"Theories pass. The frog remains” Jean Rostand
With little in the way of first tier economic data this week, market sentiment and positioning has been driven by the flow of earnings data in the US (which on the whole has been better than the low expectations, yet still ultimately form the 7th consecutive quarter of declining earnings), the fallout from rising geopolitical complexity and, most significantly, expectations regarding the extent of global monetary and fiscal stimulus.
This phenomenon has been particularly evident in Japan this week. The clear and exaggerated correlation between press reports of the size of impending fiscal stimulus from Japanese Prime Minister Abe and the JPY (as well as Japanese equity markets) highlights the intensity of the market focus and speculation. I doubt that we are the only market participants that are becoming increasingly concerned about the broad market reliance on ever lower yields fuelling ever higher equity and risk asset prices. We will have to wait until August 2nd for Abe’s stimulus announcement.
"We face neither East nor West: We face forward.” Kwame Nkrumah
Last night’s eagerly awaited FOMC announcement saw the Fed keep rates unchanged, as expected, and issue a statement that retained the possibility (but by no means certainty) of a September rate rise. In doing so, the Fed passed the parcel of uncertainty from its statement to the market.
The statement effectively upgraded the FOMC members’ assessment of the economy, declaring that the "near term risks to the economic outlook have diminished” and that household spending was "growing strongly”. Furthermore, after May weakness, June job gains were "strong” and labor utilisation had shown "some increase”. However, despite the positive aspects of the Fed’s assessment, they stopped short of overtly signalling a rate rise in September through their "soft” assessment of business investment, low inflation pressures (and inflation expectations) and the explicit statement that the Fed expects the economy to evolve in a way warranting only "gradual hikes”.
This is ultimately the key term, "gradual”. With the November 8th Fed meeting falling just a week before the US Presidential election, it is assumed that a Fed rate hike in November is unlikely. That leaves September and December for the Fed to match its own member expectations (dot-plot forecasts) of two rate rises this year. The market reaction to a Fed statement that was only lukewarm to the prospect of a September hike was a fall in US (real and nominal) rates. With nominal GDP growth running at around 3.3% and headline inflation (on the preferred PCE measure) running well below 2.0% (currently 1.6%), the Fed are in no rush. The markets are happy to keep ‘passing the US rate parcel’ lower - at least until clearer signs that the music is about to stop.
"Teach a child to read, and he or her will be able to pass a literacy test” George W. Bush
While in the very short term, the fall in (both real and nominal) US yields have imputed a lower USD / higher equity trajectory, we are increasingly of the opinion that the markets are becoming immune to valuation arguments and the overall risks associated with current monetary and fiscal policy. The price action of recent years has taught markets that in an ultra low rate environment equities rise on forward valuation and yield arguments. Our concern is that this is only true until it isn’t. Markets have, in our view, become illiterate to the risks.
"The man who is not dead still has a chance” Lebanese proverb
In FX markets we struggle to see how the macroeconomic backdrop can support a sustained USD decline and would err towards USD outperformance going forward. That is, however, with the exception of the JPY. Tomorrow is potentially a very big day for Kuroda, and the JPY. Expectations for Kuroda to unleash additions to each of the three tenets of the current QQE programme are high and we struggle to see how Kuroda can deliver in this regard. Failure to deliver would likely see a sharp appreciation of the JPY.
Before dismissing Japan or the JPY, however, there is a possibility, albeit small, that Abe announces a 50 year bond, or goes even further with a perpetual bond in next week’s fiscal stimulus package. This would change the backdrop dramatically and, as portfolio flow data continue to highlight capital outflows, such a development could well be the start of a more prolonged period of JPY weakness.
Egon: Don’t cross the streams
Egon: It would be bad.
In the 1984 film Ghostbusters, there was a running strap line, with reference to the ghost busting proton beams, to never ‘cross the streams’ from their energy weapons. The consequences were portrayed as being so bad as to cause "life as you know it to stop instantaneously and every molecule in your body exploding at the speed of light”. At the end of the film, however, the situation gets so bad that they decide to cross the streams anyway.
In recent posts we have stressed the significance of monetary policy on financial markets and, as monetary policy reaches its useful limits, the significance of the monetary interaction with fiscal policy. While there has been much talk of the prospect of the ‘crossed streams’ of Helicopter Money, we are unsure as to whether the situation is bad enough. At least yet.
The importance of monetary stimulus to market pricing, however, was further highlighted last night as reports from Nikkei News suggested that the government stimulus package, or reinvigoration of Abenomics (following Abe’s recent, convincing Upper House election victory) may only total JPY 6 trillion, after the same news service had reported JPY 20 -30 trillion over recent weeks. Reports of the higher amounts had driven USDJPY up to the recent highs of 107.50, last night’s disappointment took us back to 104 this morning.
"US economy a bright spot amid global uncertainty” US Treasury Secretary, Jack Lew
After a quiet week for US data last week, this week should bring economic attention back to the US. With consumer confidence, services PMI and new home sales today, the Fed on Wednesday and Q2 GDP on Friday, the focus will likely swing back to the relative prosperity of the US and, after a very narrow range for US yields last week (10’s stuck in a 1.55 - 1.60 range), the prospects for continued US monetary normalisation. Q2 GDP in the US is expected to highlight the resumption of US growth in the 2.5% (annualised) region, and despite the looming Presidential Elections (and barring a global catastrophe), we expect the Fed to come under increasing pressure to raise rates.
"Adversity brings out the reverse of the picture” Charles Caleb Colton
In the UK, the picture is quite the opposite. At the start of last week, MPC member Weale (and historically referenced as one of the ‘Hawks’) stated that "wage and productivity growth may argue against a rate cut” and that "any weakness may not be as severe as previous recessions”. However, this week Mr Weale has indicated to the FT that he is now in favour of immediate easing, citing last week’s awful PMI data as a prime reason to act. While the case for lower rates is perhaps more moot, it is likely that next week's ‘Super Thursday’ (as we discussed last week) will bring further QE, possibly lower rates and likely a lower GBP.
Whether the UK choose to cross the monetary and fiscal ‘streams’ will thus be up to the Chancellor at the Autumn Statement, however, it is increasingly likely that easier fiscal policy is in train amid the heightened Brexit uncertainty. In the near term we view this as GBP negative - albeit likely against a backdrop of higher volatility.
One more technical point worth making in the current environment is the recent rise in USD Libor rates. Much of the related commentary assesses the impact of new money market fund regulation on the front end of the US curve. Rises in Libor spreads have historically, however, been a precursor to higher FX volatility and more pronounced risk aversion.
"Whatever interpretation prevails at a given time is a function of power, not truth” Friedrich Nietzsche
In the current game of financial market ‘Top Trumps’, monetary accommodation trumps geopolitical concern, overvaluation, and just about any other macroeconomic argument you could make. In terms of equities and risk assets, we continue to feel that this relationship has gone too far. For example, US earnings have declined for 7 straight quarters, against a global backdrop of rising geopolitical and macroeconomic uncertainties. Yet a falling yield curve, underpinned by expectations of -relative- monetary accommodation, has produced record highs in a number of major indices this month.
In FX, however, we expect the monetary and - increasingly at this late stage of the monetary easing cycle - fiscal policies to continue to be dominant, relative to both expectations and their peers. Indeed, as monetary policy reaches the point of diminishing returns, the concept of concerted monetary and fiscal stimulus (or even monetary financing of fiscal stimulus, or ‘Helicopter Money’) has been increasingly mooted. It is unclear whether such monetary and fiscal activism will achieve its aims of boosting growth and inflation (at least directly), however, under such circumstances a country’s currency is likely to underperform, potentially significantly.
"The big print giveth and the small print taketh away” Tom Waits
Just after the release of the UK data yesterday morning, an interview with Bank of Japan Governor Hirohiko Kuroda was aired (subsequently claimed to have been recorded in June), in which he stated that there is "no need, and no possibility for Helicopter Money”. However, Nikkei news service have this week highlighted their expectation of an imminent (and extraordinarily large) fiscal stimulus, likely early August. Having gone from an estimated JPY10 trillion at the start of the week, to JPY 20 trillion mid week, overnight the news service stated that it might be as much as JPY 30 trillion, more than 5% of GDP! At the same time expectations are growing for further accommodation from the Bank of Japan, through the expansion of its (already huge) QQE programme.
In the UK, the very disappointing PMI data this morning (service sector activity falling back to its lowest level since 2009) have exacerbated expectations of further monetary easing. The interest rate markets are now almost fully pricing a 25 bp rate cut in August (~85%). We would expect that the BoE will feel the need to support sentiment and, where possible, consumer and business spending, and that likely the best way to achieve this is by turning the QE taps back on, in the hope of boosting asset prices. The Bank of England policy meeting announcement on August 4th is now the ultimate focus.
If, as has already been alluded to by the new PM (and her new next door neighbour), the fiscal stance is also loosened by reduced austerity - or a "reset of fiscal policy” as the Chancellor referred to it last night - it may be difficult to find a convincing argument that a monetary financed fiscal expansion is not occurring in the UK. Technicalities such as the permanence of the monetisation and the extent of the involvement of government remain moot (as well as the real difference between government purchases of bonds in the secondary as opposed to primary market). But it could be argued that Helicopter Money is already here - in the UK and Japan … it likely boils down to your interpretation.
Stability not Panda(monium)
The ECB policy announcement and press conference yesterday was relatively uneventful. In the Q&A session, however, Mario Draghi was asked the question, "What is the message of Europe and the ECB to the G20 this weekend?”; his response summed up the mood and message of the whole press conference… "It would be a message of stability. A message of a [EZ] recovery that continues, though at a slower pace, amid great uncertainties”... he went on to state that "those uncertainties were not especially from the eurozone, but various parts of the world and, in this climate of … geopolitical uncertainty it is very important that the G20 portray a message of stability”
During, and indeed after the ECB formalities, EUR was duly stable. In our view, however, as cyclical growth momentum slows from Q1 to Q2 (and likely H1 to H2), without any structural assistance from the national governments, the eurozone and indeed the EUR will become increasingly fragile.
"You may delay, but time will not” Benjamin Franklin
In summing up our sentiment at the current juncture, it is important to point out that while we see further (perhaps substantial) monetary easing over coming weeks (BoJ 29th July, BoE 4th August), we retain a bullish macroeconomic outlook relative to broad market expectations. While we are increasingly cautious of equities and risk asset levels (despite, and also as a function of their relentless rise on ever further global monetary and fiscal indebtedness), we are relatively hawkish on US growth and interest rate rise prospects (likely a further equity negative if our views are correct).
"Can’t tell the bottom from the top” The Hollies
In many ways global financial markets are stuck in a dichotomy. The global macro economy remains "fragile and uneven” (to quote Mario Draghi and Christine Lagarde among others) and geopolitical frailties are increasing apparent and increasingly concerning. On the flip side, the response to these seemingly endless global concerns has been ever looser monetary policy, and where possible (Japan being the extreme case) ever looser fiscal policy in the quest for higher demand, firmer growth and stronger inflation. The result, however, has been higher equities (new record levels in many instances) as ever flatter (or even negative) yield curves distort forward valuation metrics and foster a culture of corporate buybacks.
Indeed it seems that irrespective of the size or severity of the shock or event, the ultimate response is higher equity valuations on central bank liquidity and (implied) further monetary easing. Over the weekend, the failed coup attempt in Turkey is a case in point. However, unlike the economy Minister who this morning said that the economy would be back to normal within a week, we are more inclined to err on the side of ratings agency Moody’s who issued a ratings review on Turkey yesterday citing medium term implications for credit and growth against the backdrop of an already fragile current account deficit. The implications of heightened political uncertainty in Turkey for the rest of the world are, from our perspective, far greater than the ‘knee jerk’ reaction of markets to buy equities on an expectation of monetary easing. We would urge caution and prudence towards equities and risk assets.
Overnight headlines also highlighted the race to the monetary bottom as Australia and New Zealand took centre stage. In New Zealand, the issue of a consultation paper proposing an increase in Loan-To-Value (LTV) ratios (including limits for investors) by the RBNZ effectively provides greater scope for further monetary easing. NZD remains vulnerable from our perspective as August now looks increasingly likely to yield a new low in NZ interest rates.
In Australia, RBA released its latest monetary policy meeting minutes, which highlighted the view that inflation is expected to "stay quite low for some time” and that "new data will allow the Board to adjust policy if appropriate”. The RBA also reiterated the statement that the "higher AUD could complicate [economic] adjustments”.
"Success is how high you bounce when you hit bottom” George S. Patton
This weekend’s G-20 meeting in Chengdu, China will have a very heavy focus on a number of issues related to Brexit and its implications for the EU and for global trade relations. (Chengdu is the home of the Panda, however, global problems at this stage of the economic cycle are far from black and white) As if this was not enough to keep the UK and GBP firmly in the spotlight the data calendar for the UK is also action packed this week.
This morning’s inflation data came in slightly on the hawkish side of expectations, however, it is unlikely that the data contain any impact from the post Brexit period of July (the last week). If we include the core data, it does, however, add further credence to the theory that the UK data seemed to be stabilising prior to the Referendum. Tomorrow’s employment report may be more significant to gauge any evidence of the impact of uncertainty on employment (focus on the claims change for June). We have noted previously that the record high levels of employment and low levels of interest rates are likely to support household consumption through the uncertainty period.
Next up for the UK is retail sales data for the month of June (Thursday) followed by manufacturing and service sector PMI data (Friday). We retain our ‘active watch’ strategy in relation to GBP as the height of uncertainty continues to play out. At the same time, however, we do not subscribe to the many prophecies of doom towards the UK economy, housing market, or corporate evacuation that many commentators have issued. Indeed, with M&A activity likely to remain firm, as the fog of uncertainty lifts, there are a number of areas where we feel we are likely to see GBP strength over the second half of 2016. We will elaborate further over coming weeks.
"A small leak will sink a great ship” Benjamin Franklin
"It isn’t so much what’s on the table that matters, as what’s on the chairs” W. S. Gilbert
It appears to me that the number of events, statements, occurrences and releases that could be considered a surprise (including Boris Johnson’s appointment to the Foreign Office), have risen recently. Unchanged policy from the Bank of England yesterday was another.
Earlier in the week we discussed the prospect of a UK rate cut at this week’s Bank of England meeting. We suggested that the cautionary ‘tales of Brexit woe’ for the UK economy (that Mark Carney defended at the Treasury Select Committee meeting earlier in the week) and the explicit warning from Dr. Carney that further easing was likely over the summer months, in conjunction with his reputation for pre-emptive monetary activism, pointed to action this week.
"They don’t, they don’t speak for us” Radiohead, No Surprises
While we suggested that there was a chance that Carney, Vlieghe and Haldane may fail to convince enough for a majority until the full updated (Quarterly Inflation Report) forecasts are available at the August meeting, it appears Carney and Haldane failed to convince even themselves. (though Carney, as Governor, votes last. It is therefore possible that he elected not to vote in the minority at this stage). The surprise, that the sole dissent was for a mere 25bp cut in the Bank Rate, was to a certain degree, however, mitigated by the pledge that "most of the Committee expect monetary policy to be loosened in August” and that "The Committee discussed various easing options and combinations thereof”
The Bank’s approach seems very sensible, if cautious, relative to market expectations. Indeed, the statement that "the exact extent of any additional stimulus measures will be based on the Committee’s updated forecasts, and their composition will take into account interactions with the financial system” concur with our central expectation that the Bank will cut interest rates by 25bps in August, and retain the threat of reopening the Asset Purchase Fund with additional QE later in the year should it be required.
"To know how to wait is the great secret of success” Joseph Marie de Maistre
In the near term, it is likely that the UK consumer remains relatively buoyant, as employment remains near record highs, and interest rates near record lows. The biggest potential threat to growth in the medium term, however, will come from business investment spending and how it responds to the uncertainty both in terms of domestic investment and FDI. While the BoE will not have enough time or data to be able to make an assessment of the ‘post Brexit’ trend in business investment, it is likely that we will know who will sit in all the government seats and, hopefully, the government will have at least the basic framework of a plan.
In the March UK Budget, Chancellor George Osborne laid out the government’s plan for fiscal consolidation - deficit elimination by the end of the current parliament. The suggestion from Osborne’s replacement Philip Hammond is that there may be some near term fiscal relaxation, although his current line is that this may not come until the Autumn Statement. While in the near term the combination of looser fiscal and monetary policy should weigh on GBP (post relief rally), in the medium term, this could prove very positive for the UK, and for GBP. Regular readers will not be surprised that we are not bearish GBP and envisage a return to economic and currency outperformance as soon as Q4, once deferred investment and consumption are put back into the economy.
"The road to success is always under construction” Arnold Palmer
Standing back from the UK and from GBP, the combination of fiscal and monetary easing is also the core driver of current sentiment in Japan. As monetary policy (conventional and unconventional) reaches its limits, Japan is seemingly looking towards fiscal policy that boosts aggregate demand (helicopter money or perpetual bond purchases) in a monetary-financed fiscal stimulus. There will likely be a lot more discussion on this topic ahead of the BoJ meeting at the end of the month.
"We know what we are, but know not what we may be” William Shakespeare
Last week we asked "If ever there were a time for UK politics to set aside the protocols and etiquette for the sake of fulfilling the role of leadership through extreme uncertainty, surely it is now”. Today marks the beginning of the end of that uncertainty, in many respects, as Theresa May assumes the role of leader of the Conservative Party and the UK.
For financial markets a lot of uncertainty remains, however, in terms of the progressions of monetary cycles and the global economic recovery. We feel that we are entering into a new period where economic and monetary differentiation return to the fore. What’s more, the leaders of this new era of growth may not be the countries you might expect at the current juncture.
"Time and tide wait for no man” Geoffrey Chaucer
Bank of England Governor, Mark Carney, came under fire at the Treasury Committee hearing yesterday, where he was effectively asked to counter the allegations that he acted with political motivation, or under political pressure in the run up to the EU Referendum. The chair of the committee, Andrew Tyrie, proposed that there had been "a deliberate attempt to frighten the voting public by the Bank, with a political motive.” Carney responded by stating that the statements were a result of "robust discussions” about the potential risks, and the belief that if the Bank of England views something as the biggest risk to the economy then it has an obligation to raise those concerns.
Perhaps the most important inference from the debate is that of the nature of the character of the Governor himself. The statements (however controversial from Mr Tyrie’s perspective) highlight a clear proactive tendency. Indeed, acting early to prevent a deeper downturn was a key hallmark of his time as Bank of Canada Governor, ahead of the Lehman / global financial crisis. In the UK today, Mark Carney may assess the "risks” that he ‘pre-emptively’ warned of as warranting ‘pre-emptive’ monetary activism, as the MPC vote (ahead of the announcement tomorrow at noon). While we could expect support for further easing at this stage from Messrs. Vlieghe and Haldane, it is of course possible that the majority of the MPC would prefer to await further data, at the very least until the Bank’s own Quarterly Inflation Report in August.
"My policy was nothing but activism” Kiran Bedi
Financial markets have been very lively this week as global geopolitics and the prospect of (even) further monetary and fiscal stimuli play out. Following the clear upper house election victory for Shinzo Abe over the weekend, USDJPY has rallied almost 5%, amid expectations of further reinforcements to Arrows 1 and 2 (fiscal and monetary stimulus).
In global equity markets the geopolitical uncertainties have given way to expectations of increased global monetary accommodation, and if you believe that the "lower for longer” matra of monetary policy is morphing into a "lower for… ever” scenario then, even at these levels, the case for buying equities is perhaps rational.
Our view however, is that rates are not lower forever, indeed (at least in some parts of the world), they are likely not lower for long. In the US, the renewed strength in the June employment report alongside rising wage and core inflation point to an economy that warrants a rate rise this year. At the current juncture, our central forecast is for a US rate rise in December, however, the risks are likely on the hawkish side going forwards. Even in the UK, where we feel there is a risk of a (pre-emptive?) near term monetary boost, we would also expect interest rate markets to be looking in the opposite direction by the end of the year.
In this scenario, bond markets offer less value and even less sense. As Jeffrey Gundlach reportedly said last night "call me old-fashioned, but I don’t like investments where if you are right you don’t make any money”
This week is likely to be a very important week for GBP. A week in which our longer term views of UK economic and GBP outperformance may be countered by pre-emptive monetary policy action by the Bank of England. Ultimately, however, we feel we are nearing the beginning of the end for GBP weakness.