"Three shalt be the number thou shalt count, and the number of the counting shall be three. Four shalt thou not count, nor either count thou two, excepting that thou then proceed to three. Five is right out.” Monty Python's Holy Hand Grenade sketch
Since starting the year at around 2.41%, the 10 year US Treasury yield has spent a significant part of the year in the 2.90’s. However, outside of the February ‘volatility event’ that was likely caused by a sharp jump in wage inflation, markets have been relatively undeterred by the impressive rise in US yields. Above 3.0%, however, there is a near audible change in market sentiment. The impact has been most notable and most obvious in the heavily indebted emerging market space - high yield in particular - yet so far there has been little impact on equities and developed market risk assets. So far.
From our perspective, the key trigger of 10 year US yields above 3.0%, may simply be the acceleration of a higher USD. Regular readers will know that the higher USD view is one that we have held for many weeks, or even months now, however, while the rise in US yields, along with the relatively impressive price action of the USD index, has convinced some commentators, many others and many market participants continue to expect a resumption of the USD downtrend that dominated all of 2017. From our perspective the world has changed.
"If two wrongs don’t make a right, try three” Laurence J. Peter
The core theme of 2017 was that a low inflation, low interest rate, low volatility backdrop encouraged a hunt for yield that drove equities and risk assets higher. At the same time, the global economic expansion became increasingly synchronous, narrowing growth and interest rate differentials, thus undermining the USD. Over recent months, this backdrop has changed markedly. Firstly, the jump in implied wages in the US in January (while not maintained) highlighted a significantly firmer footing for inflation in the US. The prospect of higher inflation and by extension higher interest rates drove a sharp correction in US equity markets that generated a step change in baseline volatility.
Furthermore, Q1 data has highlighted a significant slowdown in global economic momentum, though in itself this is likely just a correction back towards more sustainable or trend levels of growth. By comparison, however, US growth has maintained or even accelerated over this period - in no small part as a result of the substantial US fiscal stimulus.
Lastly, from a flow perspective, US yields have risen so significantly this year (though clearly not as digitally as the impact of 3% may suggest) that it was noted yesterday by DB that "Not only does the US have the highest 2y, 5y and 10y yields in all of G10, but its 5y yield is now higher than any available 10y in other G10 countries... the point is you really don't need to take anything like the duration risk on US fixed income to get the same yield as anywhere else in G10.” Even USD cash is likely a legitimate asset - particularly if, as we anticipate, equity market sentiment deteriorates.
In short, no part of the low inflation, low rate, low vol. backdrop remains. Furthermore, growth and interest rate differentials have reasserted themselves in favour of the USD. From what we see as broadly fair value in global FX markets, the USD has significant further positive potential going forward.
Musketeers, Amigo’s, -’s a crowd, -legged race, ...times a lady?
Elsewhere, the data in the eurozone appears to have stabilised in the near term after a period of marked decline - consistent with momentum slowing back to trend from significantly above. Uncertainty around the Italian coalition and its economic programme (fiscal relaxation?) also likely weighs on near term sentiment. In Japan, very disappointing GDP data for Q1 keeps the pressure on PM Abe amid tumling voter popularity. Lastly, in the UK, Brexit headlines are likely to intensify over coming weeks as PM May’s government pledged the release of a comprehensive White Paper in June. We retain the view that the market is too negative in its expectations for a comprehensive bespoke trade deal and by extension for growth and investment. However, we are also sympathetic to the heightened uncertainty that has undermined consumer activity, growth and GBP of late.
For now at least, 3 is the magic number, and the USD likely remains dominant.
"Alone under the stormy skies”? Where Did It All Go Wrong?, Oasis
In the middle of February, the market pricing for the May Bank of England meeting implied a near 100% probability of a 25bp rate rise. Yesterday, when the MPC left the policy rate and holdings under the Asset Purchase Facility unchanged - despite two dissenting votes - it was no surprise.
The statement and accompanying press conference highlighted two clear and distinct sides to the debate. On the positive side, the Bank emphasised the view that the "labour market remains reassuringly strong” adding that the "UK economy has a very limited degree of slack” adding to their confidence that wage (and more broadly domestic) inflation pressures have strengthened. In terms of the recent disappointing growth slowdown - encapsulated by the Q1 GDP print of just 0.1% q/q, the Bank were also relatively upbeat, suggesting that underlying growth remains more resilient, that the weakness in Q1 ought to be "temporary” and that in any case upward revisions are expected to take the Q1 growth level to 0.3% q/q over coming months.
"The truth is rarely pure, and never simple” Oscar Wilde
However, as is often the case for the UK, it is not as simple as that. The Bank also highlighted "somewhat greater uncertainty about consumer spending in the near term” amid a decline in consumption (that at current rates is only around half the pre-Brexit pace). Not all of this decline can be accounted for by the slowdown in global economic momentum. Furthermore, while the Bank were clear that they expect momentum in the economy to reassert itself, the Inflation Report projections for inflation were revised marginally lower and the growth forecast for this year, revised significantly lower - to just 1.4%.
Where did it all go wrong? Well to a certain extent, as we mentioned earlier in the week, the bad weather impact on the March, and thus Q1, data was significant, yet anecdotal evidence over the ‘hottest UK May bank holiday Monday on record’ was far from suggestive of "uncertainty about consumer spending”. Time and data will tell. However, there is also undoubtedly some negative impact from the way all participants in the UK parliamentary system (including unelected Lords) have conducted their response, debate and strategy to the UK’s vote to leave the EU, the combination of which has, from our perspective, heavily dented the UK’s negotiating position, increased uncertainty on both sides and weakening sentiment. We would fully agree with the Bank’s assessment that the Brexit transition period denotes an "upside risk for the investment outlook”, and by extension consumer sentiment (and thus spending) will likely be boosted significantly by the emergence of a plan from the UK.
"Whenever you find yourself on the side of the majority, it’s time to pause and reflect” Mark Twain
From a rate perspective, however, the debate now shifts to when the Bank of England will raise rates. For a short while after the Bank announced its reduced growth and inflation forecasts, the UK rates market priced out the prospect for any rate rises at all for the rest of 2018. That is a step too far from our perspective. But it is also very unlikely that the Bank raise rates outside of the reassurance of the full suite of Quarterly Inflation Report projections. That leaves August and November. For now, our positive expectations for the underlying strength of the UK economy, the likelihood of upward revisions to Q1 GDP and the unlikeliness that the government approach to Brexit can get anything other than more organised, more coherent, and more viable, mean that we anticipate August.
"Pressure is when you play for 5 dollars a hole with only 2 in your pocket” Lee Trevino
Last week, following a marginally more hawkish Fed, we updated and reiterated our interpretation of the underlying dynamic for the USD, stressing our view that the market remained far too complacent about its recent rise. Furthermore, "while the FOMC’s hawkishness may [have been] viewed as negligible to US interest rate expectations, relative to the disappointing growth and inflation progress in other parts of the world - ...the eurozone and Japan - it is a more notably hawkish progression”. Subsequently, the USD has continued its ascent, in a remarkably well behaved manner (low volatility).
More broadly, as US yields rise across the curve - notably with the 10 year Treasury yield above 3.0% - high yield currencies have also become more vulnerable, a view that we also emphasised last week. This vulnerability of EM countries and their respective currencies was brought further into focus yesterday as Fed Chair Powell delivered a speech as part of a Swiss National Bank Conference. Powell was clear that "markets should not be surprised by the Fed’s actions” and that "Fed policy normalisation is manageable for emerging markets”. From our perspective this is an important development raising the prospect and pressure of higher US rates.
The Fed under Bernanke was almost entirely focussed on providing stimulus and adding accommodation, a stimulus that supported the global economy and encouraged cheap USD funding across EM. Under Yellen, the Fed began to carve a very cautious path towards normalisation, a caution that encompassed the global economy and, with particular sensitivity, emerging markets. Powell has taken a different line. So far at least Powell has been clear that policy normalisation is in train, supported by underlying strength in the US economy. He has been clear that while the Fed must be explicit, coherent and consistent in its communication, policy normalisation will not be overly soft footed for fear of disturbing EM or equity markets. In short, the Powell put for EM and for stocks has a significantly lower strike price than those of his predecessors.
"...the word broken is a necessity of the present” Niccolo Machiavelli
The big, if not unexpected, news of the week is yesterday’s announcement that the US will unilaterally withdraw from the Iran nuclear deal and impose sanctions, with Trump calling the deal "defective at its core”. The market response so far has been very muted, however, we are more cautious on the wider implications for risk assets, as the impacts on trade and investment, responses and retaliations are digested. Corporate investment in Iran, which has been significant over recent years, should be closely watched in this regard
"I’m sorry for the things I said when it was winter” Bumper sticker
"US adding a lot of juice to an already strong economy” Fed, Charles Evans
Earlier in the week we reiterated our concerns over the outlook for equities and risk assets and our positive outlook for the USD. Key to both of these is the interaction between economic momentum, inflation and monetary policy - both in domestically and their differentials to the rest of the world. Thus, while this week began with bank holidays and limited participation, it ends with an update on both US monetary policy and labour market conditions.
We continue to believe that the market has been far too complacent about the recent rise in the USD. Many commentators have either argued against it, seen it as minor or temporary, or even missed it altogether. Our perception of the broader market is that it remains significantly short USD (as IMM futures data would imply). At some point, that will need to be corrected. In the near term, the USD outperformance has likely been driven by widening growth and interest rate differentials, and as such the latest assessment of the Fed is of key importance.
Last night the Fed left rates unchanged at a target of 1.50% - 1.75%, as broadly expected. The accompanying statement was a modestly hawkish iteration, from our perspective, most importantly recognizing the progress of inflation - both headline and core - as having "moved close to 2 percent”, and removing the line referencing the need to monitor "inflation developments closely” - a clearly positive iteration of the Fed’s confidence in price stability.
A further positive was the statement’s reference to the fact that business "investment grew strongly” - a point debated in an FT article earlier this week claiming that corporate America is flush with cash, after a "blockbuster first quarter earnings season and December’s Tax Cuts and Jobs Act, which included a deep cut in headline corporate tax rates. This has driven a better than expected 20 per cent increase in first-quarter capex spending among the companies that have reported earnings for the period so far”.
Tempering the positive iterations in the Fed’s assessment was the emphasis that the 2% target is a symmetric one and thus implying there is flexibility for a certain amount of inflation overshoot, in addition to the assessment that "market-based inflation compensation measures remain low”.
"...relativity makes the greatest demands on the ability for abstract thoughts” Werner Heisenberg
Ultimately therefore, last night’s FOMC meeting was, in our view, a modestly hawkish monetary policy progression, synonymous with improving confidence in price stability, reduced downside risks to growth and inflation (if not yet formally acknowledged) and ultimately with a continued gradual monetary normalisation. From a rates perspective, there is no significant revelation to cause divergence from interest rate pricing for the rest of the year (or beyond). However, FX is the expression of the value, growth, inflation and interest rates of one country’s currency relative to another's. On this basis, while the FOMC’s hawkishness may be viewed as negligible to US interest rate expectations, relative to the disappointing growth and inflation progress in other parts of the world - notably the eurozone and Japan - it is a more notably hawkish progression, from our viewpoint. A further USD positive.
While this week is undoubtedly one in which the USD takes centre stage, there have been some interesting GBP developments that are perhaps worth discussing. On the data front, this morning’s service sector PMI data was disappointing. While there was a bounce from the (potentially snow impacted) sharp fall in March, it was less pronounced than expected and keeps the near term economic uncertainty at the forefront of commentators’ and investors’ minds. Politically, the situation has also taken a turn towards uncertainty and confusion, as the House of Lords impose their opinion on the Brexit negotiations.
"If I could explain it to the average person, it wouldn’t have been worth the Nobel Prize” Richard Feynman
Ultimately, we retain a positive outlook for the UK relative to market expectations (i) in terms of the underlying economic momentum in the near term and (ii) in the post-Brexit era over the longer term. From our perspective there has been too much focus on defining a name for the customs relationship between post-Brexit UK and the EU without first defining what the trading relationship that underlies any such customs is or may be. This is not to understate the complexity of the task. We remain confident that a solution is eminently possible, but it needs the dots to be joined. This week’s Economist magazine is a case in point (outside of established bias). In a briefing on global logistics ‘Thinking outside the box’ the newspaper hailed the prospect of blockchain technology in revolutionising international trade and customs. Blockchain is of course a technology whereby the UK happens to be at the leading edge of developing. However, the subsequent article on Brexit outlines only the potential difficulties of post-Brexit Customs possibilities - with no mention of the aforementioned technology and/or any eminently workable solutions. The better way to solve these issues is likely to lie in determining where the preferred end point is and then work out how best to get there…
Whatever the outcome we are firmly of the opinion that being outside the EU and in the Customs Union is the worst of all worlds. By analogy it is akin to agreeing to continue to cohabit after a divorce (with no obvious benefits) and at the same time ceding full control of the remote controller and giving the other person the final arbitration powers on any potential future decisions / disputes. Just a thought.
Sell in May?
"Pay no mind to the distant thunder” Metallica, No Leaf Clover
After a relatively slow start to the week yesterday, today is a holiday in almost all regions of the world - notably barring the US and the UK - and as such participation and liquidity are likely to be limited. Thus, it is perhaps the perfect opportunity to take a step back and review the backdrop for the global economy and financial markets. From our perspective, there are some significant moves afoot, and others ahead.
The old adage "Sell in May and go away, come back after Labor Day” is from our perspective likely very apt this year. In the US, in the near term, the strong underlying economic momentum and impressive earnings outperformance add to the case for higher equities. However, despite these tailwinds, performance has been disappointing. Following the ‘volatility event’ of early February where equities and risk assets saw a brief but significant valuation adjustments and baseline volatility experienced a regime shift, we noted (and have since maintained the view that) this move was likely a precursor to a more protracted decline the valuations of equities and risk assets later in the year.
We have noted on other occasions that equities (in this instance we are referring specifically to S&P) face a different backdrop in 2018. The low rate, low vol., low inflation environment that facilitated the high Sharpe Ratio in 2017 have given way to a backdrop of rising rates, (increasingly convincing) rising inflation and higher volatility. On a risk-adjusted basis, equity markets are no longer the same value proposition from our perspective, even if some continue to make the case that valuations are not overstretched (or even that they are cheap!). S&P above 2700 seems a tough ask at this stage and a close below 2600 (200d MA) would be technically negative. We are not saying that today is the last chance to sell. But that come Labor Day, we would expect to either be sharply lower or to have been sharply lower than current levels.
Buy in May?
"Astronomy is much more fun when you are not an astronomer” Brian May
While we are increasingly cautious of the risk of a correction in equities and risk assets, we continue to view the USD as a buy. Having noted over recent weeks that the USD was likely forming a base, and subsequently that it looked increasingly good value it has made further progress over recent sessions, breaking some technical levels that would corroborate our theory that it is bottoming / has bottomed.
Over coming days we would expect the May FOMC statement and the US employment report for April to be important factors in determining the pace of progress of the USD (and perhaps even the questioning of equity and risk asset valuations). Our base case expectations are a modest upgrade to the language surrounding inflation expectations - perhaps even replacing the "remain low” with a more positive forward-looking narrative - to further cement the addition of "The economic outlook has strengthened in recent months” in March.
We have little reason to expect any reversal in the strength of the US labour market, though more modest payroll gains should be expected with such a low unemployment rate. However, the big driver for the USD (and likely risk assets) is the dynamic surrounding wage inflation. We would suggest that the risks are to the upside in this Friday’s report.
"I’m Mr Brightside” The Killers, Mr Brightside
Despite the fact that the weather has made a sharp turn for the worse as the weekend approaches (in London at the very least), several important clouds across the globe appear to be lifting. This morning’s pictures of a hug between Kim Jong Un and Moon Jae-in is a hugely positive milestone for the region and for the planet along with the pledge of complete denuclearisation and the end to war between the North and South.
Yesterday’s suggestion that China is said to mull cutting car import duty by about a half is testimony to the view that what many had hailed as a reckless, protectionist economically illiterate threat from President Trump may end up not in a trade war, but in lower global trade tariffs, reduced barriers and freer trade.
Earlier this week we discussed our view of the importance of this week’s ECB meeting, arguing that the irreverence of the market - as a function of the likelihood (or not) of an ECB policy decision on asset purchases post the current September commitment - was perhaps missing the point. We argued that "the ECB may wish to play down expectations of tightening, at least while they have more time to assess the transience, or extent of the eurozone momentum slowdown”… and expressed the view that Draghi may state or omit reference that would lead to a lower EUR.
"I strap on my ear goggles and I’m ready to go, cos at the boards is the man they call the Mario” Beastie Boys, Sure Shot
Draghi did not make any explicit reference to the level of the EUR at yesterday’s press conference. Indeed, his only explicit reference to the EUR, other than the commitment to monitor the exchange rate (in view of previous reference to higher volatility), was to state that the EUR exchange rate was not discussed - causing a modest and brief rally in the EUR. However, it could be argued that his omissions led to a modestly lower EUR whether in relation to the lack of discussion on monetary policy (omitting a likely hawkish German viewpoint) or in relation to the prospects for tapering, or halting purchases.
The core message from the press conference was the acknowledgement of the slowing of economic momentum from the very strong levels of 2017 and the commitment to further analysis to "understand if the slowdown is temporary or permanent” - a slowdown that it was noted was broad and visible across all countries and sectors. In some respects Draghi’s testimony, offered conflicting signals as he stressed the near-term ECB approach was one of "caution, tempered by an unchanged confidence that inflation will convergence to target over the medium term” alongside calls for prudence, patience and persistence given that "underlying inflation lacks a convincing uptrend”. Ultimately the message that the ECB are pausing to assess - in itself is likely enough to disappoint the hawks (or bulls in the case of the EUR), for the near term at least.
Earlier in the week we also touched on the disappointments from a eurozone / EU perspective of the clearly diminished commitment from Chancellor Merkel to drive through the reform agenda of Mr Macron - "Germany has closed the doors on serious reform” (as characterised by Wolfgang Munchau). Perhaps frustratedly, Mario Draghi urged member states to substantially step up structural reforms and deepening of the monetary union at the meeting yesterday, stating that "monetary union remains fragile if this progress is not achieved”. However, from memory I would suggest that there has been a line in the statement, or an explicit reference in the press conference Q&A about the need for structural reform at every single meeting since Mario Draghi become ECB President in June 2011 (indeed, we have referenced this request on numerous occasions over the years). Sadly, this still seems unlikely in the near term.
"My neighbour has a circular driveway… he can’t get out” Stephen Wright
In financial markets US equities have had a more positive few days as earnings continue to outperform, despite valuations being questioned by rising US yields. We retain the view that equity markets remain fragile and progress above 2700 in S&P will likely be difficult. However, while we view part of the equity risk as a function of a sensitivity to rising nominal yields (at both consumer and corporate levels), there is a certain amount of circularity in the fact that falling equity markets tend to drive demand for treasuries and thus cap yields.This may mean equities and bond yields could end up being relatively contained in the near term.
In FX, the USD likely continues to dominate proceedings with the EUR, and after this morning’s disappointing (even more so than others) GDP release, GBP. For GBP, much attention has been given to the market pricing of a May Bank of England Rate hike, And while the GDP data is disappointing we would suggest that next Thursday’s service sector PMI is a more likely barometer of BoE action in May. A bounce in the PMI, from our perspective, means that a rate hike is still likely.