ECU's Investment Blog
"It's not whether you get knocked down, it's whether you get up” - Vince Lombardi
At the start of the week, risk sentiment was low and falling as heightened global geopolitical tensions dominated. Since then, the underlying dynamic has morphed and as we approach the US data pinnacle of the week (and arguably the month), the major themes are a positive attitude to risk assets with an underlying weak USD bias. In short: S&P spiked (as soon as geopolitical tensions eased a touch), volatility remains low (as do credit spreads) and, while US yields have risen, the notion of 3.5 – 4% fed funds rate, at some point, no longer appears to scare the markets.
While we currently view the positive attitude to risk assets, against a backdrop of global economic and political uncertainty, as a little over exuberant, there are a number of events / dynamics that have helped the more positive market mood.
The announcement from the Chinese National People’s Congress that the growth target would remain unchanged at 7.5%, was likely viewed in an overall positive light by markets. It is possible that the unchanged China GDP target is in part a concession to broader market sentiment amid still heightened EM concerns and heightened geopolitical risks surrounding the Ukraine situation. In the bigger picture, it is likely that the growth target is a bit ambitious if the administration is serious about structural reform. It is also possible that in order to achieve the foreign trade goal that the CNY will need to weaken further. We retain the view that significant risks for the Chinese (and by default global) economy remain, but in the near term, despite currency volatility, economic stability has aided risk sentiment.
"Take jobs number with a grain of salt due to weather” - Charles Plosser
In the US, the weather induced uncertainty remains and while attitude to risk assets has remained strong, USD sentiment has faltered. The Beige Book earlier in the week highlighted that, despite the harsh weather (which slowed hiring, sales and broader activity), the Fed saw the economy as still growing modestly. This is likely the key issue. Our view remains that the US economy is indeed in a stronger state than the current data suggests (weather adjusted or not). However, comments from NY Fed President Dudley that the "Fed balance sheet is likely to stay big for a long time” and that he sees "no rush” to shrink it, underlined one of the key vulnerabilities of the USD (particularly with reference to the EUR).
The economic data has done little to help the USD’s cause this week, with notable weakness in factory orders and service sector activity, especially the employment components of both has had analysts rushing to revise lower their estimates for this afternoon’s payroll data. Looking at the composite measure of activity from the ISM survey in the US, it is now below that of the eurozone for the first time in three years. We are not suggesting in any sense that this reflects a reality of faster growth in the eurozone than in the US at the moment (nor do we envisage that for a very long time) but the uncertainty over US activity is playing a big part in the current distortion.
While the US data has been disappointing, it has not been bad enough to damage sentiment to risk assets and the de facto monetary policy implications of pedestrian growth is also supportive of equities and broader risk assets. Over time, we feel that the true strength of the US economy will be revealed and that this will lead to a speeding up of the pace of tapering in the US, not a slowing as some are starting to suggest. Indeed, we would err towards the sentiment of Dallas Fed president Richard Fisher who said yesterday"I fear that we are feeding imbalances similar to those that played a role in the run-up to the last financial crisis… Fed is distorting markets and creating incentives for managers and market players to take increasing risk, some of which may result in tears.” As the Fed aims to remain behind the curve on monetary policy there are rising risks of a steeper trajectory of rate rises when they come.
"Euro is an Island of stability” - Mario Draghi
In yesterday’s main event, Mario Draghi once again confounded expectations with inaction and broadly positive rhetoric. We highlighted our concerns about the disinflationary (deflationary) pressures in the eurozone earlier in the week and how the lagging impact of a French VAT hike appears to be the only good news on that front. Yesterday, the Dutch inflation figure for February missed expectations by 4 bps to the downside, to just 0.4% annual rate on the harmonised measure; adding further confidence to our view.
ECU Global Macro Team member Kit Juckes sums the situation up nicely this morning in saying "All you can say in the defense of this reluctance to tackle pathetically slow growth, disinflation that won’t go away and a currency that hurts two-thirds of the euro area badly is that the vast bulk of Europe’s problems are not due to tight money but to bad governance and poor fiscal policies.”
This morning the EUR has made new cyclical highs above 1.39 amid very light activity and low liquidity. A weak US employment report this afternoon will likely extend the EUR’s day in the sun, however, when the weather impact on the US is quantified, this may come to an abrupt end.
"The future is no more uncertain than the present” - Walt Whitman
The Heisenberg uncertainty principle in quantum mechanics essentially states that the more precisely the momentum of a particle is determined, the less precisely its position can be known and vice versa. This mathematical law provides an interesting analogy for the current relationship between the systematic monthly economic data in the US (the momentum) and the underlying economic growth (or position of the economy). We have stated a number of times in this blog our view that the underlying growth of the US economy is stronger than the recent data implies. However, the depth of the decline in economic activity and the macroeconomic dislocations caused by the financial crisis not only required a monetary policy response that was unorthodox and uncharted, but likely induced a recovery that is similarly unorthodox and uncharted.
The recent run of weaker than anticipated data has sparked a great deal of debate and uncertainty about the strength of the US recovery, the impact of the weather (weather or not?) and the implications for Fed tapering. In many respects we feel that in a (perhaps contrived) reflection of the Heisenberg uncertainty principle, the markets have focussed their attentions too closely on the direction of the recent high frequency economic data and in doing so have lost precision on the underlying growth (or position) of the economy – which we believe remains robust (perhaps at a more modest pace than was evident in Q3, but robust nonetheless). It is certainly likely that the weather impact was significant in the recent data and indeed it is equally likely that there was some slowing in momentum also present in many areas of growth. In short we feel that the recent underperformance of the US data relative to expectations is as much a function of the volatility of the recovery as any other factor.
Breaking the bad run of data in the US is likely now needed in order to bring the focus back on the underlying strength of the US recovery, particularly in relation to other parts of the developed and emerging world. In that regard the better than expected (although still modest relative to the UK) manufacturing activity data yesterday was a step in the right direction, and leaves the (more significant) service sector equivalent in focus tomorrow. The major event for the week in the US, however, will be the February employment report on Friday.
The situation in the Ukraine has arguably been the dominant driver of investor sentiment and risk appetite over recent sessions and will continue to be an acute focus in the near and probably the medium term. For now, we will refrain from commenting on the situation, suffice to say that it adds a further element of (binary) volatility to the markets.
"Information is the resolution of uncertainty” - Claude Shannon
The main focus this week (at least ahead of the US employment report) is the ECB policy meeting on Thursday. In many respects the uncertainty surrounding this week’s meeting has increased as a function of the (two) inflation reports last week. Until the inflation reports, which showed an uptick in the final revision for January that was maintained in the initial reading for February (along with a rise in core inflation), the broad market consensus was likely looking for a form of monetary easing from the ECB as the threat of deflation grew. It could be argued, however, that the resilience in the inflation indicators gives the ECB breathing space to reflect.
In reality there are a couple of points worth reflecting on at this stage. Firstly, the fact that the eurozone inflation data for February held steady at 0.8% was a surprise in itself following the release of the individual components. Indeed, of those that have reported the data so far, there was a significant drop in Germany and Spain, and a more modest drop in Italy, yet the headline data remained unchanged. The total appears at first glance to be more than the sum of the parts!
It is possible that there was an uptick in France as a result of the lagged impact of previous VAT increases that makes up for the anomaly, however, now that the market is not expecting any action from the ECB, we would advise caution as the ECB may well be more dovish than many now expect. Further, one off tax hikes will likely not ease ECB fears about further disinflation (deflation?) and with the release of the 2016 inflation forecast, there are additional downside risks relative to expectations. We would consider anything other than the potential commitment NOT to sterilise SMP purchases (if needed to add liquidity at the very front end), as unlikely this week, but the tone of Mario Draghi may well surprise on the dovish side amid the current global geopolitical and economic uncertainty.
"Spain has passed from ‘Danger to Hope’" - Mariano Rajoy
On Tuesday we touched on the two areas in which we are becoming increasingly concerned about growth: France and Japan. On reflection we could well add Spain, China and even Russia into a broader consideration. This morning’s Spanish GDP report, while only very marginally weaker than expected, leads us to question the complacency of wellbeing towards the eurozone and perhaps more importantly ask what level of recovery, growth and debt reduction expectations are priced into the current markets. This morning Italian 10 year yields fell below 3.5% for the first time since January 2006. If we view this in the context of generally falling global yields and inflation expectations than perhaps this is understandable. However, in the context of sovereign yields as a reflection of credit quality in a country where debt / GDP is above 130% accompanied by political disunity, we could argue that the market needs to consider ‘danger’ and not just ‘hope’.
"European disinflation makes deficit cuts harder” - Pierre Moscovici
We have suggested for many months now that the level of growth in the eurozone is not sufficient to reduce the level of outstanding debt in the medium term and, while the arrest of the decline in activity across the region has caused many to become significantly more positive about the fortunes of the eurozone, we retain the view that the region underperform on a macroeconomic level and, in relation to the US and UK, that the monetary policy responses of the respective central banks will increasingly diverge as the year progresses. Hope is not an investment strategy!
China: SAFE and sound?
As the Chinese authorities try to engineer a slowdown in the credit boom and shift the drivers of economic growth towards domestic demand and away from a reliance on manufacturing and exports, concerns over the implications and ramifications of the shadow banking sector continue to dominate. Increased volatility in the (offshore (CNH) in particular) renminbi market has kept China firmly within the attentions of the financial markets over recent sessions. While many are playing down the risks to the region (at the very least on the basis that the relatively low level of government debt and history of bailouts) it would be wrong to understate the significance of the change in policy that the PBOC is trying to engineer, or the increase in uncertainty this causes in Asia.
The State Administration of Foreign Exchange (SAFE), an agency of the PBOC, commented earlier in the week that "[US] QE tapering may help relieve yuan appreciation pressure” and indeed some commentators feel that the renminbi is reaching its equilibrium level. Our concerns at this stage, however, are not in relation to the value of the CNY (or CNH) but the risks of a default event within the shadow banking sector and the ramifications for global sentiment, investment and activity.
In Japan we would also err towards ‘danger’ rather than ‘hope’. Considering the recent dramatic switch from current account surplus to deficit and a debt burden that is even more terrifying in per capita terms than as a national aggregate. In the long run a weaker yen is likely not only part of the solution to Japan’s crisis but also a consequence of it. However, in the short term the ‘danger’ for the currency is in the other direction. Historically, JPY has a strong correlation to the level of US yields and in particular the 10year US Treasury yield. Over the past 24 hours Treasury yields have moved lower and with US equities failing to hold onto any gains into new high ground, the short term risks for the JPY are arguably to the upside, particularly vs. EUR.
"Never was anything great achieved without danger” - Niccolo Machiavelli
Last (but certainly not least) the macroeconomic backdrop in the UK continues to frustrate the bears. Yesterday’s GDP release continues the positive tone and while on an annual basis the growth rate modestly disappointed the initial estimate in dipping back to 1.8%, the breakdown was far more encouraging. Perhaps most importantly (at least in terms of the sustainability of the UK recovery story) was the rise in business investment which jumped 2.4% on the quarter, significantly more than expected, going a long way to dispel the sceptics that UK growth is too reliant on the consumer.
"Companies have weathered a prolonged period of uncertainty… having warehoused cash for a number of years and with ready access to credit, leading UK corporates now have more confidence to pull the trigger – and this is evidenced in the positive GDP figures highlighting sustained business investment.” Ernst & Young
In addition, the GDP data also highlighted that the service sector (circa 75% of UK GDP) is now 1.3% above the peak it achieved prior to the 2008 crisis. From a sentiment perspective the situation also remains strong with the latest CBI growth indicator, released overnight, at its highest level since it began in 2003 and this morning’s eurozone sentiment data further highlighted outperformance within the region with the highest reading in Western Europe.
Ultimately, we feel that there is a distinct ‘danger’ that JPY strength and EUR weakness extends in the short term as the ‘hope’ of eurozone return to prosperity falters. GBP may well be on the side lines in the near term, but our bullish views remain firmly in place.
"Conformity is the jailer of freedom and the enemy of growth.” - John F. Kennedy
The week started off with a subtle shift in the communique from the global leaders of the G-20. The shift was essentially from austerity and the need to address debt, towards stimulation and the need to address growth.
Weather or not?
We have discussed at length over the past months and quarters, how there seems to have been an endless procession of macroeconomic events (or non-events) that have provided a pretext for investment inactivity on the basis of uncertainty. These events arguably began with the surprise US Federal Reserve decision to delay the tapering of QE last September, and more recently have been reincarnated in the form of weather-induced weakness in the US economic trajectory, a phenomenon we have referred to as the ‘Weather or not’ uncertainty.
We have also suggested over recent months that the recovery in the global economy from such extremes of credit, demand and sentiment distortions will by no means be as uniform as in previous recovery periods. Indeed some of the deterioration in the recent US (and other) macroeconomic data does likely amount to a slowdown, but that does not mean that the trend has changed. We retain the view that the recovery in the US is stronger than the recent data would imply and that ultimately this should prove positive for the USD, however, we also retain the view that the data in the recovery will remain volatile - the ‘Whether or not’ uncertainty.
The complications and implications of the increased uncertainty in financial markets are far reaching, but one key implication is the cross asset correlations which have broken down or become inconsistent or unstable of late. The impact of this has further promoted position squaring and reduced speculative participation.
"Stronger growth may justify a rate rise earlier” - MPC, Martin Weale
Within the developed market world we continue to view the UK as the leading light for growth and with increasing confidence from the Bank of England that business investment is turning a corner, we would echo the sentiment of policy board member Ben Broadbent that "there is better news on the way”. GBP related M&A flows (and much speculation as to the timing of those flows) have increased volatility in GBP over the past weeks, and while the positive impact of these flows will wane over coming weeks, we continue to see ‘the case for sterling’ as a strong one.
Despite the Bank of England suggesting that their central expectation for Q4 GDP growth was in the region of 0.9% quarter on quarter, the market is looking for 0.7% when the preliminary estimate is released tomorrow. Historically, however, UK growth data has a tendency to be revised up from its initial estimate and thus while we see modest upside risks to the data, the ‘upside’ is perhaps more likely to come in the form of subsequent revisions. However, any further improvements in the business investment data should be keenly watched as a guide to the future strength of UK growth and the pound.
"All change is not growth, all movement is not forward” - Ellen Glasgow
While we remain positive about the growth trajectories and prospects for the UK and the US, there are some areas of the developed world where we are less comfortable, indeed in France and Japan we are increasingly concerned.
There was an excellent article in the L A Times on Sunday that looked at demographic fragility of France. The article pointed out that the "young and enterprising in France soon realise that elsewhere…obstacles to success are fewer and opportunities greater”, while also pointing out that hundreds of thousands of French retirees are spending at least part of their golden years (and golden eggs?) in other countries. If we combine this with the lack of structural reform and threat of marked economic deterioration, this is not a sustainable dynamic for France and comments such as French Industry Minister Montebourg made this morning that "Euro strength is absurd” will likely become increasingly audible.
In Japan, the disappointment of the Q4 growth data have brought into question many aspects and side effects of the three arrows of Abenomics, and with energy prices surging in a reflection of the decline of the JPY, January saw a record trade deficit. It is perhaps even more surprising that after the ‘shock and awe’ of the immense QQE (Quantitative and Qualitative Easing), Japan seems to be mulling further easing, even as the US and UK in particular look towards monetary normalisation,. It is perhaps not surprising therefore that the concept of a fiscal crisis, surrounding the most heavily indebted major economic nation, has been often mentioned by Kuroda of late. Retail trade and inflation data from Japan at the end of this week will be closely watched.
For today it seems likely that financial markets will maintain their slow lumbering inactivity, however, close attention should be paid to equity markets where having made new highs in the S&P last night, the index fell back and futures are indicating further (modest) losses today. Equity sentiment from here is very important as, following the EM exodus last month, it is likely that the predominance of those funds have been put to work in developed market equities. Risk sentiment is becoming increasingly important.
"A committee is a group that keeps minutes and loses hours” - Milton Berle
With the release of the Bank of England and Federal Reserve board minutes yesterday, the focus of market attention shifted back towards monetary policy.
In the UK, the minutes from the February meeting were broadly as expected and in keeping with the basis for the transition of monetary policy to ‘phase two’ of forward guidance. The committee suggested that it expects "UK recovery momentum to continue in coming quarters”, while further acknowledging that the inflation slowdown is partly due to the strength of the pound. The Bank’s Paul Fisher summed up the current status of interest rates as "not now, gradually when we do, and not very high when we get there.”
More significant from our perspective was the release of the UK unemployment report. The headline ILO unemployment rate (the centrepiece of phase one of forward guidance) rose to 7.2% generating a mildly negative reaction in GBP. However, the detail of the data highlights a markedly more positive bias. Firstly, the uptick in the unemployment rate is likely a simple statistical anomaly as a function of the calculation of the 3 month on 3 month averaging of the index and we fully expect the unemployment rate to continue its decline, falling below 7% over the coming months. Secondly, the claims data showed further improvement and support the view of continued improvement in the ILO measure. Thirdly, wage growth showed further signs of life and supports the notion that real wages will turn positive this year, further supporting consumer expenditure (circa 70% of UK GDP). Lastly, but perhaps most importantly from a monetary policy standpoint, if we take that fact that the economy grew at 0.7% in the last three months and hours worked rose 0.4%, then the data indicate a pick-up in productivity. This is a function of recovery that has so far eluded the UK, and puzzled policy makers. Continued productivity growth could be a key factor in driving wage gains going forward and thus be a key factor for the BoE in phase two.
In the US, the minutes from the January meeting, the last under the governorship of Ben Bernanke, were similarly as expected. The key points from the minutes were firstly the reiteration that the path of tapering will remain constant unless there is a ‘significant’ derailing of US growth. While the market assesses the current softness in the US data (and questions the legitimacy of the weather distortion claims), the market has viewed this as a possibility of stopping the taper. However, moving into the spring we continue to suggest that it is perhaps more likely that the taper amount is increased not decreased or stopped. Secondly, the Fed introduced the concept of evolving its forward guidance away from threshold based guidance and towards a more "qualitative guidance” at or around the 6.5% unemployment level. A move that largely mirrors that of the BoE.
"It is not certain that everything is uncertain” Blaise Pascal
Perhaps the biggest issue concerning global markets at the moment is the uncertainty surrounding the US economic momentum. Severe weather has clearly been an issue for many parts of the US and some of the empirical data for less or unaffected states shows continued strength. However, the longer the weather induced weakness continues the less certain the market is becoming in terms of the strength of the US recovery. Back in September surrounding the Fed non-taper, the market had a similar wobble in its conviction over US economic strength. As was the case then, we continue to hold the view that, while uneven, the US economy will continue to outperform in 2014. The implications for Emerging markets, the USD and broader investor sentiment in this regard are significant and thus in the near term it is likely that we will witness a pick-up in volatility, before uncertainty lifts.
"Technological progress has merely provided us with a more efficient means of going backwards.” -Aldous Huxley
On Tuesday we reiterated our thoughts on the slowdown in the empirical data for Germany (and the eurozone) in December noting… "We now anticipate that the stronger-than-expected GDP print in Q4 for the eurozone is likely a near-term top and that economic underperformance from the eurozone will reassert itself over the coming months and quarters.”
This is a view that we continue to hold and the weakness in the French (and to a certain degree German) PMI data for February perhaps strengthens the argument. It could be argued that the ECB were ahead of the market at the February ECB press conference, expressing more comfort in the growth backdrop. This was subsequently backed up by the release of the stronger GDP data. It will now be interesting to see how quick the ECB are to react to or dismiss what we see as a more sinister period of weakness in the eurozone, particularly if the December weakness extends into January.
The eurozone economy is edging along (flattered by the Q4 GDP data to a certain degree) too slowly to get unemployment or budget deficits down fast enough or to make any headway into its debt. Further, whereas the US and the UK have been through significant periods of rebalancing from a corporate and from a household perspective, the eurozone has not. Indeed, in the UK and US the health of company cash reserves and corporate earnings have provided confidence from their respective central banks that business investment will increase in 2014 and drive growth in a more balanced manner than the consumer driven growth we have seen to this point.
Comments overnight from French President Hollande that "the crisis is behind us” conjure up images of the caricatured French leader uttering those words on a pantomime stage, with the oversized depiction of ‘the crisis’ standing behind the President comedically pushing its index finger vertically over its lips… sshhhhh!
"When you can measure what you are talking about and express it in numbers, you know something about it.” Lord Kelvin
Overnight there were a number of volatility inspiring events after the quiet of yesterday’s US bank holiday. Firstly, there was some significant debate about the Chinese Central Bank Repo activity (PBOC conducted repos for the first time since June), which is essentially designed to withdraw liquidity from the system. We see this as a seasonal operation related to the withdrawal of the liquidity pumped into markets over the Chinese New Year holidays. Indeed with Chinese rates having fallen from their elevated levels earlier in the year this is likely an insignificant event, however, the market will continue to watch for pressure on front-0end China rates as a barometer for potentially more sinister liquidity concerns in the region as the authorities continue to try and ‘manage’ an economic slowdown.
In Australia the focus was on the minutes from the Reserve Bank of Australia (RBA) following the higher than expected inflation data for Q4. In essence the minutes advocate the implicit move to a neutral monetary policy bias as a result of the surprise (to markets and very possibly the RBA) higher inflation (and inflation expectations), noting that a "period of stable rates is likely to be prudent”. Further, it appeared that there was some deeper debate at the RBA about the origins of the inflation uptick that was responsible for removing the implicit easing bias. The statement that the "Q4 CPI data contained noise as well as the inflation signal” perhaps suggests that the previous inference that the fall in the AUD had greater pass through inflationary impact than expected, is being reconsidered.
"Give me a lever long enough and a fulcrum on which to place it, and I will move the world.” - Archimedes
Also overnight, the Bank of Japan, as expected, made no change to the pace at which it buys assets, or indeed to rates, however, it doubled the size of two existing lending facilities. In reality the direct implications are likely minimal (aimed at boosting the supply and demand of credit), however, what it does do is send a message to the market that the BoJ are willing to ease further. The JPY and Nikkei duly obliged.
Perhaps the most interesting dynamic in the developed world currencies at the moment is the Great British Pound (GBP). The monetary policy debate has taken a new implicit direction in the form of phase two of forward guidance, where the primary driver is the Bank’s own estimate of economic slack. It is thus interesting to note the comments of David Miles overnight, who suggested that there are a range of views on the MPC about spare capacity, and while he sees business investment picking up to more normal levels, "there is no immediate case for higher rates”. It is also worth taking a step back and viewing these comments in relation to Miles’s reputation as the ‘arch dove’ of the MPC and one would likely expect his central expectation to be at the dovish extreme.
"When a philosopher says something is true then it is trivial. When he says something is not trivial then it is false.” - Carl Friedrich Gauss
Miles also suggested that the pound’s recent increase "not trivial” and in the context of the forward guidance transition back towards a more classical form of inflation targeting, today’s inflation release was very important. The data seem to have backed the sentiment of David Miles with the headline CPI print coming in below the 2% target for the first time since November 2009. Perhaps most notable was the significant drop in core CPI, thanks to a drop in core goods inflation. This suggests that the stronger pound may be starting to have disinflationary effects and is thus growth positive as the move to positive real wage growth accelerates. In addition, at the producer level, some indications of pricing power are increasingly evident in the January PPI data while input prices continue to fall, suggesting an improving backdrop for profit margins.
"For every action there is an equal and opposite reaction” Isaac Newton
The lower inflation print may assist in the BoE’s message (and desire) to maintain rates lower for longer than the market expects as a result of GBP strength (Perhaps ironically the exact opposite of the situation facing the RBA) and in doing so may be viewed as a short term GBP negative as a function of reduced interest rate spread support for GBP. However, in our view the medium term effects of the resultant boost to the growth backdrop will continue to suggest economic divergence in favour of the UK and ultimately the pound.
Lastly, the eurozone deserves a mention at the current juncture after GDP reports beat expectations quite broadly at the end of last week. Prior to this we had noted the fact that there had been a sharp underperformance of the macroeconomic data for December. This morning’s ZEW data, whilst remaining strong in the current conditions index, points to some concerns over the durability of the economic momentum in Germany and the eurozone as expectations fell back. We now expect that the stronger than expected GDP print in Q4 for the eurozone is likely a near term top and that economic underperformance from the eurozone will reassert itself over coming months and quarters.