Stronger than expected (producer price) inflation data from China earlier in the week and the Trump testimony yesterday keep the fiscal reflation story (lead by China and the US) a key focal point for global growth in 2017. This afternoon, the market will focus on the words and emphasis of Janet Yellen (and other Fed speakers) to give direction to US rates and the USD. In the near term we expect the USD to remain relatively firm even if it is currently on the back foot. Quietly, however, we expect GBP will reassert itself over coming sessions, weeks and months.
"Do not be too hard, lest you be broken; do not be too soft, lest you be squeezed”
Ali ibn Abi Talib
So far this week, GBP has been on the back foot and, yet, clearly not as a function of any weakness in the macroeconomic backdrop. The only two data prints released this week have been better than expected improvements. GBP weakness has come singularly in the form of negative political sentiment. Prime Minister Theresa May has subsequently blamed the media for the fall in GBP as the press reported that she is planning a so called ‘Hard Brexit’. May made it clear that she does not accept the terms "Hard and Soft Brexit”.
From our perspective, the key point here is that the next two years for the UK are likely a period of intense strategic negotiation. The EU have made it clear that they will be playing ‘hard ball’ in the negotiations, as was evident in their choice of lead negotiator, Michel Barnier, whose opening gambit was the threat to conduct negotiations in French. We would expect no less than ‘hard ball’ from the UK. That is not to say that such a tactic will ultimately result in what the press refer to as a ‘Hard Brexit’ (and all the negative connotations that come with it).
The end of the world is nigh?
Last week, the Bank of England’s Chief economist, Andy Haldane, declared the economists’ prophecies of immediate doom for the UK economy following the Referendum verdict as the profession’s "Michael Fish moment” (technically the anti-Michael Fish moment, as the much famed weatherman said "don’t worry, there will NOT be a hurricane” - Haldane et al. were suggesting quite the opposite). However, in the face of continued better-than-expected economic activity, the vast majority of forecasters have merely kicked their negative forecasts down the road a little.
Britain ended last year as the strongest of the world’s advanced economies with growth accelerating in the six months after the Brexit vote. Business activity hit a 17-month high last month, meaning that the economy grew by 2.2 per cent last year.
The outperformance of UK growth relative to economists estimates in H2 2016 were largely as a function of higher consumption. For the most part, the core economists view was that the Brexit shock to confidence and uncertainty would curtail spending (and boost saving). What actually happened was maintained spending and heightened borrowing (at the expense of savings) a phenomenon which you would associate with rising confidence. December PMI data for manufacturing, services and construction all surprised to the topside in December sets.
"The question isn’t who is going to let me; its who is going to stop me” Ayn Rand
The question for 2017 is therefore, is the maintained consumer strength (and the continued lack of the much predicted economic collapse) enough to reduce business uncertainty and encourage business investment. In that regard, recent inward M&A activity and a sharp bounce in business confidence in the UK’s tech industry is likely a key barometer going forward. Google, Facebook, Snapchat and Apple have all committed investment to the UK since the Vote to leave the EU
Recent signs of stronger external demand from the US (as well as from a cyclical, not structural, perspective from elsewhere in Europe) is also likely to mute the negative impact and implications of Brexit negatives and uncertainties, especially with GBP at such cheap levels (both historically and with respect to our quantitative valuation metrics).
We would argue that the current pricing of GBP, at the very least on a valuation basis is already ‘broadly’ pricing in a ‘Hard Brexit’ scenario (as defined by the popular press - the worst of all worlds?). If that is the case, then the potential for upside surprise for the UK economy and for GBP is significant. With the UK economic growth maintaining its momentum (manufacturing, services and construction activity all accelerated further in December), money supply strong, consumption firm and inflation expected to rise over coming quarters, the BoE may well find their monetary bias edging towards the realms of tightening (from its current neutral) in February as the QE programme is set to reach a pause.
Back to Front?
Over coming weeks, we will expand on our thoughts further in relation to other countries and currencies. News that eurozone unemployment fell last month, on the face of it, seems like a positive development. However, if we look a little closer and see that youth unemployment rose strongly (to 21.2%), it is hard to see the positives in anything but a very short term light. Recently, the market has taken a similarly short termist view of the UK and GBP in relation to the eurozone (EU) and EUR - in Brexit.
"It’s like deja vu all over again” Yogi Berra
This time last year, headlines, positioning and broad market sentiment were driven by a sharp sell off in Chinese equity markets that quickly spread to global equities and risk assets. The decline in sentiment also brought with it a fresh wave of global monetary easing, including negative rates in Japan and delayed normalisation in the US. This year, the first move to raise eyebrows in global financial markets is the move in offshore Chinese yuan FX rates (CNH), gaining the most on record over the past two-day period, the implications of which (beyond the knee jerk reactions so far) are yet to be determined.
On the 1st January, the Chinese authorities maintained the individual allowance for the purchase of foreign exchange, yet added the deterrent of a wall of further paperwork to do so. While the authorities defend against capital outflows, higher US yields and secular wealth diversification flows counter their actions. Our view remains that capital outflows will continue to be an issue for the Chinese authorities for some time to come (and that this has significant implications for US yields as a result of China’s reserve holdings of US Treasuries) . However, we are yet to be convinced that the current market moves in offshore yuan FX are the start of a global market event - more wobble than collapse - indeed a resumption of the yuan downtrend at some point is both likely and desirable for the Chinese economy, from our viewpoint.
"Better a diamond with a flaw, than a pebble without” Confucius
China service sector activity data released overnight confirmed a further increase in December, taking the composite reading (that includes the better-than-expected manufacturing survey from earlier in the week) further into expansionary territory, and a 45 month high. The strong data may well have provided the directional impetus, but it is likely that the data only exacerbated the current theme of yuan (offshore at least) appreciation on the basis of a significant funding squeeze. We reference offshore yuan in this instance as the spread between onshore and offshore, which is currently at its widest level in 5 years - highlighting the impact of cross border flow restrictions, positioning and sentiment.
As local banks (the main yuan clearers) continue to be incentivised to sell USDCNH spot, the cost of funding has increased sharply (from around zero in November to around 280bps today for t/n). However, for now at least, we expect this to remain a specific (and short term) risk issue for the CNH market and for the Chinese authorities, but not necessarily for it to become a globally dominant issue. The knee jerk reaction in FX has been to sell USD universally, however, we continue to hold a modestly bullish medium term view of the USD for now.
Three Arrows, One Sledgehammer?
That brings us neatly to last nights FOMC meeting minutes from December. From our viewpoint the minutes continued the hawkish outperformance of expectations that has characterised Fed communications over recent months.
The minutes highlighted a more optimistic business outlook and continued consumer spending growth, noting that "improved confidence could boost investment”. Almost all Fed officials expected the labour market to overshoot. The committee weighed this against the downside risks of a stronger USD and weakness abroad. However, the core of the debate was about the implications of the implied fiscal stimulus of Trumponomics. [Where Abenomics is famed for its ‘three arrows’ approach it is likely Trumponomics is more akin to a ‘one sledgehammer’ approach].
While there was some debate on the FOMC about the uncertainty of fiscal policy affects, many officials judged that the Fed may need to raise rates faster. Officials also made clear the need to weigh "upside risks to growth from fiscal policy”. Furthermore, the fact that only around half of Fed officials included fiscal policy changes into their forecasts, means that there is likely room for an upward revision to the ‘dot plot’, if Trump delivers.
"Success consists of going from failure to failure without loss of enthusiasm.” Winston Churchill
As we move towards the final days of 2016, the USD has reached its highest level in 14 years. That means that the last time the USD was at its current level, Girls Aloud had a Christmas number 1 with ‘Sound of the Underground’, Pierce Brosnan was still James Bond and the European Union voted to add 10 new countries that were keen to join the EU. Fast forward to today, Girls Aloud have long since been outdated and split; Brosnan’s Bond, outdated and replaced and; the EU… well, watch this space!
Just a year later, in 2003, both Germany and France sanctioned fiscal overspending that breached the Stability and Growth Pact (SGP) rules to limit budget deficits to 3% of GDP. The Finance ministers of the, then 15, member states voted against sanction or fines. They voted not to enforce the rules designed to protect the stability of the single currency and instead to cede power to democratically elected national governments.
The recent decision by the Greek government to pay its pensioners a Christmas bonus, despite the strict terms of its ongoing bailout programme, has reignited concerns about the sustainability of Greek debt and also the social and cultural differences within the ‘union’. The irony here is that German Chancellor Wolfgang Schaeuble said last night "if we do not stick to the rules, the eurozone will fall apart.”
With Bundesbank President Jens Weidmann stating last night that he sees "no chance for an EU fiscal union”, the argument becomes more circular...
"It’s the economy stupid” Bill Clinton 1992 Presidential campaign slogan
The current global macroeconomic backdrop is driven by optimism. Optimism largely that fiscal policy will reach the parts of the economy that monetary policy has failed (or has reached the point of diminished marginal returns) to stimulate. Optimism, at least in the US, that this fiscal boost, at a time when inflation is moving in the right direction and employment is within touching distance of what might be referred to as ‘full’, will cause the spillover effects of higher growth, higher inflation, higher yields (and thus higher returns?). Indeed, you could say that in the US, many important indicators are acting in the same direction. In the Eurozone, the indicators, politics, and sentiment are acting in many disparate directions
"Economic outlook remains weak with downside risks” Pier Carlo Padoan
According to Reuters yesterday, French banks are suing the ECB to reduce capital requirements. [At the same time, Italy and Spain face a lost generation due to unfathomably high youth unemployment (and neither have a government stable or strong enough for change)]. Draghi, has been urging national governments, for as long as he has been easing monetary policy, to utilise lower rates to initiate structural reform - to boost the longer term growth potential of the members and the union as a whole. All members have singularly failed to do this in any meaningful way.
Another potential boost to the eurozone economy has likely also been squandered. It is that the resolution and recapitalisation of the banking system that took place in the UK and US relatively soon after the onset of the financial crisis, has been kicked down the road in the eurozone. NPL’s and a troubled banking sector in the eurozone do not foster healthy credit creation for businesses.
If the answer to the eurozone ills is not lending or fiscal union or, it seems, a united front, then we better hope for economic growth.
"Pessimism leads to weakness, optimism to power” William James
In the UK, the much stronger than expected economic backdrop is still battling the consensus forecasts that continue to push back their prophecies of impending economic doom. In Japan, this week’s policy meeting gave us unchanged policy, but a more optimistic economic outlook. For us, this is central to the current backdrop. Optimism. In the case of Japan this likely means a higher equity market rather than a higher currency, but in the US (and to a lesser degree, outside of its currency, the UK) it could mean higher equity, currency and yield markets
In the US, if the bond market can learn to live with a higher USD, then yields, equities and the USD can all go up. Essentially, for as long as the market is underpinned by optimism, the barrier to even higher Treasury yields remains weak. What better time than the ‘Season of Goodwill’ and the impending Happy New Year to foster optimism.
"Not the first half you might have expected, even though the score might suggest that it was” John Motson
In likely the last key policy event of the year, the Fed raised their interest rate target range 25bps to 0.5% - 0.75%; a move that was unanimous by FOMC voting members and unanimously expected by the market. The Fed statement highlighted recent (further) solid job gains, expectations that inflation will "rise to 2% as headwinds fade” and, from our perspective most importantly, the "considerable” rise in market based inflation compensation gauges.
While the rate hike itself was uniformly expected by commentators and market participants alike, the Fed managed a hawkish surprise by raising their (aggregate) economic projections. This means that the central Fed projections now envisage three rate rises in 2017 (up from two) and a higher long term (or equilibrium) rate of 3.00%. Furthermore, this heralds a significant inflexion point (even with the first Fed rate hike, longer term rate projections were revised lower, not higher). The Fed is leading the way in normalising global interest rates and while many other central banks seem to be increasingly shying away from unconventional monetary policies, outright tightening remains a long way off.
Yellen highlighted the "considerable uncertainty about future economic [and fiscal] policy” and while in the Q&A she stressed that the Fed has time to wait and see what policy changes occur, she was clear that some Fed members had revised up their rate outlook’s on the basis of a more supportive fiscal backdrop.
"We will have to adjust as we learn more about fiscal policy” Janet Yellen
From our perspective this is the key debate over coming months. If Trumponomics (fiscal stimulus, structural reform and a 3.5% growth target) generates the desired economic stimulus, where does inflation go? And what do the Fed do about it?
The central Fed projections also see US real growth of 2.1% in 2017 and 2.0% in 2018, very close to the equilibrium (or potential) rate of growth for the US economy. Thus with the US labour market close to full employment and inflation on track to reach its target well within the forecast horizon, a significant fiscal expansion risks a significant inflation overshoot, hence the market response in driving Treasury yields sharply higher
The Fed have the interim difficulty of providing monetary support to an economy that is about to undergo new management - and the uncertainty of what that management (and more importantly management aim) is going to look like. This is also true for the UK, though the period of uncertainty is likely to be more prolonged in the UK’s case.
"Sometimes the journey tells you a lot about your destination” Drake
Yesterday, Brexit secretary David Davis revealed that his department’s plans for negotiations between the UK and Brussels will not be published until February at the earliest as we "need to know the destination before deciding on the transition”. Davis stated that there was, as yet, no decision on staying in the single market, or paying for EU market access, other than to stress that the government are "aiming for maximum free access to all possible markets” in a deal that will be "all negotiable within 18 months”.
In the meantime, the UK economy continues to outperform expectations and its peers, as we have continued to espouse. Retail sales this morning are a clear example, with annual growth at an impressive 6.6%.
In the eurozone, the economic, political and social differentials from within the monetary ‘union’ continue to highlight themselves. In Greece, after much hailed progress, the government decision to give its pensioners a EUR 617 million Christmas present backfired spectacularly as the European Stability Mechanism (ESM) said it would "temporarily” suspend its debt relief programme.
"All that glisters is not gold” William Shakespeare, The Merchant of Venice
Ultimately, the move in US rate markets, driven by surging inflation expectations, remains the key driver of financial markets. Last night’s collapse in the gold price is testament to the vulnerabilities of wider financial markets as a result. Tighter financing conditions for the emerging market world are also likely to add pressure into year-end (even if many EM countries are currently shielded by a resurgent oil price).
In the longer term, we are less convinced of a sustainable uptrend in the USD. However, the current trend could last well into Q1, before we get the chance to evaluate the ‘actual’ costs and benefits of Trumponomics. For the rest of the year we retain our (at the time of making them) possibly extreme views that 0.8000 in EURGBP and 3.00% in US 10 year yields are attainable before the 2016 calendar needs throwing away.