrastructure, there is a strong argument that central clearing remains predominantly in London.
Essentially, despite the modest decline in risk appetite and confidence this week we retain a positive outlook towards the broader economic recovery - led by the US - and specifically towards the UK and GBP. An interesting core theme in markets this week has been the extension of the yield curve flattening in the US, which runs counter to our expectations of improving confidence and US leading that recovery. In this regard, Friday’s US employment report will likely be key.
"There is poison in the fang of the serpent” Chanakya
A strong US GDP revision (to its highest level in 3 years), an upbeat assessment of the US economy from (soon to be ex) Fed Chair Janet Yellen and the nomination of Marvin Goodfriend have given US yields something of a filip. However, with a sharp and unexpected sell-off in the FAANG (Facebook, Apple, Amazon, Netflix, Google) stocks yesterday, the tentative 21% correction in bitcoin and the much awaited release of the October core PCE inflation gauge, the sustainability of this near term bounce is likely to be tested. Against this backdrop it is perhaps interesting to summarise some of the dominant market themes, particularly those most exposed or affected by the immediate term inflation vs. risk dynamic.
In the UK, there has been a much more positive period of press speculation on the proximity of the EU and UK to an agreement on both the financial settlement (or Brexit bill) and the Irish border issue - thus dramatically increasing the proximity of stage 2 of the negotiations - the mutually beneficial topic of trade. The numbers being mooted, and generally accepted, are between EUR 40 billion and EUR 55 billion (net of receipts). From our point of view it is important to put these numbers into perspective. Firstly, the final number constitutes around 2.5% of UK GDP. Secondly, it will not be settled as a lump sum, but will be spread over a period of up to 40 years on a diminishing scale "when they [the bills] fall due”. Thirdly, as Daniel Hannan put it, the settlement should not be looked at as a divorce bill, but rather "how quickly we taper away our existing payments”.
If the speculation is correct and the UK, EU negotiations are poised to move towards trade talks (and the swift agreement of a 2 year transition deal to further ease near term business uncertainty), we anticipate the mood to be far more cooperative than phase 1. After all the payment of a bill is to the benefit of one side and to the detriment of the other in equal measure. On the other hand, trade will only occur where it is mutually beneficial.
This sentiment was echoed yesterday by Andreas Dombret, an executive board member of the Bundesbank, who said that the movement of companies to Frankfurt prompted by the Brexit vote would bring the German financial centre closer to the capital markets "yet the door needs to be kept open to a close and deep partnership with the UK… one opportunity for such a bridge could be… central counterparty clearing”.
On a further positive note, recent figures show that despite the uncertainty caused by Brexit and the disorderly and fractious negotiations, the UK’s tech companies attracted USD 5.4 billion in 2017, more than double the UK’s closest European rival, Germany. We retain the view that GBP is significantly undervalued, and that the potential for the underlying economics and even politics to outperform market expectations remains high.
"Indecision may or may not be my problem” Jimmy Buffett
In the US, the Senate testimony from both Powell and Yellen added to the debate as to whether the current inflation weakness is temporary in nature, and whether the Phillips Curve is flat, kinked or outdated. This afternoon’s core PCE reading, the Fed’s preferred inflation gauge, will be very keenly watched in this regard. However, for FX, there is likely another important dimension to note. Yesterday’s sharp decline of FANG stocks highlighted the correction risks in what are, on most measures, very highly valued equity prices.
Higher inflation readings should imply higher yields and a steeper yield curve - and a higher USD. If the prospect of higher interest rates causes further (disorderly) declines in equities, however, it may have the opposite effect on the US yield curve, as ‘safe haven’ flows emerge / dominate. Both scenarios likely favour higher inflation and a stronger USD going forward, but the uniformity of the current relationship will have a lot to do with the reaction function of an equity market that has known little but gains in the past 10 years. Bitcoin may be worth watching in the near term as a barometer of market sentiment.
As monetary policy decisions in the US become more complex (potentially with acute negative feedback loops), Janet Yellen may well be glad to step aside.
Lastly, there has been much speculation in the markets recently that the Bank of Japan are nearing a hawkish pivot in their monetary policy. Much of this debate comes from the BoJ analysis of a concept known as the reversal rate (where accommodative monetary policy reverses its intended effect and becomes contractionary for lending as a complex function of bank asset holdings, interest rate pass through and capital constraints).
This, combined with a lower US yield curve, drove USDJPY to its lowest level since September at the start of this week. But, we expect the Bank of Japan to maintain its super accommodative monetary policy, as much of the world reluctantly follows the Fed’s hawkish lead on higher inflation. Without a significant risk-off event, we can envisage USDJPY rising as high as 120 in Q1. On that note, markets will be closely watching the FAANGs as we move into December.
"All these things into position” Radiohead, Street Spirit (Fade Out)
Over recent weeks there has been a significant impact on global financial markets, and by extension currencies, as a result of the implications of market positioning - In FX the build up of USD shorts and subsequent rotation into JPY and CHF (and ultimately a position squeeze) could be closely traced over the period. The next few weeks are likely to be dominated by a different type of positioning - political positioning.
The most obvious and likely critical example is the UK and EU’s respective positioning in the run up to the EU Summit, on December 13th and 14th. The press has recently been far more positive on the prospect of ‘sufficient progress’ with regard to the commitment to a principle if not to an exact value - of the financial settlement, or Brexit bill. The Sunday Times quoted EU sources in this regard, stating that "A deal is doable. This is a breakthrough”.
However, while the bill negotiations show signs of progress, the situation regarding the Irish border has arguably become more complex - at least in the very near term. The position of the UK negotiators has, up until now, been that the ultimate proposal for the ‘borderless border’ between the Republic of Ireland and Northern Ireland is dependent on the nature of the trade deal in phase 2. However, due to the sensitivity of the arrangement to the Irish economy and more importantly the people and communities, the Irish government has heightened importance in the negotiation. It appears that the Irish Deputy PM has resigned, thus leading to the withdrawal of a ‘No Confidence Motion’ (in the minority government) that had until earlier today threatened to force a general election and thus much greater Brexit uncertainty. Resolution is made infinitely more complex when you do not know with whom to resolve.
"Leadership is a choice, not a position” Stephen Covey
In the US, the important political positioning is occurring in relation to the tax bill and its progress (or otherwise) through the Senate this week (Senate Budget Committee to pass the bill today, with a procedural vote on the Senate floor tomorrow, votes on amendments on Thursday, and a vote on final passage Friday). There has been much debate on the tax bill and its implications for the deficit, wealth distribution and growth and inflation - with no unanimous opinions. However, it is likely that a successful tax bill will be a positive impetus, at the very least in the near term, for US rates and for the USD.
From a monetary policy standpoint, markets received a prepared Senate testimony from the new Fed governor Jerome Powell last night. In pledging to support the economy’s progress to "full recovery”, with the expectation that interest rates will rise "somewhat further”, there was clear continuity in the (language and) position of the new Fed Chair. However, a more nuanced commitment to "flexibility” and decisive action in the face of "new threats” were likely an effort to impose his personal authority and the pledge to weigh deregulation while keeping "core reforms”, likely a nod to his appointment through an alignment to a Trump election pledge.
"Tests show banks could lend through a disorderly Brexit” Mark Carney
Today the Bank of England released its 2017 stress test of the UK banking system. "For the first time since the Bank of England launched its stress test in 2014, no bank needs to strengthen its capital position… the UK banking system is resilient to deep simultaneous recessions [more severe than the global financial crisis] in the UK and global economies, large falls in asset prices and a separate stress of misconduct costs.” In fact, the stress test shows that the UK’s banks are three times stronger than they were 10 years ago and able to remain strong enough to keep lending during the combined impact of a 4.7% drop in GDP, bank rate surging to 4% and house prices falling by a third - without raising further capital now in order to do so.
Marginally positive news on the Irish political front, very positive news on the strength of the UK banking system and progress on the UK financial settlement with the EU are further reasons for us to maintain our positive bias towards GBP in FX markets. It is common at this time of year for banks and institutions to publish their forecasts for the upcoming new year. Most proffer downside predictions for GBP. We disagree. In fact, recent developments have strengthened our positive resolve towards GBP, and in the medium term we view GBP as significantly undervalued, economic forecasts as too pessimistic and short positioning as too extended.
"A delicate balance” Like Spinning Plates, Radiohead
On the eve of the Thanksgiving Holiday in the US, financial markets were focussed on both fiscal and monetary evolutions on either side of the Atlantic. In the UK, the primary focus was on the Autumn Statement and more specifically the balance that the Chancellor would maintain between the central Conservative pillar of fiscal responsibility and the need for fiscal support and guidance in some areas of the economy - a balancing act complicated further by the widely expected downgrades to central growth and productivity forecasts.
As growth and productivity continue to disappoint, the tighter fiscal outlook has forced the Chancellor to slow the pace at which borrowing is reduced. Resisting calls to relax fiscal responsibility from some popular press, and abandon it altogether from across the aisle, the Chancellor delivered a Budget that balances support for people on squeezed incomes with support for business and the wider economy - avoiding the many potential policy banana skins. Action on business rates, R&D tax credit, the National Productivity Investment Fund and Brexit planning (in the form of a GBP 3 billion funding allocation over 2 years) should leave UK firms stable against the current uncertainty and better placed to exploit the opportunities that a successful Brexit likely offers.
"Confidence will return when there is Brexit clarity” Philip Hammond
In recent posts, we have discussed that the positive impact of a concerted upswing in global growth concurrent the Brexit process likely induces a transient underperformance, as the UK transitions from full alignment to the EU to a global alignment. Our point being that underperforming a fast growing global economy, is significantly more favourable than underperforming (contacting further) in a global contraction.
Some commentators have been quick to point out that the new, lower ONS forecasts plot a growth trajectory that remains below 2% for the entire forecast period (2022) for the first time in modern history. It could equally be argued that the impact of likely the largest economic change in modern history is not projected to push growth below 1% in any period.
Furthermore, we would argue at least at the back end of the forecast horizon that the projections are too pessimistic. Direct support for driverless car technology and infrastructure, direct and contingent support for the UK’s increasingly cutting-edge tech sector, as well as more supportive general business tax measures are progressive. Signs of stability from this morning’s second iteration of Q3 GDP - confirming a (modest) growth pickup from H1, and the manufacturing data from earlier in the week showing order books having been filled up to the strongest level in 30 years - are further encouraging signs for the UK.
"If you can’t explain it simply, you don’t understand it well enough” Albert Einstein
On the other side of the Atlantic, last night brought the minutes from the 1st November FOMC policy meeting. The meeting itself brought a unanimous vote for unchanged policy and a statement that gave an upbeat description of economic activity (upgrading the language to "solid” for the first time since January 2015), despite the near term impact of the storms. It also highlighted continued strength in the labour market and the broad expectation of further gradual hikes, despite noting disappointing inflation expectations.
Last night’s minutes, however, gave a slightly more dovish tone to the same meeting, noting that while "many policy makers saw near term rate hike as warranted”, that "a few” opposed it on weaker inflation grounds. The minutes also pointed to concerns over lower for longer inflation and weak inflation expectations balanced by a concern for "possible financial imbalances”. Amid this temporal uncertainty, there is also an added complexity for Fed policy and by extension the yield curve and the USD - that is the fact that the Fed is experiencing a changing of the guard en masse.
"...the way of progress was neither swift nor easy” Marie Curie
We retain our positive view of the UK and of GBP. Moreover, we see potential for the rise in UK sentiment and GBP to accelerate in the relatively near term, as progress towards Brexit clarity outperforms expectations and the progression towards trade talks sees negotiations evolve from conflict to cooperation, from compensation to mutual benefit.
The USD on the other hand is a little more complex. In the near term, last night’s minutes undermine confidence in 2018 rate rises and keep the US yield curve (very) flat - the term premium for 10 year US Treasuries over 2 year instruments is just 58bps - its lowest since 2007. However, while this paints a worrying backdrop for the USD, the minutes are potentially balanced by an imminent fiscal stimulus from tax reform, likely boosted by wage inflation pressures (as the unemployment rate drops below 4% in early 2018) and actually countered by current strong real growth rates. In the words of Radiohead "...a delicate balance”
"It’s the good advice, that you just didn’t take” Alanis Morissette, Ironic
This week got off to a marginally troubled start as the ‘Jamaica Coalition’ talks (between the CDU/CSU, FDP and Green parties) in Germany hit a roadblock. Perhaps ironically, the issue that appears to have caused the breakdown in cross party talks was disagreement over Merkel’s insistence on an immigration cap - an issue that played a primary role in the UK’s decision to offer voters a referendum on EU membership, after its request for an immigration cap, among other things, was denied. The deadlock appears to suggest an election re-run in January, with polling updates suggesting the likelihood of a mandate for another ‘grand coalition’. A further irony is that a Chancellor - whose name was entered into one German dictionary manufacturer as a verb, "merkeln” meaning ‘unable to make decisions or give your own opinions - should have her last term marked by failure to form a government - at the first attempt at least. The reaction of financial markets, however, has been remarkably apathetic.
"Start with what’s right rather than what is acceptable” Franz Kafka
Against the current global backdrop of economic strength and political uncertainty, apathy has become relatively commonplace. There are defined risks, but not necessarily large or urgent enough to drive liquidation or capitulation. For the first time in years, global growth is exceeding forecasts. Global monetary policy remains expansionary. FX markets also seem a little bit ‘merkeln’, however, the recent rotation of the market out of short USD (and towards short CHF and JPY) likely leads to a more stable backdrop for a sustainable move in 2018. If the US administration pass a tax reform bill without too much dilution, our view is increasingly positive for the USD.
In the US, activity is likely condensed into the first half this week, as the Thanksgiving holidays and the new lead retail barometer Black Friday shorten the proceedings. The US is leading the way on economic strength (above 3% annualised in Q2 and Q3), with a backdrop of very accommodative monetary policy (heightened by the flatness of the US yield curve) and, as such, the market will pay keen attention to the FOMC minutes on Wednesday evening. However, with the interest rate curve implying a 97.1% probability of a December rate hike, it seems unlikely that the economic narrative of the minutes can generate a hawkish surprise.
On that note, last night Janet Yellen formally announced her intention to step down from the Federal Reserve Board in February, when her replacement as Fed Chair is sworn in. Her statement portrays her confidence in the continuity at the Fed under Powell, yet at the same time points out her not inconsequential achievement of leaving a US "economy close to achieving the Fed’s dual mandate”
"I like people who shake other people up and make them feel uncomfortable” Jim Morrison
It is likely that the rest of 2017 is characterised (at least in terms of the scheduled occurrences) by two defined events: the expected US rate hike, on the 13th December, and the EU Summit on the 14th December, at which it is hoped talks may progress to phase 2.
While the body language of the Brexit negotiations appears tense and uncomfortable, it is difficult to decipher how much of this is intentional messaging to their respective representations that they are indeed driving a hard bargain. Our view, that the painfully slow pace of phase 1 will be reversed in phase 2 (and that a trade agreement will be faster and more far reaching than any current market expectations), remains. This sentiment was given some credence yesterday when Michel Barnier stated that the bloc was preparing for an ambitious trade deal with the UK, despite at this stage heavily caveating the inclusion of financial services.
As the UK’s economic momentum is being questioned by the Bank of England, attention turns to tomorrow’s all important event (no, not the start of the first Ashes test in Brisbane) - The Chancellor’s Autumn Statement. Spreadsheet Phil will be under pressure from many directions as he tries to balance the government’s hard fought deficit reduction credibility against a growing populist swell behind a loosening of the fiscal purse strings. One could argue that the economic case for higher government spending at this stage of the economic cycle is weak, with the unemployment rate at 4.3% and the Bank of England just off the back of a rate rise - difficult to argue for the necessity of a fiscal boost to demand.
However, recent accounting wizardry (such as moving the national housing association balance sheet into the private from public sector liability) will enable some tactical giveaways - it is expected that housebuilding will be the beneficiary - though the Chancellor may have to be a bit more imaginative if he is to balance the desires and demands from within the Conservative Party, let alone the House. In many respects, he may rather open the batting against the fast bowling onslaught of Starc and Cummins.