"The conventional view serves to protect us from the painful job of thinking” J. K. Galbraith
The UK employment report for the fourth quarter received a lukewarm reception from financial markets yesterday, mainly due to the fact that wage inflation disappointed expectations, rising just 2.6% y/y (both including and excluding bonus payments). However, the jobs data was strong. Employment rose 37,000 to its highest level on record, and the momentum was maintained in the (narrower) ONS data for January, registering a much bigger fall in the claimant count than expected.
While the unemployment rate remained unchanged at 4.8% for the October to December period, the single month rate fell to 4.6% in December, from 4.9% in November - within touching distance of the latest downward revision to the Bank of England’s estimate for the equilibrium level.
Herein lies the issue. There has been much debate about the equilibrium level of unemployment, or NAIRU (non accelerating inflationary rate of unemployment) in the UK - the level below which inflation rises - ultimately as a function of its interaction with wage inflation and productivity, both of which have been curiously subdued - not just in the UK, but globally.
UK productivity, while slowing marginally in Q4, recorded a year of consecutive improvements for the first time in more than 5 years in 2016. Productivity has been the missing piece of the global economic recovery puzzle for a number of years now. In the UK, we view productivity as a key upside risk for the UK in 2017 and beyond.
Productivity growth is intimately connected with wage growth, but it is also a function of business investment (the equivalent of structural reform at the corporate level). As the uncertainty surrounding Brexit begins to lift in 2017 (as negotiations progress) we would expect business investment to pick up, productivity gains to be maintained (if not accelerate) and ultimately for wage inflation to emerge. If this is the case, the economic outperformance of the UK in 2017 and 2018 will have the consequence not only of making GBP look very cheap at its current level, but of forcing another extension or u-turn from those economists and forecasters clinging to prophecies of doom for the UK economy.
"Get your facts first, then you can distort them as you please” Mark Twain
Furthermore, commentators and markets have used both strong and weak inflation forecasts as arguments to sell the pound, while strong economic data has been somewhat overlooked. The reason being fear of Brexit consequences, particularly from those who forecast a sharp and immediate collapse of the UK economy the moment a Leave vote was announced. Slowly and progressively, however, businesses and countries have signalled desire to invest in and promote trade with the UK.
The subdued inflation data earlier in the weak was not only good for UK real wage growth (a picture that is potentially more concerning in Germany at the current juncture - particularly in light of policymakers continual reminders that current German growth is driven by domestic demand), but it also narrowed negative real yields in the UK. Our view remains that relative real rates are likely to correct significantly during 2017. On that basis so too should GBP.
"Procrastination is the art of keeping up with yesterday” Don Marquis
Yesterday’s CPI, retail sales and Empire State manufacturing data from the US painted a picture of an economy gaining momentum, and as that momentum gains, of inflationary pressure building at the core level.
The USD has traded pretty sideways over recent weeks during a period where we had suggested that there was room for some corrective downside as President Trump got caught up with protectionism and immigration. We have however maintained the view that the delivery of tax measures from the Trump administration are likely to dominate equity markets, inflation expectations, and ultimately US yields (technical breaks above 50bps in real yields and above 2.60% in 10 year nominal yields would be very significant). A plan that meets, or beats expectations is likely to bring with it an acceleration in the pace of Fed normalisation and a potentially sharp rise in the USD.
"Boldly going forward ‘cause we can’t find reverse” Star Trekkin’, The Firm
Trekkies will be familiar with the term Kobayashi Maru, the training exercise in the fictional Star Trek universe designed to test the character of starfleet academy cadets in a no-win scenario. A no-win scenario defined by a set of rules that can only be overcome by changing the rules. In many regards, the eurozone and its member states offer an interesting real life parody to this iconic, fictional exercise.
On the face of it you may be forgiven for assuming that things are on the up for the eurozone, indeed many commentators have. Growth and inflation are both higher and pointing in the right direction. The latest set of forecasts from the European Commission, published yesterday, marks the first time in almost a decade that the Commission has predicted all EU countries will grow during the forecast period.
From our perspective, however, the backdrop is not as rosy or as simple as that. While growth and inflation are trending higher at the current juncture, the majority of this ‘trend’ is a function of base effects, and energy (as many ECB members have alluded). Furthermore, there remains little sign of convergence of growth or inflation trends across the region, something which we would see as essential for the sustainability of the project.
Greece is another example of the complexities and ‘no-win’ dynamic within the eurozone. Yesterday, Bank of Greece governor Yannis Stournaras warned that the country must secure an immediate release of further bailout funds from its creditors or risk recession - again. The German position remains that debt forgiveness is not possible within the eurozone treaties. The IMF position remains that the Greek debt burden, and the budget surplus required under the current programme just to maintain it, are both unsustainable. Greece disagrees, in part, with both.
Going forward, we expect political uncertainty across the region to increase as first the Dutch elections (15th March) and subsequently French and German elections intensify the national focus within the eurozone. Bond spreads between member states have risen of late, and we continue to monitor spreads as a barometer of eurozone uncertainty. Meanwhile we see the EUR remaining on the back foot
"Insufficient facts always invite danger” Mr Spock
Today, to a certain degree, the market focus will swing back towards Janet Yellen and US as the Fed Chair provides monetary policy testimony to the Senate Banking Committee. Her economic assessment will likely follow a cautious but upbeat path, consistent with the widely accepted Fed stance of a gradual removal of monetary accommodation. However, the main focus of markets will likely be on how expectations of fiscal policy will impact the pace of Fed normalisation.
The expiry of the US debt ceiling on March 15th provides a timely reminder of the enormity of the USD debt burden and will also likely calibrate the timing and magnitude of the expected fiscal stimulus. With markets broadly pricing the three rate hikes that the Fed projections suggest, it is unlikely that the current path is revised up as a function of anything but a credible fiscal boost. However, with equity markets at new record highs and Treasury yields holding up despite the resignation of National Security adviser (seemingly for national security breaches), it remains clear that expectations for the Trump Administration's announcements on taxation are strong. Following Trump’s statement last week, we are on heightened alert for the tax announcements as early as next week.
"I’ve giv’n her all she’s got Captain” Montgomery "Scotty” Scott
Elsewhere, recent strength in the broad commodity complex and a stabilisation in global growth have put AUD on a firmer footing. The release of an Australian business conditions index at its highest level for nine years, combined with Chinese inflation data at multi-year highs, led to AUD outperformance overnight. Despite the uncertainty and fragility of global trade (and more specifically Trump’s cancellation of TPP) and the geographical and geological reliance of the Australian economy on trade, the technical backdrop is increasingly positive for AUD.
Finally the UK is worth a mention. Not just because the European Commission have become the latest in a long list of institutions to revise up their growth forecasts for the UK in 2017. Nor because of a survey that suggests only 1% of startups surveyed by Silicon Valley Bank said that they will move their headquarters to somewhere else in Europe following Brexit. However, after so many column inches on the negative implications for the consumer of declining real income growth in 2017, UK inflation rose less than expected in January. Tomorrow’s UK employment report will be closely watched, particularly the earnings growth component.
"I almost never lose” Donald Trump
As Trump gets caught up with the US legal hierarchy in his quest to reinstate his wildly unpopular immigration ban (and in berating Nordstrom for its treatment of the "great person” that happens to be his daughter), market expectations of the imminence and impact of his tax plans wane. As these expectations wane, so to do the markets expectations of the broader fiscal stimulus and inflation expectations, which culminated in a sharp rally in US Treasury markets / drop in US yields yesterday.
In reality, the fall in yields was a global phenomena and not simply limited to the US. Furthermore, the recent trend of widening eurozone spreads also reversed somewhat yesterday, as Bunds underperformed the periphery. However, while the movement of the US yield curve (and as we have stated in recent commentaries the USD) is increasingly dependent on the new US administration’s progress (and conviction) on fiscal reform, we view the pullback in eurozone spreads as very much a temporary phenomena.
"The collision of a wish with unyielding reality” Alain De Botton
With little news on US policy intentions and very little in the way of incoming global economic data, much of the emphasis of financial markets has been roundly on the eurozone. Rightly so in our opinion. On numerous occasions we have been critical of a eurozone that when facing problems has kicked the can down the road (if they admitted that there was a problem in the first place). A perfect example of this is the singular failure of the eurozone to address its banking sector’s debt, capital and, npl’s following the financial crisis. Nearly 10 years on the failure of Italy’s Unicredit to achieve its rights issue targets by the February 23rd deadline would signal significant trouble for the Italian and by default (pun not intended, initially at least) the eurozone banking sector.
Another perfect example of the eurozone’s inability to deal with a problem, and also one that threatens to destabilise the whole region is Greece. The recent IMF consultation pointed out that "Greece… faces fundamental challenges: (i) a vulnerable structure of the public finances; (ii) significant tax evasion and an ineffective tax administration; (iii) impaired bank and private sector balance sheets; and (iv) pervasive structural obstacles to investment and growth. Moreover, its public debt remains highly unsustainable, despite generous official relief already provided by its European partners.” The IMF go on to suggest that by 2060 Greek government debt to GDP will be 275% from 180% this year.
The IMF point out that "extensive fiscal consolidation and internal devaluation have come with substantial costs for society” and its calculations suggest that the economic collapse is deeper and more prolonged than the US Great Depression. Still the German Finance Minister rules out debt haircut for any EU member, as it is ruled out under the Lisbon Treaty. We expect that support for Grexit will grow in 2017, both domestically and internationally.
Mark Carney has made his view clear that the legal architecture of the financial system could collapse amid a messy Brexit, hurting European customers of the City of London more than the UK itself. Draghi says he is unworried - We are troubled by the suggestion that this infers that the ECB are also unprepared.
Eurozone troubled remain numerous and this is not to mention the increased political turbulence that has the potential to rock the eurozone, and the EUR over coming months.
"The real fight starts now” Jeremy Corbyn
Last night, the UK government successfully defended against an array of proposed amendments to the the Article 50 bill. There were nine proposed amendments to the bill, ranging from the rights of EU migrants to the opinion of the Gibraltar Government. All were rejected, as the final, unamended EU (Notification of Withdrawal) Bill was passed by 494 votes to 122.
Jeremy Corbyn’s remarks that "the real fight starts now”, in relation to ensuring a Brexit that "protects jobs, living standards and the economy”, have brought ridicule from the Labour ‘Remain’ contingent (one critic parodying Corbyn’s words to Harold II immediately after his defeat in the Battle of Hastings), however, as far as the country and the negotiations are concerned this sentiment appears about right from our viewpoint.
"Prospect of US economic policies still uncertain” Hiroshi Nakaso
Ahead of the important US - Japan meeting tomorrow, Deputy BoJ governor Nakaso was on the wires overnight highlighting the risks to Japan from a slowing China, Brexit and EU debt concerns. Not to mention the uncertainty surrounding US economic policy and its implications for the all important USDJPY exchange rate. In that regard it is worth noting that Japan’s trade surplus for 2016, released yesterday, showed a 25% increase to a 9 year high.
"...everybody in the world will be famous for fifteen minutes” Andy Warhol
Following the infamous "whatever it takes” commentary from ECB President Mario Draghi almost five years ago, eurozone bond yields (and thus implied credit spreads) entered a long period of sustained convergence, aided in no small part by ECB QE programmes. With the possible exception of Greece, whose insufficient credit rating left them outside the ECB remit for bond purchases under QE, the region’s credit spreads narrowed as bond yields declined.
However, as central bankers reach the end of their fifteen minutes of fame (to paraphrase Carney referencing Warhol) and economies increasingly look towards fiscal policy to guide the next stage of the global economic recovery, intra-eurozone bond (or credit) spreads are likely to come under increased scrutiny. Political concerns and economic (and inflationary) divergence will only exacerbate this issue. Yesterday, amid rising political concern in France the Bund OAT (Germany vs. France) spread reached its widest in 3 years at above 70 bps (10 year). At the same time banking sector (and Non Performing Loan - NPL) concerns drove the Bund BTP (Germany vs. Italy) spread above 200 bps for the first time in a similar period.
The last two sessions have seen EUR come under pressure as credit spreads have widened and polls have narrowed. In France, Marine Le Pen, aided by the nepotism and conformity of her opposition, appears to be the only Presidential candidate who can be confident of reaching the second round of voting, even if she is unlikely to win it. In Germany, Chancellor Merkel’s governing bloc (CDU/CSU) was overtaken by the Social Democrats (SPD - led by newly elected leader Martin Schulz - formerly President of the European Parliament) in a poll for the first time since 2010, underscoring the uncertainty surrounding political continuity in Germany.
Le Pen’s plans to remove central bank independence, return to a national currency unit and fire up the printing presses are troubling to the markets, and while she is given little chance of winning the second round, a Trump victory a month before the US election seemed impossible. With elections in the Netherlands in just over one month, and continuing socio-political troubles in Italy and Portugal, the backdrop for the eurozone remains far from stable, politically at least.
"There is no friendship in trade” Cornelius Vanderbilt
Furthermore, S&P Global Ratings pointed out overnight that amid the slowdown in global trade it is the EU that is likely the most vulnerable. "Europe is more exposed than other regions to decreasing trade levels because of its high trade intensity.” In fact, the EU as a bloc ranks above China as the world’s top exporter, second only to the US in terms of its imports. Protectionist leanings of the new US administration combined with the Chinese move towards a consumption-led economy add further to the pressures on Europe.
If we sum the negative implications of falling global trade, rising global protectionism and rising political discontent and populism, then Mario Draghi may once again be faced with the difficulties of troublesome intra-eurozone credit divergence. This time, however, stating that he will do "whatever it takes” is likely to have a significantly reduced impact when much of his monetary heavy artillery is spent.
"... better, better, better, better…” Hey Jude, The Beatles
In the UK, GBP has been dented this week with little data to guide sentiment, and it seems M&A activity weighs. While much of the UK’s doomsayer commentariat focus on the recent dip in credit expansion and pullback in BRC retail sales in January as reasons to be gloomy, new car sales reached their highest in 12 years in January. More significantly, a PwC report out this morning claims that the UK will enjoy the fastest economic boom between now and 2050 than any other G7 nation - on the premise that the UK remains open to global talent.
Twenty years ago, the US trade data was the highest profile release and the biggest market on the global economic data calendar. Long since overtaken by the US employment report, the trade data may, however, begin a resurgence in focus. Protectionist policies of the new President of the United States are likely to bring increased scrutiny, and at the very least it should be watched with interest from the eurozone.
"Now is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning” Winston Churchill
Yesterday was the latest Super Thursday update from the Bank of England - so called as the BoE released the MPC decision, the policy meeting minutes and the Quarterly Inflation Report. From a policy perspective there were three key updates to the Bank’s forecasts (and thus policy outlook).
Firstly, the Bank raised its growth forecast for this year quite significantly to 2.0%, and more modestly for the next two years. To put this into perspective, the Bank’s GDP forecast for 2017 in the meeting directly after the UK vote to leave the EU was a mere 0.8%; this was raised to 1.4% as recently as November and, following continued economic strength, notably led by the consumer, to the current 2.0%. In a nod to his prophecies of UK economic doom surrounding the Brexit vote, Carney maintained that consumers will face increasing headwinds in 2017 as real wage growth is eroded by imported inflation, and stated that "the Brexit journey is really just beginning.”
Secondly, the Bank lowered its inflation projection by 14 bps to 2.43% at the end of the forecast horizon - principal policy signalling device. However, a core emphasis from the minutes was the revelation that some policy makers have become more concerned about accelerating inflation and wished to add to the previous MPC statement that the BoE has "limited tolerance” for inflation above their 2% target by stating that they were "closer to those limits”. Lastly, the MPC lowered their expectation of the equilibrium unemployment rate (or NAIRU), to 4.5%, from 5.0% - effectively suggesting that unemployment can get to 4.5% without generating wage inflation pressure.
Carney was also clear to point out that the projections in the February Inflation Report and the continuing suitability of the BoE’s current policy stance depend on three judgements: (i) "That the lower level of GBP continues to boost consumer prices broadly as expected and without adverse consequences for inflation expectations further ahead”; (ii) "That regular pay growth does indeed remain modest, consistent with the MPC’s updated assessment of the degree of slack in the labour market.”and; (iii) "The hitherto resilient rates of household spending growth to slow as real income gains weaken.” Higher inflation expectations, higher wages or a more resilient consumer would thus likely stretch the MPC’s "limited tolerance” and see yields (and GBP) pressure the topside.
"In my end is my beginning” Mary Queen of Scots
Ultimately, a higher growth trajectory and inflation closer to target are positive developments for the UK economy and GBP, tempered marginally by the view that there is likely more slack in the labour market. Furthermore, Carney gave a vehement dismissal of fears that banks will leave the UK after Brexit, stating that London is where the people, capacity, collateral, trading and derivative books and clearing are all based and that any move of jobs to the EU would be a "very, very complicated exercise” and one with "huge operational” and "huge financial” risks.
We would agree with Governor Carney that the Brexit journey is really just beginning. However, just as Carney defended the prospects of the UK banking and finance industry, we would defend the broader prospects of UK economic resilience and maintain that we see GBP as undervalued at current levels.
"...the sky is the beginning of the limit” MC Hammer
Earlier in the week we highlighted our immediate near term bias towards USD weakness, yet that we fully expected this to be corrective in nature and transient. We pointed out that while our medium term view remained one of tighter US monetary policy with upside economic and inflation risks as a function of fiscal reform and stimulus, that in the near term the geopolitical side effects of the enactment of some of Trump’s more controversial election pledge policies has undermined sentiment, yields and likely the USD.
We continue to see this as the case; at least until the topic of Trump’s interventions turns to tax, most specifically corporate tax. This is the point at which, for US Treasury yields and the USD at least, the situation starts to become more positive. Corporate tax cuts are likely the best chance to boost business investment, raise productivity and thus to increase US economic growth. Furthermore, the relatively upbeat February FOMC statement highlights business investment and productivity weaknesses as the main drag on the US economy, and point to a faster pace of monetary normalisation.
"Brevity and conciseness are the parents of correction” Hosea Ballou
Regular readers will be well aware of our medium term view of USD strength. The core premise for this view is that, as the Federal Reserve resume their ‘gradual’ monetary normalisation - based on a stronger economy and improved and encouraging signs that inflation is likely to move above target around the policy relevant horizon - President Trump is likely to launch a combination of fiscal and infrastructure spending that should be (perhaps significantly) both growth and inflation friendly.
The combination of a recovering economy, where the central bank’s employment and inflation targets are all but met, and significant fiscal activism will likely boost inflation and interest rate expectations significantly. It has been argued by some commentators that the markets priced the ‘Trump effect’ into interest rate and equity markets in 2016 and in part this is fair. However, Trump has proven true to his word (and each election pledge) so far, so we have no reason to believe he will disappoint on a combination of tax and infrastructure spending - a significant fiscal stimulus. On that basis we retain our USD outperformance view.
"Progress requires setbacks” Henry Spencer
However, in the short term, the risks for the USD are increasingly in the other direction. President Trump’s surprise travel ban at the weekend sent a shock wave through equity markets yesterday. Overnight, his sacking of Acting Attorney General Sally Yates, after she told justice department lawyers not to defend his executive order banning entry for people from seven Muslim-majority countries, added to political woes. In 2016, markets were on ‘Fed watch’ as monetary policy drove markets and the USD. In 2017 markets are on ‘Trump watch’ as fiscal policy and, increasingly, political risk drives sentiment and valuations.
Furthermore, and in addition to the rising political risk premium for the USD, currency futures data highlights that the speculative market (as defined by the CFTC) is the longest of USD than it has been in 2 years. From our perspective, the chances of a ‘wobble’ in the value of the USD are heightened against the current backdrop. The significant amount of economic data over the rest of the week also add to the risks as we see them.
"Price is what you pay. Value is what you get” Warren Buffet
In the eurozone, this morning’s inflation data for France, Spain and the region as a whole surprised sharply to the upside on the headline measure to 1.8% y/y. In reality, the ECB has been warning for several months that the calendar impact of historic energy price declines would lead to "a sharp jump in inflation around the turn of the year”. They have also warned, that policy will likely look through the ‘temporary’ price spikes and focus on core inflation for the region - which was much more subdued at +0.9% y/y. In the near term however, this rising eurozone inflation, albeit temporary, may well fuel a near term EUR rise, particularly if a USD sell off takes hold.
In the UK, the House of Commons begins a 2 day debate on Article 50 and Brexit. We think that it is very unlikely that the resultant Commons vote does anything but pass the bill, once it is formerly delivered. Furthermore, the release of the UK consumer credit data this morning seems to have hit something of a ‘raw nerve’ with the markets and GBP has underperformed as a result. While the data showed much lower than expected consumer credit creation, it follows on from a very strong November number, and the series itself has been volatile of late. Our view of the UK remains resilient. We expect the UK to outperform both expectations and its peers. GBP, in the medium term, the same.