ECU's Investment Blog
"The longer the excuse, the less likely it is the truth” Robert Half
As we move closer towards the year end, heightened geopolitical and economic tensions are combining with reduced liquidity and market risk appetite to increase volatility across FX markets. Within this, there are two clear themes interacting: firstly position reduction is increasingly evident and, as the recent, clear macroeconomic case for US and USD outperformance has played out in positioning, the USD is the key protagonist in this respect.
Secondly, the severe decline in the oil price has had (and is likely still to have) significant implications for credit, growth, inflation and valuations across the predominance of financial markets. While the impact on some developed nations (outside the near term disinflationary impact) is less clear, for those economies with a higher dependence on oil exports (Russia, Norway…) it is a clear negative.
"Low inflation justifies low rates, not zero” James Bullard
The major event of the week is tomorrow’s FOMC meeting and following a period of heightened risk aversion (and safe haven buying of US Treasuries) US interest rate hike expectations have been blurred from the mid-2015 area that seemed much clearer just a few weeks ago. Consensus expectations are for the removal of the "considerable time” language from the statement. However, following months of debate, and Yellen’s data dependence rhetoric (that all but removed the meaning of the phrase) the impact of the removal of "considerable time” may be muted.
At the current juncture in the global economic progression and financial market consciousness it is likely that the market will shift its attention from the debate over ‘time’ to the debate over oil, and the Fed views of the implications for the US growth and inflation. There are clearly positives and negatives for all nations from a lower oil price. In the near term the sharp decline is being seen by FX markets as a disinflationary stimulus that reduces the urgency for central banks with a hawkish bias (Fed, BoE) to embark on the tightening cycle as near term inflation rates decline. In the medium term the stimulus (as we argued last week) likely has a greater impact on economies with greater economic momentum.
"Price is what you pay. Value is what you get” Warren Buffet
In the UK this morning, inflation for the month of November surprised to the downside on both headline and core measures. With weaker food and energy prices feeding through into lower core prices, any pressure on the BoE to tighten rates in the near term is somewhat diminished. Following on from Mark Carneys warning at the November Inflation Report that he may have to write a letter to the Chancellor (required if inflation is more than 1% above or below the 2% target) explaining the inflation undershoot, this morning showed a headline print at the 1.0% threshold.
From our perspective, the ‘pushing back’ of interest rate hike expectations in the UK has already been priced (bar an unexpected downturn in the UK economy). Further declines in the oil price or disinflationary pressure from this point likely turn market attention back towards those regions with negative economic momentum, and the economic stimulus that may be needed to regain a positive inflation trajectory. QE in the Eurozone remains firmly on the table.
"Manana is not a credible fiscal plan” George Osborne
Furthermore, a report from S&P yesterday stated that 6 years after the financial crisis struck, the disparate and struggling Eurozone economies have still not overcome their imbalances – and progress could be grinding to a halt. With growing external debts in the periphery, and rising external assets in the core (Germany, Holland, Belgium) the Eurozone is becoming increasingly divergent, and in our view, increasingly fragile.
"The blocked channel of internal Eurozone adjustment could further draw out the desired external deleveraging in the debtor countries, extending the period of weak demand in those countries.” S&P
As the market eyes the Fed tomorrow, it will do so minded of the fact that macroeconomic fundamentals can fail to be reflected in financial markets during periods of geopolitical stress or risk aversion. Over the next few weeks we will lay out some of our views and expectations for 2015 as a very complex dynamic likely plays out for the rest of 2014.
"The fall in the oil price benefits no-one” - Venezuelan Foreign Minister
As we approach the end of another week, nudging ever closer to the end of the year, the dominant driver of sentiment and direction for financial markets remains the oil price. A further cut in demand forecasts from the IEA this morning highlights that the price declines are driven by both demand and supply factors and as such are unlikely to self-correct in the short term.
As the oil price continues to decline the debate about the implications for the global economy and financial markets intensifies. It is clear that the impact for the consumer is positive as fuel and energy cost declines act as a tax cut. However, the magnitude of the impact is not linear across the globe as taxation, and the relationship of national currencies to the USD blur the direct effects of an oil price decline.
The impact on global financial markets are further blurred by the inclusion of reduced energy company revenues, the credit implications of energy debt and the implications for inflation dynamics and monetary policy. This is not to mention the impact and implications for terms of trade in producer countries across the broader commodities spectrum.
It is likely that the implications of an oil price decline are therefore not linear and while we hold the view that the price decline is a clear medium term positive for the global consumer (and thus likely the global economy), that further declines in the near term may undermine sentiment towards equities and risk assets.
"SME access to finance remains a concern” ECB
In the eurozone the situation remains, at best complicated. The second the of the ECB’s TLTRO liquidity auctions drew stronger demand for the first, however, at the expected level of EUR 130B it brings the total Eurozone bank utilisation at around half the level the ECB made available (EUR 200B out of EUR 400B). Furthermore, it is debateable whether the TLTRO (or even their un-targeted predecessor) will actually drive credit creation in the eurozone, as underlying bank lending continues to fall (albeit with some signs that this decline is moderating of late).
In addition to the other ‘non-conventional’ ECB measures, Asset Backed Securities (ABS) purchases and Covered Bond purchases, the total balance sheet expansion remains modest (certainly in comparison to the "expectation” of the ECB that the balance sheet will expand to 2012 levels) maintaining the likelihood that further measures, including full blown QE are in train.
"Low inflation justifies low rates, not zero” James Bullard
Yesterday, stronger retail sales in the US led to higher equity markets in the US, which were subsequently followed higher by China and Japan, to a certain extent stabilising the declining sentiment that had seen sharp declines earlier in the week.
An article in the Australian Financial Review (AFR) yesterday cited RBA head Glenn Stevens and his view that AUD at 0.7500 vs. USD was preferable to 0.8500, as the Australian terms of trade deterioration accelerates. Stevens also played down the likelihood of rate cuts in the near term, yet we still see a clear case for AUD weakness going forward.
Whilst maintaining a sharp focus on the evolving foreign exchange market dynamic, as lower liquidity and higher nervousness increase volatility, our broad medium term views remain unchanged. We continue to favour US and USD outperformance going into (and likely throughout) 2015 most acutely at the expense of those economies where further monetary easing is likely (EUR, JPY), but also AUD, NZD and JPY.
As we move into the close of this week, it is worth taking a moment to think about the general election in Japan over the weekend. This week the JPY has appreciated sharply as equity and risk sentiment deteriorated. Year-end position weighting reduction has likely played a significant role in the JPY rise, however, from our perspective the election risks are skewed to the topside for Abe and the LDP. If Abe gains a greater majority in parliament (enabling single party rule) then it will likely be viewed as a stronger mandate for the redoubling the efforts of Abenomics – a clear (yet indirect) result of which has been a markedly weaker JPY.
"There is no terror in the bang, only in the anticipation of it” Alfred Hitchcock
Last week ended with a bang as the November US employment report smashed expectations on the payroll measure (adding 321,000 jobs in the month) and also provided some signs of wage inflation pressure as average hourly earnings data also beat expectations. The financial market reaction drove up equities, US yields (particularly at the front end of the curve) and the USD. Indeed, the 2 year EURUSD forward points (which we have often quoted as a key driver of the EURUSD exchange rate) pushed above the recent cycle high to their widest level since before the crisis (a period where zero interest rate policy was not the global norm).
As the US economic data has accelerated from the low point in Q1 2014 (and pedestrian pace prior to that) we have long been advocates of the US recovery story, and indeed the USD recovery story. As we move into the closing stages of 2014, there are two other core global macroeconomic drivers that are likely to shape the way broader markets evolve in 2015, both of which are current drivers of sentiment and positioning: Global equity markets and Oil.
"Oil is mightier than the sword” Everett Dirksen
Since energy prices started to fall in June they have come down by over 40% with increased supply (in the hunt for increased market share), weaker demand and the loss of the cartel power of OPEC (none of which seem temporary) weighing on the ‘black gold’. In the financial markets at least, there has been much debate over the implications on inflation and the knock on effects for monetary policy and in many respects this is very pertinent at what we consider a critical juncture for global monetary policy divergence. However, little emphasis has been placed on the economic boost of a lower oil price to the real global economy.
It has been estimated that a USD40 fall in the oil price generates a transfer of wealth in the region of USD 1.4 trillion from oil producers to oil consumers. As the oil consumers are far more likely to spend the new found wealth sooner than you might expect the producers to, this is in itself a significant boost to the global economy. It could be argued that the effects will be felt greatest in the US as the lower taxes mean a cleaner pass through (an argument that would favour continued US growth outperformance). At the consumer level the impact of such a fall in the price of oil could be in the region of USD 200B and it could be argued that the impact is greatest for those countries where there is growth, not contraction.
"I’m involved in the stock market, which is fun and, sometimes very painful” Regis Philbin
It has long been a concern of central bankers and market commentators alike that the eventual move towards monetary normalisation will lead to heightened volatility in markets. Most notably the concern (in the developed markets) is that the removal of monetary stimulus is a negative for equity markets. As we move into reduced liquidity of the year end and holiday period, sentiment towards equity markets becomes a more acute driver of price levels.
The sharp sell-off in China stocks overnight has heightened the awareness of this possibility (a stock market decline) further, and after having weathered geopolitical, demand and supply side shocks, and as we approach monetary normalisation in the US (at least), any further broad (global) equity negative could well be the straw that broke the camel’s back.
Respected US ‘Fed watcher’ Jon Hilsenrath overnight debates the merits of removing the "considerable time” wording from the statement at next week’s FOMC meeting. In general we would agree, that the considerable time language, now largely irrelevant, should be removed at the current juncture. However, if equity sentiment were to decline in a meaningful way between now and the meeting next week, the Fed may err on the dovish side (bringing their recent protestation that there is no ‘Fed put’ into question). Either way, equities deserve a heightened focus going into year-end.
"S&P sees most Eurozone economies in recession next year” S&P
In the Eurozone, stories of splits within the ECB and of the potential for an early election in Greece add to the complexity of the backdrop. The situation will continue to remain challenging for the Eurozone in 2015. A topic we will expand on further in coming weeks.
In Australia, the move up in 2y US rates has been mirrored by a move down in the equivalent AUD rates, as the market expectations shift towards monetary easing from tightening (albeit delayed for a considerable period) and that has been expressed through a move lower in the AUD. In the UK, industrial production data was weaker than expected, but the consumer appears to be retaining strength (if not gaining more), which will only be exacerbated further by the decline in oil prices.
Overall our core views remain unchanged in that we favour the USD and GBP, on economic and monetary divergence, over JPY, EUR, AUD and NZD, though with half an eye on the equity market (and oil), AUD and EUR are arguably the most efficient expression of this view.
"If everything seems under control, you are not going fast enough” Mario Andretti
In the UK, the main event of the week was the Autumn Statement, from Chancellor George Osborne. The statement was generally well received by GBP in FX and by UK interest rates as the unexpected forecasts of a lower deficit in the years ahead (funded by savings in welfare and more significantly debt funding costs outpace lower fiscal receipts as a result of weak wage inflation) boosted sentiment.
In the longer term, the UK still has a long way to go to resolve its deficit, debt and current account issues, however, we continue to view the UK economy (and thus GBP) as well placed to outperform its peers (except perhaps the US and the USD). After a notable bounce in GBP on Wednesday, yesterday the emphasis and focus turned to the Eurozone and to the ECB.
"I have no plans, and no plans to plan” Mario Cuomo
Going into the ECB meeting, there was broad consensus among commentators that the announcement of an ECB QE programme was a step too far at the current juncture. Indeed, comments from ECB vice President Vitor Constancio that recent measures must be given time to work but that a QE programme was likely before spring (first quarter of 2015) had shaped those market expectations. There was, however, some market disappointment that the ECB did not explicitly lay out a framework for the initiation of a broad QE programme.
Draghi also put paid to the possibility of an easing of the terms of the December TLTRO, suggesting instead that the lower growth and inflation forecasts should in themselves be sufficient motivation for bank take-up. Further, the amendment to the opening statement in which balance sheet expansion (to 2012 levels) was termed an ‘intention’ rather than a target, was another marginally less dovish development that combined to boost the EUR.
"Downward GDP forecast revision is substantial” - Mario Draghi
Countering the less dovish components, however, the ECB lowered both growth and inflation forecasts further amid explicit reference to data and survey signals of a "weakening growth profile”. Falling oil prices were highlighted as a downside price risk, as the latest inflation forecasts do not include the latest oil prices and are thus largely a function of weaker growth.
Mario Draghi also clearly highlighted that the ECB "will not tolerate a prolonged deviation from the price goal”. The (technical) rationale is that a prolonged undershooting of inflation undermines inflation expectations and falling inflation expectations would equate to an unwanted tightening of monetary policy against the current zero bound. This implies the need for further accommodation from the ECB, likely in the form of sovereign or corporate bond buying (or both), early in 2015 and likely also a (perhaps significantly) lower EUR.
With reference to the exchange rate, Draghi maintained the explicit reference to "differences in policy cycles globally” that highlights a continued desire (albeit implicitly) for further currency weakness. It is also perhaps pertinent that after Draghi downplayed the commitment to action at the January ECB meeting (causing a negative reaction in European equities and a rise in the value of the EUR), an ECB statement was released late in the day that suggested the ECB were preparing a broad based QE package for January.
"Power wears out those who do not have it” Mario Puzo
Today the market attention turns back to the US and the November employment report. After the bounce in EURUSD following yesterday’s ECB meeting, and the subsequent pullback in the USD, the USD has regained much of the ground it lost (breaking into new highs vs. JPY). Against this backdrop we would anticipate that a number anywhere above 210 will be enough to see the USD close the week at the highs with better than expected average earning data accelerating any move in US yields and the USD.
After this week we would expect liquidity to slow into year end, however, we retain the view that there are some significant moves still to come in FX in 2014. It is interesting to note the heightened rhetoric from market commentators about the concentration of market positioning in the long USD trade, and the risk of correction. We disagree. The USD is currently at around 5 year highs on a trade weighted basis, but far from expecting a sharp pullback in the USD, we see a fundamental rationale for a significant extension of the USD move. Any decline in liquidity into year-end may further exacerbate this move against what we see as the most vulnerable currencies of EUR, JPY AUD and NZD
"Half past autumn has arrived” - Gordon Parks
In the UK today, the focus will be on the Autumn Statement, as (after the recent pronouncements from Prime Minister Cameron on immigration), the political positioning begins in earnest ahead of the May elections. Much of the press focus of late has centred on the fiscal deficit and the lack of progress in reducing it, despite the strongest growth in G7 in 2014. Much of the blame in this respect lies with the structural labour market shift towards lower paid jobs that has kept wage inflation disappointingly low and generated a significant underperformance in tax receipts (particularly income tax receipts) for the Treasury.
Negative sentiment towards the UK (which appears to be greater externally than internally) has been heightened by continued expectations of a slowdown in economic momentum, not least by the Bank of England. However, it is also true to say that the BoE held a similar view going in to the 2nd and 3rd quarters of 2014.
From a foreign exchange perspective, the UK is only one half of any story (or any exchange rate) and in terms of economic and monetary differentiation, GBP remains in a strong position from our perspective. It has been well noted from BoE officials the main risk to UK economic momentum comes from a further deterioration in the Eurozone – at the current juncture, however, particularly with rate hike expectations in the UK pushed back to the end of 2015, and with sentiment more clearly negative, we continue to favour GBP over the EUR.
"This year will see the strongest growth of consumer spending in real terms since 2007” - Andrew Sentence
Furthermore, while the market has been quick to delay its expectations for the first rate hikes in the UK as inflation has declined (in no small part due to the oil price), there has been very little focus on the positive implications for the consumer from the sharp decline in oil price and the knock on implications for fuel, heating and broader cost declines – not to mention the positive implications for UK Business (and clearly the rest of the world). We remain very positive on UK consumption going into 2015, given the additional boost from cheaper energy and fuel, and (as we did in Q2 and Q3) expect UK GDP to outperform Bank of England central expectations for a slowdown. In this respect we feel that the slowdown in business activity and sentiment in September / October (surrounding the political uncertainty of the Scottish Referendum) was something of a ‘red herring’. This morning’s stronger than expected Service sector PMI, bouncing back strongly in November, is a case in point.
"First rate rise will be the start of a new process” - Stanley Fischer
This week is likely to also be key for the US heading into year end with the employment report on Friday (preceded by the private sector ADP release later today) and service sector PMI also coming out later today. With the USD at its highest level since 2009, speculation has grown about the longevity of the USD rally. We remain positive on the USD and feel that in many instances the USD has a long way to go to reach what we would consider neutral valuation levels (EUR, JPY, AUD and NZD remain the key areas of potential further weakness). Through much of the USD rally this year (and some of the corrections) we have emphasised the importance of US yields. As the focus of attention turns to Friday’s employment data, 2 year US yields are approaching the year’s highs (also the high since 2011) a break above 59bps would, in our view, signal a new wave of USD buying.
"Wisdom consists of the anticipation of consequences” - Norman Cousins
Before we get to the big event of the US data calendar, however, Mario Draghi takes centre stage tomorrow in another much anticipated ECB meeting and press conference. Heightened by his clear rebuttle of the ‘dissent in the ranks’ rumours at last month’s ECB meeting, the market continues to expect further stimulatory efforts from Draghi. He has made it clear that sovereign (as well as corporate) QE is on the table as a policy option, pushing eurozone bond yields (in some cases to all-time lows).
While we do not expect full blown QE at this week’s ECB meeting, we would anticipate that Draghi leaves the door open for action early in 2015. The tone of Draghi’s testimony, however, is likely to remain focussed on the weaknesses and risks to the economic recovery as well as continuing to ask questions of national governments. In direct comparison to the three arrows of Abenomics in Japan, Draghi can only provide monetary stimulus, whilst fiscal stimulus and structural reform must come from the national governments (an argument from the German contingent against QE is that it weakens the necessity for structural reform and thus provides only a short term impact).
Whatever way we approach the problem that is the Eurozone, we struggle to reach a conclusion that does not imply further weakness in the EUR, particularly vs. the USD and GBP. While QE may begin to address some of the issues of the Eurozone when we move into 2015, there is still significant room for EUR depreciation in 2014.
"My only regret in life is that I did not drink more champagne” - John Maynard Keynes
As we move into the holiday thinned period of the US Thanksgiving celebrations, the data calendar is fairly light, yet what there is in the US (Durable goods orders, weekly jobless claims, PCE, Chicago PMI and Michigan confidence) is brought forward to today. While there has been some volatility in the US data of late, yesterday’s Q3 GDP revision, continues to highlight the significant economic momentum in the US. The 3.9% q/q annualised growth, led by consumer and business spending continue to support the case for higher short end US yields and a higher USD over the medium term. Something to celebrate over the Holidays!
"The next move in policy is going to be an increase” - Mark Carney
In the UK, this morning saw the revision to the Q3 GDP data. On a headline basis the data was in line with expectations of a (still strong) growth rate of 0.7% q/q. The economic momentum in the UK, in particular relative to its European peers, remains compelling. In the breakdown, private consumption was better than expected, as was the (dominant) service sector activity, however, an upward revision to the government expenditure component and a downward revision to net trade take some shine off the data. Business investment was also revised lower on the release, contrary to recent upward revisions, but we would be hesitant to extrapolate any weakness on this front as it is likely that the uncertainty surrounding the Scottish Referendum, brought with it a one-off pause in UK investment commitment.
This morning’s press covers much of the testimony of BoE governor Carney to parliament yesterday, in relation to the latest Quarterly Inflation Report. While many of the headlines, and much of the sentiment emphasises the governor’s statements that the economy "is still in need of stimulus”, the core differentiator in our perspective of the world is that unlike the Eurozone or Japan, the UK retains its tightening bias – "the next move in policy is going to be an increase”.
Furthermore, market expectations for the first rate hike in the UK are now broadly centred around November 2015. In our view this is too cautious and we would suggest that the first rate rise will come earlier than market expectations in the UK and that it is likely that the second rate rise may well come at around the time the market is currently expecting the first. This pace of normalisation would still provide a significant level of monetary "stimulus” (that Carney suggests is still required), not just in a historic sense but also in relation to the ‘new normal’.
We have discussed previously our view that the UK will likely continue to outperform expectations over coming quarters and the recent developments in the oil price only boost our expectations for consumption and investment over coming months. In that regard, headlines from tomorrow’s OPEC meeting may be significant, if not immediately apparent in the GBP exchange rates.
"Walking is the only way proven to stave off cognitive decline” Dan Buettner
The other big event of the week is the release today of Jean-Claude Juncker’s EUR 300B investment plan, which ECU Global Macro team member, Kit Juckes describes this morning as a plan "which moves money around like deck-chairs on the titanic rather than creating new investment funds”. Even as expectations of sovereign QE in the Eurozone grow (increasingly for the December meeting) the outlook for the Eurozone, from our perspective continues to be very bleak over the medium term. Interestingly, despite the significant fall in the value of the EUR in currency markets, German import prices are still falling at a 1.2% y/y rate. As Germany continues to import disinflation, the prospects for further easing from the ECB and further (significant) declines in the EUR remain likely as the region remains too weak to stand on its own feet – let alone walk!