ECU's Investment Blog
In a traditional economic ‘Goldilocks’ scenario, global growth (and all its constituents) would be not too slow, not too fast, but "just right”. Today we pick three major economies to highlight that things are not too bad, not too good or much more ‘right’ than consensus.
"Q1 employment, income data showed growth ‘not bad’” - China NBS
In China, concern has been growing over the past quarters that the ‘engineered’ economic slowdown needed to facilitate the structural rebalancing would generate a ‘hard landing’ in China, the ramifications of which would be felt across the global economy. So far, however, the reduced growth forecasts have so far been met and the concerns over a domino effect in shadow banking and trade credit sectors have failed to materialise in a meaningful way. In terms of the market psyche, the macroeconomic backdrop, at least for now, is not as bad as expected.
"Recent data indicate ‘slowly improving economy’” - Fed Rosengren
In the US, as we moved into 2014, expectations for growth were picking up following the initiation of tapering by the Fed and the resolution of the debt ceiling debacle that had implied a sharp drop in the fiscal drag for 2014 (amounting to as much as a 1.5% boost to GDP for the year). The reality since that point, however, has been one of increased uncertainty and (weather induced?) macroeconomic disappointment.
A new element of uncertainty for the USD has been the medium term neutral Fed Funds rate. In the old normal, base rates of around 5% would likely have implied 10 year yields around 4-6%. In the new normal, the level at which base rates may be considered neutral may be as low as 3%. Subsequently, and amid recent geopolitical uncertainty and spates of risk aversion, the market has struggled to get comfortable with the ‘new normal’ 10 year yield level and the resultant shape of the yield curve. The USD has struggled against this backdrop.
Despite the recent uncertainties surrounding the US data we maintain our view that the US recovery will pick up. We maintain a positive outlook for the USD.
"UK economy is getting better” - BoE Broadbent
In the UK, things as we see them are far better than consensus. Expectations are still centred around current account weakness but, as today’s employment report suggests, the momentum in the UK economic recovery is significant. We have long discussed the fact that the consumer led phase of the recovery, further boosted by a return to real wage growth, will likely be complemented by the return of business investment. Further, from a currency perspective, we maintain our view that the first UK rate rise will come earlier than the consensus view of mid-2015, indeed my personal view is that the first rate hike comes as early as Q4 2014).
In the medium term we have concerns over the Chinese growth story and the many potential pitfalls that await throughout the adjustment process (indeed, we have broad concerns about the fragilities within the wider EM space). In the US and the UK, however, while central perception may be that weaknesses dominate, we maintain the view that the situation is better than the consensus view, and better than the official data in many areas suggests. We would even go so far as to say that in the UK and US, things may soon be viewed as "just right”!
The FOMC minutes from the March policy meeting, released this week, appear to have been the trigger point for a widespread portfolio / position adjustment across all asset classes. Lower equities, lower bond yields and a weaker USD, being some of the core themes. Such moves have been exaggerated by the breakdown of correlations and, in many cases, the underlying macroeconomic dynamics in:
"what appears to be excruciating corrections to misbalanced portfolio and trading positions across all asset classes including currencies.” - Jim Vogel, FTN
In our view, the comment from the Fed (suggesting "forecasts overstate the rate rise pace”) is more a function of the diverse spread of views within the FOMC than of an overt attempt to lower expectations. Indeed, "many” participants indicated that the market expectation of the future course of rates was reasonably aligned with those of policy makers. US 10y bond yields are now below the levels they were at the time of the March FOMC…
It is clear, however, that the Fed does seem intent to err on the side of accommodation. To adopt a motor racing analogy, it appears that the Fed intends to accelerate all the way into the corner attempting to hit the brakes as late as possible and change course. This strategy is not without danger. Clinging to easy policy a decade ago provided sufficient fuel for a massive credit bubble, the bursting of which precipitated the first phase of the global financial crisis.
Traditional monetary policy indicators, such as the Taylor Rule likely, imply that US rates should already be above 1%, not their current (almost) zero level and, as the economy normalises further, then we should expect monetary policy to normalise also. The FOMC may think that they are supporting the nascent recovery in the US, with half an eye on the implications of policy tightening on the global economy. It is possible, however, that the continued dovish bias, which boosts equities and emerging markets assets and drags credit spreads and peripheral yield spreads tighter, undermines the USD and inflates risk appetite; arguably a recipe for simply making things worse.
Ultimately, the US economy will normalise and our central view is that the current progress in this regard is greater than the official data suggest. Against the improving macroeconomic backdrop in the US, pumping more air into markets will only make the market reaction even bigger when rate hikes are needed and, by that point, elevate the magnitude of hikes needed may be even greater. There is nothing wrong with rising interest rates, in a growing economy – it is therefore surprising that the Fed are so reluctant to suggest this (publicly at least).
The Opposite Attracts?
In many respects the situation in the eurozone is the exact opposite. Monetary policy, while proclaimed as accommodative by the ECB, is unquestionably too tight (A Taylor Rule approach would suggest rates closer to -2%!) and yet the Central Bank appears reluctant to ease further, despite being urged to act by the IMF. On an economic comparison, we also see the underlying growth trajectory as weaker than the official data suggest. Domestic demand, availability of credit and the significant drag on growth from the debt burden are being masked in international markets by a hunt for yield that has seen a huge reduction in risk premia that is increasingly misaligned with fundamentals.
The Greek return to capital markets is a case in point. Around 2 years ago, EUR 130B of Greek debt was restructured, at great expense to private investors. Today, despite its bailouts, Greek national debt remains at an unsustainable 175% of GDP and yet investors were seemingly falling over themselves to lend to Greece for 5 years, for an annual return of just 4.95%. A phenomenon described by City AM editor Allister Heath as "indicative of the apparent short-termist stupidity of too many market participants.”
One emerging sign in financial markets seems to be the recent developments in tech stocks, where the recent sharp sell-off has been widely attributed to concerns over inflated valuations. If this theme develops across wider markets, then we see wider adjustments being made in FX.
"UK economy showing first rays of sunshine” - Danny Alexander
Today we take a step back from the short term fluctuations and intense focus of the markets on the monetary policy dynamics of the US and eurozone that have dominated market (and commentator) analysis of late and take a look at the UK. Regular readers will be aware of our conviction on the strength of the UK recovery and after a period where the UK data seemingly plateaued (albeit at historically high levels), sentiment towards the UK and GBP deteriorated sharply. Our view however remains unwaivering and the recent data outperformance amid growing signs of rising business investment suggests that the (near term at the very least) future for the UK and for GBP is potentially very bright indeed.
Yesterday the IMF released its updated global economic forecasts which highlighted the UK growth prospects as the brightest among G7 nations. The new IMF forecast for the UK is 2.9% this year, up from 2.4% as recently as January and just 1.5% a year ago. Indeed when asked specifically about the UK economic performance and the IMF’s previous warning about the need to change fiscal course, IMF chief economist Olivier Blanchard said "It is fair to say that our forecast was too pessimistic … growth was clearly stronger”. Further, their expectation is for UK growth to retain the higher baseline level well into 2015, where the IMF predicts a further 2.5%.
The IMF did caution that business investment and exports remained disappointing, however, this is where we believe the next leg of UK growth and likely the next leg of broader GBP strength emanates from as we move into H2.
"all the right notes, but not necessarily in the right order” - Eric Morecambe
The British Chamber of Commerce (BCC) suggested this week that manufacturing and services firms are reporting the strongest investment and export growth in more than a century. The BCC said services exports surged in Q1 with 38% more firms suggesting outward trade is rising rather than falling. In addition to this manufacturing firms posted record increases in employment and investment, confounding the concern of over-reliance on the consumer at this stage of the recovery and that business investment remains weak.
Yesterday also brought stronger than expected industrial production data (after a disappointing January) and perhaps most significantly the National Institute of Economic and Social Research (NIESR) released their estimate of Q1 UK GDP, which suggest the fastest pace of expansion in 4 years at 0.9% quarter on quarter. The ONS data for Q4, highlighted encouraging signs for UK business investment when the breakdown became available and, if our expectations and the anecdotal evidence proves correct we would anticipate that this could translate into a 1% (or above) reading for the official Q1 GDP release.
"If the facts don’t fit the theory, change the facts” - Albert Einstein
On a technical note (and one which has been largely ignored by the broader market), the Office of National Statistics (ONS) has announced that it is changing measurements of areas such as business investment (including R&D) and pensions savings in their national account statistics, potentially increasing the size of the economy (under the new facts!) by up to 5% as well as boosting (at least the appearance) of stability through a significantly higher recorded savings ratio.
Our analyses continue to support our (now long held) view that the UK leads G7 in monetary tightening with the first rate rise expected in Q4 2014 (followed and subsequently outpaced by rate rises in the US from Q1 2015) and as this realisation filters through into the market it is likely to further boost GBP. We have also stressed that we continue to see increasing economic outperformance in the US and on this basis, the next leg of GBP strength is unlikely to be centred around a higher GBP vs. USD as was the case in H2 ’13, but we see a broader strength in GBP reflected in significant gains vs. EUR, AUD, CAD and (though potentially with much higher volatility) JPY.
In summary, GBP and the UK have not been central to the markets attention of late and even when attention has been drawn to the pound it has been met with apathy and increasingly negative sentiment. Recent data and forecasts should, however, bring a positive GBP focus back to the fore and as the economic recovery broadens, and clearer signs of a pick-up in business sentiment and investment pick up (as we expect it to) GBP should have many more days in the sun.
"Hope is not an investment strategy” - Investment Proverb
With very little of note happening over the weekend our focus of attention and search for stimulus turns back to last week’s key events (ECB and NFP) and ahead to this week’s data and events, most notably the minutes from the March FOMC meeting.
Last week we discussed how we view the USD as significantly undervalued and that we anticipate that the (imminent) recovery in the US macroeconomic data will see an increased focus on the normalisation of US monetary policy and thus a normalisation in the value of the USD. The US employment report for March, was in our view, the start of this process. While unspectacular, the March report brought employment growth back into line with trend at around 1.7%, strong enough to keep the unemployment rate trending lower and despite a small down-tick in wage growth, the link between wage growth and unemployment seems to be intact and it is likely that wage growth continues to pick up further in the months ahead.
While we view this as a positive for the US economy, for the USD and ultimately for US rates, the Treasury market likely came to the conclusion that the data was not strong enough to fuel the fixed income sell off and thus rates closed sharply lower, undermining an extension in the USD (indeed likely driving the positional unwind in USDJPY, after a week of steady gains). We view this as more a function of short term position adjustment, than of macroeconomic fundamentals.
"We fear things in proportion to our ignorance of them” - Christian Nestell Bovee
In the press conference following the ECB statement last Thursday, President Draghi was asked what his biggest fear was, to which he replied, "a more protracted stagnation, longer than the baseline scenario”. We have suggested on a number of occasions our views that the combination of high debt, high unemployment and weak credit conditions implies that growth in the eurozone will remain stagnated for an extended period. This is our central expectation not our fear!
The April ECB meeting will also likely be remembered as the meeting at which Draghi announced unanimous support for the use of both QE and negative interest rates "if needed” and, in our view most importantly he clarified that such tools would not only be used if there was a significant threat of deflation, but also if they viewed it likely that inflation would remain too low for too long.
We have three points to make on the ECB and monetary policy:
Firstly, Draghi stressed the point that low inflation makes the adjustment of imbalances more difficult (in both public and private sectors). This is further complicated by the extreme levels of debt. Analysis from BoAML suggests that inflation at around 0.5% could add a further 10-15% to the public debt-to-GDP ratio in each country, even with rates at current levels. In this situation, combined with the high fiscal deficits across the region, default risks rise significantly. This is particularly pertinent given the huge decline in risk premium in over the past year. This under-pricing of risk premium in conjunction with what we see as deteriorating conditions is a significant risk for the eurozone going forward.
Secondly, Draghi highlighted the risks to high unemployment from low levels of inflation and vice versa. Draghi suggested that the longer the unemployment rate remains high the more likely that it becomes structural (as an increasing number of issues within the eurozone are) and thus much more difficult to lower through conventional monetary policy measures.
Thirdly, and in many respects most significantly, Draghi highlighted the cyclical lag in the eurozone in saying "the US is way more advanced in their recovery than we are”. Indeed, while in part this may have been aimed at the EURUSD exchange rate (which it is possible that the dovish bias in general was targeting specifically) it clearly highlights, and compounds our long held view of monetary (as well as economic) divergence between the eurozone and the US (and indeed UK). He further expanded to suggest that there are differences between the US and eurozone in terms of the transmission mechanism for monetary policy where in the US it is a function of capital markets, whereas in the eurozone it is more a function of bank lending channels. This may suggest that a more targeted credit easing may be the next stage of non-conventional monetary policy in the eurozone, as opposed to more conventional QE, perhaps in conjunction with a lowering of rates (and even a negative deposit rate)
Hopes and Fears
In summary, the we feel that a core theme will develop over coming months and that is a theme where in the US hopes will grow and the Fed moves towards monetary normalisation, whereas in the eurozone, fears will grow and the ECB will move (perhaps at a faster rate) towards further monetary stimulus. Against this backdrop we see EURUSD declining significantly.
"Maybe life is random, but I doubt it” - Steve Tyler
Now that April fool’s day is out of the way and the new financial year approaches, perhaps it is a good time to take a step back to assess the current macroeconomic backdrop. We have discussed regularly of late the considerably lower than normal participation rates in FX and the intermittent periods of sharp movements followed often by periods of low volume, tight ranges in FX. We continue to believe that this is the (albeit at times confused or even at times random) calm before the storm – a precursor to some significant corrections in the baseline levels of many foreign exchange rates.
For many months now it has been the first week of every month that has seen the greatest concentration of activity and interest (and thus movement) in FX as the market acutely assesses the impact and implications of the ECB rhetoric and (in)action and the US employment report. Perhaps at this juncture it is pertinent to focus on these two reports due later this week.
In the eurozone, the divergence between the current level of FX and the macroeconomic reality is perhaps the most acute. Our fair value models suggest a rate of around 1.23 in EURUSD reflects long term PPP, balance of payments, monetary aggregates and equilibrium exchange rate modelling – a far cry from the current level. Indeed on a trade weighted basis we view the EUR as more than 11% overvalued.
Over the past few weeks we have also highlighted two further dynamics within the ECB and the eurozone. Firstly, was our view that the ECB is becoming increasingly concerned by the level of the EUR. We noted that the explicit quantification of the impact of the EUR rise on the level of inflation in the eurozone (from Mario Draghi at the ECB press conference last month) was likely intended to be viewed as significant and, as such, could be seen as the first stage of verbal intervention. In reality the -0.4% figure was largely ignored by the market.
Secondly, we have highlighted the concern from a policy perspective of the growing divergence within the eurozone, which could ultimately be categorised as Germany against the rest. Indeed the in the press this week there has been the suggestion From the German Finance Ministry that they anticipate rates rising within a year. Herein lays the issue. For Germany higher rates and or a higher EUR may even be helpful for the economy going forward, for the rest of the eurozone this concept is at best moot and at worst a serious negative to the fragile recovery in most eurozone countries.
"Goals transform a random walk into a chase.” - Mihaly Csikszentmihalyi
In the US our valuation models and our broad macroeconomic analysis suggest that the USD is significantly undervalued (most specifically in the G8 space), however, the underlying dynamic is very different. Now that Yellen et al. have shifted the emphasis away from the explicit unemployment threshold to an implicit broader, data dependent policy target, the emphasis on the data is greater than ever. Our view remains that following the period of weather weakness, there is a strong likelihood that the data bounces back strongly at the start of Q2 (the slingshot effect!), perhaps even stronger than the underlying trend as consumption and investment expenditure resume after the delays in Q1. In that regard we would not rule out a 250k (or even higher) payroll number on Friday.
At the start of this week the eurozone inflation data for March disappointed expectations and fell to just 0.5% year on year, with Spain unexpectedly falling into negative territory (although it is likely that the ECB would refer to it as something other than deflation under their definition). The reaction to the data, however, was somewhat surprising. Despite Draghi’s comments that the ECB would act on further deterioration in the inflation dynamic, the vast predominance of commentators have decried the possibility of action from the ECB tomorrow, indeed ECB vice President Constancio said yesterday that we "should not draw conclusions from the March inflation”, suggesting that the April figure will likely be higher.
From our perspective, while it is unclear just what the most effective policy response from the ECB could be, the balance of risks is skewed towards additional easing from the ECB tomorrow. With the growing divergence within the zone some form of nationally targeted credit easing is perhaps most likely, and while QE at this stage is less likely, a small rate cut cannot be ruled out. We should note that, while the level of the EUR is not an official and articulated goal of ECB policy, the central bank is acutely aware of the implications of the exchange rate for growth and inflation within the eurozone. The topic of currency may therefore be raised (most likely in the Q&A) and whatever is said will carry significant weight
In summary, we are suggesting that we are at a very significant juncture for the FX markets and for (the potential divergence of) monetary policy as we attempt to look through the heightened randomness of some of the Q1 data (and to a certain degree some of the FX price action). Private sector employment growth will be keenly watched this afternoon as a precursor to the official data on Friday but Mario Draghi will be the central focal point of markets.
"Perplexity is the beginning of knowledge.” - Khalil Gibran
One theme that has developed over the past weeks has been the increase in official rhetoric in relation to the EUR exchange rate. The official line remains that the ECB does not have an exchange rate target, but upon delivering this message Draghi et al.are keen to add that the exchange rate is important for growth and inflation. We touched on this topic last week when we suggested that the press conference announcement from Draghi that the rise in the EUR since the lows of 2011 has subtracted 0.4 percentage points from headline inflation – an amount which we believe Draghi intended the market to view as a significant number – at the time, the market did not.
Another technical reason why we have witnessed an increase in the EUR level debate among ECB members may well be the recent divergence in the currency’s relationship with interest rates. Interest rate expectations have been volatile this year with the US 10 year rate traversing the 2.50% - 3.00% range since the onset of tapering in December and European rates in some instances moving further than US rates in both directions. The chart below highlights, however, that the very high correlation between the 2 year EUR vs. USD forward points and the EURUSD exchange rate (highly significant through 2013 – and prior) has broken down sharply over recent weeks.
One factor that has countered the influence of the rate spread has been the improvement in risk appetite, which in the eurozone could be reflected as a function of the spread between core sovereign debt (Germany) and the debt of those at the battleground for contagion (Spain and Italy). These spreads have narrowed dramatically since the OMT ‘bazooka’. Current levels, however, bring into question the divergence from the relative fundamental dynamic. Indeed US hedge fund manager ,Jeffery Gundlach yesterday said "I am flabbergasted that people are buying Spanish, Italian debt”
It is very possible that the reduction in market participation in FX and the inherent geopolitical and global macroeconomic uncertainty has exacerbated these divergences, but we now see a heightened probability that these correlations are corrected by a lower EUR over coming weeks.
The Start NOT the End
Over recent weeks we have also witnessed a rise in the use of the phrase "The euro crisis is not yet over” from the likes of Draghi, Schaeuble and others and whether or not this is intended to heighten focus on the relative level of the EUR or not, it certainly brings attention to the relative medium term path of monetary policy in the eurozone, particularly with reference to the UK and the US.
"Stuff happens when Fed changes course” - RBA Governor, Glenn Stevens
We have debated this point on a number of occasions and while it has been frustratingly slow to come to fruition, we continue to believe that the divergence in monetary policy bias will become increasingly important for the EUR vs. the USD and GBP. We continue to reflect on the ‘Yellen un-doved’ FOMC meeting last week as a very important transitional point for US monetary policy and this morning’s UK retail sales data continue to highlight the economic outperformance of the UK.
Our core view remains that the BoE raise the benchmark interest rate in Q4 2014, followed (and subsequently outpaced) by the Fed in Q1 2015. The inflation data from the eurozone on Monday will be very significant for the ECB and for monetary policy within the eurozone, where a further drop could encourage additional easing from the ECB.