"Data is the new oil” Kevin Plank
Yesterday, headlines, market activity and risk sentiment were dominated, not by global macroeconomic developments, geopolitical shifts or bond (or equity) market sentiment, but by oil. For the first time since 2008, the Organisation of the Petroleum Exporting Countries (OPEC) agreed to a reduction in output. In reality the cut, at the lower end of a previously discussed range, leaves global oil production still very close to record high levels, the cut itself is contingent on non-OPEC members cutting their output and is only in place for six months. However, a cut is a cut, and (after threatening action that has ultimately failed to materialise so many times before) the market reaction is, in our view, completely justifiable. Indeed, the action provides credibility to OPEC, and at current levels likely underpins oil in the near term.
If we then overlay the oil market developments (and likely near term trading bias) onto the recent broader global macroeconomic themes, it is likely that they exacerbate recent moves. The combination of a near surreptitious rise in US wage and price inflation, the prospect of Trump induced productivity gains, capital inflow and (make America great again) growth resurgence have driven Bond markets lower (thus yields higher) and the USD higher. All else being equal, the higher inflationary implications of a rising oil price will likely add fuel to that fire.
Indeed, as we move towards year end and the potential for (even further) reduced liquidity conditions, we are increasingly cautious of a disorderly sell off in the US bond market. While it is not our central scenario, we would not rule out the possibility of a 3.0% US 10 year Treasury yield this month. Ridiculous as it may sound. Any signs of accelerating US inflationary pressures will further unnerve bond market longs, already on the back foot. In this respect, tomorrow’s US employment report (both tightness of the labour market and wage pressure) will be very closely watched.
On Tuesday we outlined the three key events of this week and thus after OPEC and the US employment report for November, market focus will shift to Italy. It is hard to pinpoint the exact ramifications of a no vote in Sunday’s referendum, however, from our viewpoint, neither outcome signifies a positive development for a nation desperately in need of structural (and banking) reform, a resolution (if not solution) on NPL’s and perhaps more importantly a plan to prevent the zero growth of the last twenty years from continuing. From our perspective, the eurozone project itself has a great deal to do over the coming year in order to prevent an existential crisis. We maintain our view from earlier in the week that EUR remains a sell on rallies vs the USD, and just a sell against GBP.
That neatly brings us on to the UK. Last night, Mark Carney gave a defense of the UK’s banking system and its function as "the investment banker for Europe”, and that it is absolutely in the interest of the European Union that there is an orderly transition”. Carney’s words were likely aimed to counter and clarify a raft of European speakers who have suggested that entire banking functions simply be picked up and moved to Paris, or Frankfurt... or Bratislava.
Carney also pointed out that the greatest risks facing the UK’s financial future were global, rather than domestic, and that the UK has "demonstrated its ability to dampen rather than amplify the impact on the real economy of a series of shocks”.
This morning, the Secretary of State for Exiting the European Union, David Davis gave some much needed colour on the UK’s Brexit negotiating position. Mr Davis stated that he would "expect to see pretty free movement of highly talented labour” and that businesses should be aware that that this is not "shutting the door”. Mr Davis went on to state that barrier free access is achievable by a number of different means and whether transitional arrangements are needed or not depend on the outcome of the negotiations.
"There is only one step from the sublime to the ridiculous” Napoleon Bonaparte
"You may have the universe if I may have Italy” Giuseppe Verdi
In financial markets this week there are three events that dominate views, opinion and positioning. In chronological order these events are: (i) Tomorrow’s OPEC meeting where, with so many nations seeking exemptions to an otherwise acceptable production cap (not to mention the absence of a significant nation altogether), an agreement appears unlikely; (ii) Friday’s US employment report for November, where nothing short of an unexpected and unexplained collapse in employment would likely alter expectations of a rate rise in the US on the 14th of December; (iii) Lastly, and most significantly in our view, is the Italian Referendum on constitutional reform.
Billed as potentially the third leg of global populist revolt in 2016, the reform bill is aimed at reducing the powers of the regions and ultimately making the upper house or Senate subordinate to the lower house, or the Chamber of Deputies. This together with a new electoral law, which would effectively give the biggest parliamentary party a majority, is framed by Renzi as a means to unshackle Italy’s political process (that has enabled no fewer than 65 changes of government since 1945) and enable the structural reform needed to reinvigorate an economy hamstrung by non-performing loans (NPL’s) and sluggish growth, that sees real GDP per capita lower than it was 20 years ago.
"Its rather unusual for Italy to be at the forefront of pro-market initiatives” Mario Monti
Critics would argue, however, that Renzi’s ‘reforms’ are just the opposite, maintaining or encouraging flouting of democracy in the upper house and regions, while stopping short of achieving the political engagement that could bring about meaningful economic and structural reform. While we are far from convinced that a yes vote is in any way a panacea of Italy’s troubles, a no vote may well be a painful test for Italy’s (and by default much of Europe’s) banks. It will also likely weigh on equities and risk assets and certainly won’t help the EUR.
In the bigger picture, a no vote could cause the emergence of an existential issue for the eurozone in one of two ways. Firstly with debts of more than 130% of GDP, the third biggest economy in the eurozone is too big to bail out. Secondly, if, as he has stated, Renzi falls on his sword and resigns in the face of defeat, the next biggest party, the five star movement have promised a referendum on EU membership.
"I couldn’t settle in Italy. It was like living in a foreign country” Ian Rush
On the basis of the potential impact of the events ahead of us this week, it is unlikely that we see a significant trend in FX or wider markets over the next couple of days. A 10 year Treasury / Bund spread that sits comfortably above 200bps (levels last seen in the late 80’s) and a US yield curve that likely retains an upside bias into 2017 implies little upside for EURUSD. A no vote in the Italian Referendum could however imply a significant downside for the Italian banking sector, credit spreads, equities and the EUR. We continue to favour GBP over EUR in the near term and any USD sell offs may offer an opportunity to add USD longs against the EUR.
"...give a little fillip to set the world in motion” Blaise Pascal
Earlier in the week we suggested that this week’s Autumn Statement was a "significant (perhaps even one-off) opportunity for the UK government to provide a credible and competitive fiscal boost and structural reform.” Hammond delivered a statement that avoided the tinkering and politicking of his predecessors and instead focussed on delivering what could be described as a cautious fiscal fillip. Activist enough to provide a focal point away from the negatives of potential Brexit uncertainties and towards the positives of innovation, infrastructure and productivity.
"There is much uncertainty about uncertainty” BoE, Kristin Forbes
External member of the Bank of England’s Monetary Policy Committee Kristin Forbes, highlighted her view that uncertainty is getting more blame than it deserves at the current juncture, and that the UK has battled well through this period despite feelings of uncertainty. If Hammond’s Autumn Statement can achieve a further normalisation of the balance of perceived risks for the UK, we then see (potentially substantial) upside possibilities for the UK and for GBP.
The key points of the Autumn Statement were the creation of a GBP 23 billion National Productivity Investment Fund - aimed at boosting productivity and countering the expected slowdown ahead - and core infrastructure investments into R&D, housing, transport and a new digital network. Hammond also maintained his predecessor’s pledge to lower the rate of corporate tax (and selected personal taxes). The fiscal fillip will be paid for by removing the pledge to balance the books by the end of the current parliamentary term and the resultant increased gilt issuance will likely lead to further steepening of the UK yield curve. Overall, however, we would view the statement as a positive development for the UK and for GBP.
"Not the first half you might have expected, even though the score might suggest that it was” John Motson
In the US, last night delivered the minutes from the November FOMC meeting. The minutes contained references such as, "officials saw rate hike appropriate relatively soon” and the majority of Fed officials saw "risks roughly balanced” offering further confirmation that the Fed intends to take the second step on the path of normalisation at the December meeting. The market response, however, was nullified by the fact that a December rate hike is 100% priced into the money market curve.
Ahead of today’s Thanksgiving Holiday, US economic data gave further rise for positivity as gauges of durable goods expenditure, consumer confidence and manufacturing all beat expectations, driving the US yield curve ever higher. Rising US yields have been the core driver behind the USD strength over recent weeks (the USD rose to its highest level since 2003 on a trade weighted basis overnight). A phenomena that has the potential to continue in the near term.
"A leader is a person you will follow to a place you wouldn’t go by yourself” Joel A. Barker
We have noted recently that while there is a macroeconomic case for a higher (and steeper) US rate curve (albeit we remain skeptical about the magnitude of the move based largely on projected growth and inflation boost from Trump fiscal stimulus), the argument for higher and steeper yield curves in Europe and Japan does not logically follow. In these regions we remain of the view that central banks retain an easing bias and that the next move in each instance is likely to be further easing, not tightening. Fitch the rating agency for example has a forecast for Japan’s interest rates to fall from their current -0.10% to -0.50% by the end of 2017. In that respect, with the US bond market closed today, it will be interesting to note the direction of European and Japanese yield moves without the underlying drag of the US curve.
"I am now convinced that theoretical physics is actually philosophy” Max Born
Over the weekend, NASA researchers released a paper that suggests an engine invented by a British engineer 16 years ago, purporting to produce thrust without propellant, might just work. If this is the case then it would be one of the most remarkable advances in the history of science. The problem being that in doing so it would contradict at least one fundamental law of physics.
Nicknamed the Cannae Drive (from the infamous Star Trek quote "ye cannae change the laws of physics”) such an engine would theoretically be capable of accelerating indefinitely. It is perhaps ironic that this paper should come to the be published at a time where there has been an explosion in the questioning of previously believed ‘fundamental laws’ of economics (macro, socio and political) and a willingness to embrace the alternatives.
In the words of Carl Sagan, "Extraordinary claims require extraordinary evidence” and while this is uniformly the case in science, in financial markets extraordinary claims can generate extraordinary moves if they can generate credible expectations. If Donald Trump is to live up to those expectations he (and the market) have created, he may well need a machine to generate thrust without propellant. He may well need a Cannae Drive.
Go with the Flow?
There is no getting away from the Trump effect in financial markets at the moment. Based around expectations of a substantial fiscal injection and corporate tax cut, capital flow projections, inflation expectations and growth expectations have driven 10 year US Treasury yields up around 65 bps in 2 weeks and, as the capital flows out of bond markets and into equities, the Russell 2000 (one of the broadest indices of US equity) has risen more than 18% from the lows over the same period. That is not to mention the simultaneous rise in the USD.
From our perspective, the USD has likely done enough to reflect the relative yield differential movements across global fixed income markets. Equities are increasingly overvalued and Treasuries (the core driver of the recent asset dynamic) may well need to see a more defined increase in inflation or an acceleration in US growth to justify the regime shift and, to make further significant gains.
In contrast, recent ECB publications highlight the continued need for monetary accommodation in the eurozone "even if there are many encouraging trends in the euro area economy, the recovery remains highly reliant on a constellation of financing conditions that, in turn, depend on continued monetary support.” Similarly, the commitment of the BoJ in its "yield curve control” variation of QQE, means that they too will be continuing with monetary accommodation. This likely means that any rallies in EUR or JPY will ultimately be sold into.
"Complacency is the great disease of your autumn years” Nick Cave
This week, however, very likely belongs not to Turkeys but to Mr Hammond and to the pound. Some months ago we discussed the prospect of substantial fiscal stimulus from the Autumn Statement. More recently official rhetoric, lower growth forecasts (and higher government financing costs) have tempered our (and the markets) expectations of fiscal loosening. In our view, this is a significant (perhaps even one-off) opportunity for the UK government to provide a credible and competitive (vs. EU) fiscal boost and structural reform (infrastructure, tax - both simplification and lower corporate rates). This is an Autumn Statement that we feel is well worth watching.
The Prime Minister gave GBP a boost yesterday when she struck a more conciliatory tone at the CBI. Her suggestion that there may be room for a transition period for UK businesses in order to maintain continuity and reduce uncertainty came as a welcome development. Mrs May will likely continue to be opaque about the Government’s Brexit negotiating strategy, however, we would expect further subtle, supportive titbits such as this to calm affected parties.
"People who think they know everything are a great annoyance to those of us who do” Isaac Asimov
Since we last wrote financial markets have had a significant adjustment to the ‘shock’ US Presidential win of Donald Trump. For the second time in 2016 the people have rejected the overwhelming advice of the elite, intellectuals and financiers and instead opted for change. It is perhaps not surprising in this respect that Oxford dictionaries declared "post-truth” - an adjective relating to circumstances in which objective facts are less influential in shaping public opinion than emotional appeals - its 2016 international word of the year.
"If all economists were laid end to end, they’d never reach a conclusion” George Bernard Shaw
Trumponomic theory is essentially based upon a substantial (somewhere around 3% of GDP) fiscal stimulus, a substantial corporate tax cut and a ‘make America great again’ protectionist trade stance. Discounting the knee-jerk reaction to the election result, the overwhelming response of financial markets has been that the prospect of tax cuts and infrastructure spending trump (pun intended) the negative effects of protectionism.
The biggest regime shift in financial markets has undoubtedly been the shift in US rate expectations. Ten year Treasury yields have risen over 50bps since the post announcement reaction lows, just over a week ago. Capital flows out of US fixed income markets have, however, driven two other key capital flow dynamics: firstly, it has generated significant capital flows into equity markets. A flow which we have concerns over the sustainability of, and despite the sharp revaluation over the past week, we retain a negative bias towards equities not least because of the negative implications of potential protectionist US trade policies; secondly, it has dragged all global yields higher. BoJ governor Kuroda’s testimony to parliament overnight stated "Just because US rates are rising doesn’t mean Japan’s have to rise as well”, as sentiment we would expect to be mirrored by a number of other countries for which rising bond yields (tightening monetary conditions) is not a helpful progression.
"2017 all depends on what happens with fiscal policy” Philadelphia Fed, Patrick Harker
By now the markets have had the time and the liquidity to adjust portfolio’s and positioning to the new regime, and we may be approaching a period where markets can take a more objective look at the regime shift and review the situation going forward.
The case for USD strength is perhaps the most compelling, particularly if we see a pick-up in global central banks (ex-US) pushing back against their rising domestic yields either directly or indirectly. Indeed, higher US yields are also compelling if the tax cut / fiscal stimulus comes to fruition. Corporate tax cuts of the order mooted by Trump will likely see substantial capital inflows, potentially dwarfing the corporate tax inversion trend of recent years. Thus inward capital flows should be further supportive of both inflation and the USD. However, this interest rate and inflation dynamic is a US phenomenon, not a global one.
Before the UK General Election in 2015 the Conservatives, under David Cameron, became increasingly concerned by the populist uprising and the resultant threat of UKIP. The result was the inclusion of the EU Referendum in the Conservative manifesto. After a surprise majority Conservative victory, the rest (a vote to leave the EU) is history. While the populist vote in the US was another clear winner, the process is very different. In France, however, the threat of the extreme right wing of Le Pen will undoubtedly drag the opposition to the political right. The ramifications of that are potentially more damaging to the euro project than Brexit. If Le Pen does well early on, what is the probability that the opposition (in whatever form that takes over the next month's) offers a Referendum on EU membership as part of their election pledge? We retain a negative bias towards Europe.
However, there is one region where we think that the 2016 international word of the year is very fitting. In the UK, central banks, a large number of politicians, economists and the elite have to a large degree "shaped public [financial market] opinion” by what could be described as emotional or subjective forecasts, while the objective facts, such as today’s retail sales data (highlighting current annual retail sales growth of 7.4%) are less influential. If we add to that the possibility that the UK moves from the back of the trade deal queue under Obama to the front under Trump, the prospects for the UK and for GBP remain positive, from our perspective.
"The poll that matters is the one that happens on election day” Heather Wilson
After all the ups and downs, the surprises and disappointments, bombshells and revelations, the US Presidential race result is finally upon us. Despite the obvious flaws of both candidates neither opponent has been good enough to pull away from the other in the polls. The latest projections suggest that Clinton will win with a projected 301-237 electoral edge (270 needed to claim victory). However, as recent performance of polls in extrapolating a result being have been so poor, high disillusionment and populism remain a big risk to Clinton and the Democrats.
Overlaying that uncertainty on to financial markets offers another level of complexity. The FBI statement, just as markets opened in for the start of the week, have in theory removed a real threat to the Clinton Campaign. The market reaction was risk-on, with equities rallying more than 2% from the low close on Friday. Historically, a Democratic win would be considered to have a negative equity bias, however, this time round, the extreme approach of Mr Trump has likely reversed the correlation. It is at this point that we would add caution, however, as in our view the relief rally in equities and risk assets may be a lot briefer than expected (aided by the significance of the rally into the start of this week).
All eyes are on the announcement of the swing states, and Florida and Ohio in particular. However, with voting expected to be close, and Trump having already hinted at a reluctance to concede should there be the slightest glimmer of hope, the probability of recounts and intransigence are high.
"Conformity is the jailer of freedom and the enemy of growth” John F. Kennedy
While the whole world holds its breath for the outcome of today’s vote, it is perhaps a good time to take a step back and look at the UK and its Brexit struggles.
This morning, the Institute for Fiscal Studies released a paper in which they suggest that the outlook for public finances has already worsened by GBP 25 billion since Chancellor Osborne’s final Budget earlier this year, with higher servicing costs, slower growth and a demographic deterioration behind the decline. We have argued before that the near term prospects for the UK and for GBP could be significantly impacted by structural and fiscal reform and the Autumn statement.
The OBR are expected to revise growth forecasts down alongside the Autumn statement, reducing Chancellor Hammond’s ability to offer any substantial fiscal loosening beyond the removal of fixed deficit targets for the time being. However, we retain the view that there is still much that can be done by the Chancellor to encourage business investment (arguably the missing piece of growth and productivity puzzles in the UK).
From our perspective, we retain a bullish view of the UK and GBP, both relative to expectations (including recent IFS forecasts) and its peers. This morning’s retail sales data from the British Retail Consortium (BRC) showed a strong rise in activity in October - sentiment mirrored by strong sales growth data from Barclaycard for the same month.
"One cannot plan for the unexpected” Aaron Klug
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