"If you want to make enemies, try to change something” Woodrow Wilson
The main focus of today will be the House of Representatives vote on ‘Trump-care’, where Donald Trump gets his first encounter with the democratic process of decision making in public office - as opposed to the authoritarian decision making process of Trump Inc. It is perhaps relevant to note that the frequency with which the newly elected President Trump used the term ‘i’ when outlining his plans, not ‘we’. Trump may well discover that while there is an ‘i’ in business, there is no ‘i’ in democracy... or congress.
President Trump has been clear to point out that the details of the Trumponomics fiscal stimulus plan (to make America great again) can not be fully calibrated until the cost of the healthcare overhaul is known. Thus if the Healthcare bill does not pass through (what is only the first stage of the US ratification process), it could be damaging to Trump’s tax plans, to expectations of fiscally accommodative corporate expenditure growth, global financial market confidence and the reflation trade rally in equities and risk assets.
Further, the broader market is becoming less convinced about the strength of the US economic recovery, with numerous interest rate spreads and indicators suggesting that investors are scaling back expectations of future Fed hikes. The spread between 5 and 30 year yields in the US is now at its lowest level since 2007 which, from such a low base, highlights the concern over the duration of the US recovery and or the monetary tightening cycle. Markets now need action, or at least the clear progression towards that action, to maintain the broad market confidence.
After the FOMC meeting press conference last week, Federal Reserve Board Chair Janet Yellen said "the simple message is the economy is doing well. We have confidence in the robustness of the economy and its resilience to shocks”. Markets will therefore be paying close attention to any variations around this sentiment when she addresses a Community Development Conference today.
"If you do not change direction you may end up where you are heading” Lao Tzu
The theme in the US may well be that ‘continuation down the path of inaction is causing growing market concern’. Yet, on this particular theme, the eurozone are grand masters. Since 2009, Greece has had nine different governments, more than a dozen austerity measures, multiple bailouts, capital controls and a 50% haircut to bond holders through a debt restructure. However, a solution remains elusive. By July, without another bailout, Greece will effectively be bankrupt all over again.
As France goes to the polls next month, much of the financial commentary will revolve around the potential shock and negativity of a (very unlikely) Marine Le Pen victory, and the relief of a Macron win. The problem, however, is that even the good news has bad connotations, if viewed through the lens of inaction. Furthermore, if the Greece debt debacle draws German bank losses (among others), the backdrop for the German elections later in the year may not be quite as placid as they are currently perceived.
"I watch the ripples change their size” David Bowie, Changes
In the UK, however, as regular readers will be fully aware, we are far more positive. Today’s retail sales data highlighted the maintained strength of the UK consumer, complementing data earlier in the week from the Confederation of British Industry, highlighting surging export orders. The popular press continue to espouse economists’ continual postponement of their forecasted economic decline, reminiscent of a doomsayer’s sandwich board etched with the words "the end of the world is nigh”, while everyone else gets on with their business.
The start of the Brexit process next week will almost certainly bring with it a volatility of sentiment and market pricing. However, what it cannot bring is prolonged inaction. That, we believe, will ultimately be a big positive for the UK - and ultimately for GBP.
"I never worry about action, but only inaction” Winston Churchill
At the end of January, we argued the case that in our view it was unlikely that the USD strengthened significantly until President Trump delivers on his promised fiscal loosening and infrastructure spending. Indeed, we suggested that the short-term risks to the USD were likely to the downside, at least until he does. Since then, despite the heightened political concerns in the eurozone, despite the signs of further economic slowdown in China and even despite a rate rise in the US, the USD index is now lower (albeit only marginally). Furthermore, we now see the short term risks to the downside for the USD as more acute.
Theoretically, tighter monetary policy and looser fiscal policy should be a classic scenario for currency strength. However, the FOMC and the Administration have been quick to point out their lack of support for a stronger USD. The Fed have done so on the grounds that a stronger USD dents growth and weakens inflation. The Administration on the grounds that it weakens ‘fair’ trade and costs US jobs.
While the Fed raised interest rates in March, they did so at the same time as downgrading its economic forecasts over time. Despite the fact that Fed speakers have begun to suggest business investment is picking up, and rates are rising, the biggest boost to US productivity and thus longer term growth can only come from implementation of structural reform and infrastructure spending. Therefore, increasing concern over the potential risks to the congressional agenda, against the current global reflation, likely equate to downside risks for the USD.
"It was impossible to get a conversation going, everyone was talking too much” Yogi Berra
From our perspective, downside risks are also dominant for Europe and for the EUR. The procrastination and inaction of the eurozone was again highlighted yesterday as Eurogroup Head Jeroen Dijsselbloem stated that "key Greek issues need talks”. In our view, this procrastination and inaction is a major driver of the key risks to Europe and the eurozone. ECB President Mario Draghi has been pleading with national governments to enact structural reform since the ‘breathing room’ he provided the periphery states with the "whatever it takes” speech in 2012. Banking reform (and balance sheet consolidation / reform) is another example of the outstanding and much needed action across the eurozone.
Last night, an historic Presidential debate took place in France between the top 5 candidates ahead of the first round of the election in just over a month’s time. An immediate response poll suggests Macron was deemed the most convincing and polled significantly higher on the questions such as "Who has the best plan for France?” and "Who has the best qualities to become the next President?” EUR rallied as a result. From our perspective, none of the candidates offer the kind of reform (or even action) potential that the dormant power of France is so badly in need of.
"Trade deals are meant to create win-win situations” Angela Merkel (20th March 2017)
In the UK, Prime Minister May announced yesterday that Article 50 will be triggered on the 29th March, firing the starting gun on the two-year period of ‘Brexit’ negotiations. The ultimate goal for both side in a negotiation should be to secure the best terms possible for each other. Indeed, the whole ethos of global trade is build around the concept of mutual benefit. Attempts to punish the UK or to aim to make the UK worse off as a result of negotiations goes against all that global trade objectives stand for.
Most importantly, it is not countries and certainly not unelected European bureaucrats that facilitate and engage in trade, it is companies. We would argue that the motivation of these companies will continue to engage with one another in mutually beneficial trade - not the pursuit of a political agenda to make sure that the UK is worse off outside the ‘club’. If ‘punishing the UK for leaving the EU does become the focus of negotiations, then it will likely damage EU trade and its credibility, both internally and externally.
The biggest threat to the EU and the single market is not the UK leaving, but prolonged economic decline. From our perspective, the best way of ensuring growth and stability of the EU is through a comprehensive free trade agreement with the UK.
"The man who has experienced shipwreck shudders even at calm sea” Ovid
Earlier this week, we highlighted the concentration of events and market risk points surrounding the 15th of March - and noted Shakespeare’s warning from the Roman Calendar equivalent. Amid the heightened expectation (and implied volatilities), the Fed delivered a 25bp interest rate hike and issued a statement and press conference that we would best describe as ‘calm’. Indeed, the calmness of the Fed was such that its economic and rate projections were little (if at all) changed from the previous meeting. The FOMC had predicted three rate hikes in 2017 and after delivering on the first, they now expect two more!
With markets 100% priced for the outcome, the fact that Minneapolis Fed Governor, Neel Kashkari, dissented in favour of unchanged rates is noteworthy. So too is the inclusion of the reference to the inflation target as being "symmetric”, and the statement that inflation will "stabilise around 2% over the medium term”. All suggesting that the Fed feels in no way behind the curve. Furthermore, the Fed played down the implications of the recent increase in inflation by highlighting that (when adjusted for food and energy prices) core inflation "was little changed and continued to run somewhat below 2%”.
In reality, the Fed appears to be sticking to its game plan and while the markets may have got over-excited about the prospects of an acceleration in the pace of normalisation, the Fed has not. At least not yet.
"Show me the money” Jerry MaGuire
Herein lies the issue. Regular readers will be fully aware that we are cautious of any further USD outperformance - unless or until we see the extent of the US fiscal stimulus, regulatory reform and infrastructure package details. Yellen was clear to point out that the decision to raise rates "does not represent a reassessment of economic outlook or of the appropriate course for monetary policy” and that there is "great uncertainty” about the timing, size and character of the potential ‘Make America Great Again” policies of the new administration.
However, while we have no real issues with a reflective pull back in US yields and even the USD, the Fed clearly noted that business investment had "firmed somewhat” complementing continued rises in household spending and wage inflation. If and when Trumponomics delivers, there is significant upside potential for the US economy, the US yield curve and the USD
Until that point, as the US yield curve remains relatively contained, the environment remains uniquely supportive for ‘carry trades’ - carry ‘on’. In the wider currency universe this is clearly applicable to the emerging market benchmarks such as RUB, ZAR and MXN, but the arguments can be clearly extrapolated to the likes of AUD and NZD within the G-10 space.
Stuck in a Rutte?
In the days other main focus, the Dutch election saw the far right support fall short of projections, with Mark Rutte and the People’s Party for Freedom and Democracy retaining the biggest number of seats in the Dutch Parliament. European bond spreads have narrowed in a sign of relief (most notably in France and Italy). However, while there are clear positives in the Netherlands, it is still likely to take many months before a sufficiently large cross-party (likely at least 4) agreement is reached to find a coalition government.
"Beware the Ides of March” William Shakespeare
After a relatively slow start to the week, the ‘Ides of March’ (15th March on the Roman calendar) bring plenty to beware, at least from a financial market volatility perspective. This year the 15th of March hosts the FOMC policy meeting, the expiry of the US debt ceiling (a raise is expected from both), a significant unemployment report for the UK, inflation report from the US and the General Election in the Netherlands. Furthermore, on the 16th we have policy meetings from the Bank of Japan, Swiss National Bank and the Bank of England. Not to mention the G-20 meeting into the weekend.
As we enter this period of heightened event risk, it is perhaps prudent to first assess the current footing of financial markets, before considering their next steps. Oil has stabilised below $50 along with industrial metals and even gold. Equity markets have retained their bid tone, up strongly in 2017, and equity volatility trundles along at or around historic lows.
Furthermore, ahead of the all important FOMC meeting, 10 year nominal US Treasury yields sit pretty much bang on the all important 2.60% yield level that likely defines the boundary of a higher (and steeper) yield environment. Real yields sit on their equivalent ‘regime shift’ boundary at 0.60% ahead of the inflation report expected to show headline consumer prices reach 2.7%.
The FOMC meeting will confirm whether the rate rise that the market has already fully discounted will become reality. But more importantly perhaps, the combination of press conference insight, and updated Summary Economic Projections (SEP’s) will act as a key barometer for markets that are currently erring towards 4 US rate hikes this year.
Let us also not forget the potentially significant multiplier effect of planned fiscal loosening in the US as well as infrastructure, border tax and jobs measures from the Trump administration, all of which are likely to exacerbate upward pressure on inflation, rates and the USD.
There are two types of economist:
Those who can extrapolate from incomplete data...
After a recent run of disappointing UK data, many commentators have extrapolated this short term loss of momentum, combining the rising inflation dynamic to paint a less than rosy projection. In this regard, we view this week’s UK employment report as very significant for the near term direction of UK sentiment and of GBP. Inflation is forecast to rise to the Bank of England’s 2% target this month with a peak only 0.4 percentage points higher at 2.4% - hardly a notable breach of the target by historic standards. It is, therefore, likely important that the labour market strength and wage inflation keeps pace.
In this regard, while the Bank of England notably lowered its estimate of the equilibrium or NAIRU rate of unemployment (the rate above that at which labour market tightness generates rising wages) at the last BoE meeting, it is significant that MPC member Ian McCafferty highlighted his disagreement with this a few days ago, suggesting he believes it to be closer to 4.75%.
Our view remains that the UK is still in a very strong position and with employment at an 11 year high in Q4 (youth unemployment at just 12.6% - a far cry from the ~40% in Italy, or ~50% in Spain) we continue to expect UK outperformance from consumption. As we move into the negotiation period of the UK leaving the EU, we would expect UK businesses to react to any opportunities that present themselves with rising business investment.
First world problems?
Yesterday, Scottish First Minister Nicola Sturgeon announced that she would ask the Scottish Parliament to approve a another "once in a generation” referendum on UK membership, just 2 years after the first. Within hours, the European Commission confirmed that an independent Scotland would have to reapply for EU membership. With a fiscal deficit greater than that of Greece, such a plan is far from certain. Many economists would suggest that the case for independence collapsed with the oil price. This does not mean that Sturgeon’s actions could not add a further level of uncertainty to already complex negotiations
On a lighter note, comments from the Chief Executive of a Chinese private equity fund caught my eye earlier in the week. Ms Li stated that her company will continue to invest in projects in the UK as "in China property is oversupplied and overpriced… this has nothing to do with whether you have Brexit or not. [The UK] is a safe haven.”
"You in the UK see Brexit as huge but back home in China, we see this as a ‘first-world problem’” said Ms Li
"Marriage is a great invention; then again, so is a bicycle repair kit” Billy Connolly
Yesterday at the press conference following the ECB meeting, Mario Draghi did the equivalent of a parent slowly removing their counterbalancing hand of support, while their child attempts to cycle away on their own. The removal of this supportive hand was in some sense surreptitious, to avoid the alarm of the child (read markets), and while Draghi’s testimony was full of self praise for the support he has offered in getting to this stage, huge accommodation (stabilisers, elbow pads and a crash helmet in our analogy) remains.
In essence, Draghi indicated that the balance of risks has improved and that while those risks are still skewed to the downside, "sentiment indicators point to a pickup in momentum” and the "risks of deflation have largely disappeared”. The removal of the pledge to "use all instruments within the mandate” to attain the inflation target is likely the first step in the slow gradual pace of normalisation in the eurozone. A pace dragged back substantially by the lack of any "self-sustained inflation adjustment”.
Let us not forget, however, that while this sounds encouraging, the ECB are still expanding their stimulus through asset purchases under QE at a pace of EUR 80 billion every month, reduced to EUR 60 billion per month from April for a further nine months. Let us also not forget that the eurozone deposit rate remains at -0.40% and that it is not likely to rise until mid 2019 under current projections.
Most significantly from our perspective, Draghi reiterated (again) that euro area growth continues to be damped by sluggish reform pace and the (still) ongoing balance sheet adjustment. The eurozone and the EUR breathed a sigh of relief yesterday, however from our perspective the slow erosion of economic slack, driven by cyclical (transient) momentum, does not alter the fact that the region will likely face an increasingly negative interest rate and structural reform differential over coming years. Not to mention its political hurdles.
"The perils of duck hunting are especially great for the duck” Walter Cronkite
As is the case with many things in life, perspective is key to framing market sentiment. In some scenarios, the prospect of a President in France without the backing and support of a party in parliament may spark the use of the term ‘lame duck’, and concerns about inability to change. This would be true of both candidates leading in the polls. When it comes to Le Pen, this has been viewed as a good thing by markets; a self regulating mechanism against her far right leanings. The reality, however, is that with it looking increasingly likely to be a run-off between Le Pen and Macron, neither are likely to have the ability to enact the reform that France so desperately needs to escape the sluggish growth and popular disquiet. While a Macron win may remove a near term risk, it does little to improve the long term outlook for France or indeed the eurozone.
"Never permit a dichotomy to rule your life” Pablo Picasso
In the US, the reflation trade has bounced back strongly over recent sessions, despite an uncharacteristic period of relative silence from President Trump - and thus no detail on corporate tax cuts, border tax or infrastructure. However, while we retain the view that it is the White House and Congress that are the most significant medium term drivers of the US economy, the reflation story and the USD (through the potential to boost demand, investment and productivity), the near term picture is driven by the renewed focus on US monetary policy.
Moreover, against a backdrop of improved global economic momentum (albeit cyclical or transient in some cases) that takes away one of the Fed’s excuses for inaction, today’s US employment report is a key focus. However, it is no longer a question of whether or not the Fed raise rates next Wednesday, but rather an indicator of the pace at which the process of Fed normalisation will evolve (accelerate?).
With 10 year US Treasury yields at the technically significant 2.60% level, the implications of the US employment report (following surprise strength from a private sector equivalent index earlier in the week) are very significant for the US yield curve, the USD and potentially global commodities (priced in USD).
Signs that wage inflation is picking up amid continued strength in US job growth will strengthen the argument that the US is approaching, if not at, its equilibrium unemployment level. This in turn should lead to a steepening of the US yield curve and a further strengthening of the USD. The dichotomy here is that the implications of further job growth is potentially troubling, not just for commodities and emerging markets but potentially for Trumponomics.
"...life is a balance between idealism and realism” Peter Hook
This weekend saw the annual session of the National People’s Congress - China’s top legislature - where Premier Li outlined the government’s plans to cut overcapacity in some ‘old industries’ and reduce the tax burden of corporations. In doing so, Li stated that monetary policy will remain accommodative and that fiscal policy (infrastructure spending) will remain proactive. Notably, Premier Li pledged to continue reforms to attain the economic growth target of 6.5% this year - a target that he described as "realistic and in keeping with economic principles”.
While the growth target is the lowest in 20 years, at a level that has historically been assumed to be the rate of growth needed to maintain stable employment, the economy’s potential growth rate is likely nowhere near 6.5 per cent. Indeed, it may be no higher than 3 per cent. Thus, attaining even the reduced target likely requires taking further risks with excessive credit creation and shadow banking expansion. The fact that China’s banking sector has overtaken that of the eurozone to become the world’s largest by assets is, on the one hand, a sign of china’s increased influence on world finance, but on the other a sign of (unsustainable) reliance on debt to fuel economic growth.
"EU of different speeds is needed to avoid paralysis” Angela Merkel
In Europe, anti euro sentiment parties are leading in the polls in France and Italy (following the split in the PD following Renzi’s departure), and as the EU braces itself for Brexit negotiations a joint address from Merkel, Hollande, Gentiloni and Rajoy outlined their view of the need for a multi-speed EU. This is a development that Merkel argued was needed to "avoid paralysis”. We would argue that the more likely result of a multi-speed EU (or eurozone) would be to facilitate its demise.
At a time when divergence within the region’s growth and inflation dynamics are at their most acute, a two-speed EU would likely create ‘rival blocks’, and perpetuate divisions and divergences. If the intent is to forge a closer integration (which likely requires political as well as economic integration), then while Italy, France and Germany may be willing to align themselves, the enthusiasm among the rest to form one or many alternative speed blocs is likely much less compelling. Indeed, instead of closer integration we would suggest a sharply increased chance of disintegration.
Furthermore, the argument for blocs within a bloc, in our view makes the construct even more fragile and even more unsustainable and in our view a two-speed eurozone would necessitate two EUR currency benchmarks.
"Cynical realism is the intelligent man’s best excuse for doing nothing about an intolerable situation” Aldous Huxley
With France, Germany and Holland all going to the polls in 2017 (as well as Italy some time before May 2018) there may be a much higher level of politicking at the current juncture - a theme we intend to explore further over coming weeks. Such ‘progress’ may be viewed by Merkel et al. as a more palatable alternative to the far right, and anti euro protagonists that have made up so much ground in eurozone politics in recent years. Weakness in economic data, such as the very disappointing German factory orders (that casts doubt on the generally accepted theory of building eurozone economic momentum), will only add to the political disquiet.
Ultimately we are increasingly concerned about the divergence and stability of the eurozone. We continue to believe that the market has overpriced the risks to the UK from Brexit (Mark Carney does not even view Brexit as the biggest risk to the domestic UK economy) and equally has underpriced the risks of Brexit to the eurozone. As such we continue to view EURGBP as markedly overvalued.