"... all the right notes, but not necessarily in the right order” Eric Morecambe
Since our last piece earlier this week, there have been relatively few developments. In fact the developments have been more continuation than revelation; more intent than content.
The long awaited tax plans of the Trump administration were laid out, by Treasury Secretary Mnuchin, in a short list of bullet points. Less of a plan and more of a rough outline, the details provided little sign of an Administration that has full confidence in its ability to pass bills into law. Indeed, the US Tax foundation declared that there was not enough detail in the tax plan to enable them to model it.
The announcement offered a revised set of principles for tax reform, which appear to reduce the size of the proposed tax cut compared with the campaign proposal. The current Democratic resistance to Trump’s plans - not to mention the necessary debt ceiling extension debate - does not set a conducive backdrop for a tax cut that would likely add $2 trillion at a time when Federal Budget deficits are expected to keep rising. While the White House appears likely to rely on optimistic growth assumptions to offset most of the fiscal effects of the proposed tax cut, congress will likely not.
"You usually have to wait for that which is worth waiting for” Craig Bruce
Following the ECB press conference in March, there was significant airtime afforded to the possibility that the ECB could raise interest rates before the end of the QE programme - recently extended to December, of the tapered amount of EUR 60 billion per month. The concept was made more credible by the fact that the deposit rate is currently negative, and that German policymakers had expressed clear views that this was hurting banking sector profitability, and thus stability. At the time this provided a significant ‘lift’ to the EUR.
This week’s ECB statement suggested that they are still some way from tapering asset purchases or raising interest rates. Indeed, Mario Draghi was clear in the statement that they see "rates at present or lower level past the QE horizon” and in the Q&A that there was "no need to discuss the sequencing of exit now” when the ECB is "not sufficiently confident that inflation is on track”.
On the positive side, the statement highlighted that the "downside risks to the economy have further diminished”, amid "signs of a somewhat stronger global recovery”. This morning’s jump in core inflation to 1.2% y/y, its highest since 2013, put the cat among the pigeons. However, it is likely that the jump at least partly reflects the timing of Easter and it is likely to take a more sustained push, or convincing structural reform efforts to nudge the ECB into a more hawkish mode. Draghi continued to stress, in near exasperation, that "structural reforms must be stepped up substantially”, urging "other policy actors to contribute more decisively” as euro area growth remains "damped by sluggish reform pace.”
In essence the ECB message was on the dovish side of expectations, despite the recent improvements in economic momentum, and a higher inflation trajectory. Stronger data are likely to enable the ECB to drop "or lower" part of the statement and add greater flexibility on the sequencing of policy normalisation to be envisaged going forward. Barring a sharp decline in risk appetite, a decline in activity or a sharp rise in the EUR we would expect a step further towards ECB policy normalisation in June. An ECB rate rise, however remains a long way off from our viewpoint.
The Bank of Japan kept monetary policy unchanged on Thursday while upgrading their view of the economic outlook as a function of improving trends in production and export activity. This signals its confidence that a pick-up in overseas demand will help sustain an export-driven recovery. The official monetary policy line, however, remains that risks to the economy and prices remain skewed to the downside and furthermore that it is likely to be later than FY2018 before CPI is stable and over 2% (yet another push back of the time by which the Bank of Japan will achieve their monetary policy target).
"In winter I plot and plan. In spring, I move” Henry Rollins
Last week we commented on the UK retail sales data for March, coming in unexpectedly weak noting our view that the data could be accounted for by the timing of Easter (March in 2016, April in 2017). We also added that anecdotal evidence suggested a strong Easter period for UK retailers. Yesterday’s release of the CBI retailing reported sales appear to back this notion with the index for April rising sharply from 9 in March to 38 in April (confounding expectations of a further drop to 6).
This morning’s Q1 GDP release came in on the low side of expectations at just 0.3% q/q. However, we would argue that the same ‘Easter effect’ will be apparent in the Q1 data as was (now) clear in the March data. This is in addition to the fact that UK GDP has a tendency to be revised higher over time. Furthermore, the Bank of England came a step closer to monetary normalisation yesterday by completing their targeted GBP 10 billion of corporate bond purchases under its expanded QE programme.
On a different note, the Bank of England finally agreed on a risk-free reference rate to replace LIBOR. The new benchmark will be the SONIA rate (Sterling OverNight Index Average - Not the 80’s ginger pop act)
"We can only see a short distance ahead, but we can see plenty there that needs to be done” Alan Turing
This weekend’s first round of the French Presidential election highlighted a number of significant developments. Firstly, after the ‘surprise’ outcomes in the UK Referendum on membership of the EU and the US Presidential election, the French results were almost exactly as the polls had predicted for some time. Perhaps the French electorate are more honest in the face of opinion polls than their UK or US equivalents. Perhaps they have a more uniform demographic distribution. Perhaps the surprise is yet to come?
Secondly, the failure of the two establishment parties to secure a run-off place between them is another key indicator of discontent within the status quo across the globe. Indeed around 48% of the vote went to anti-establishment candidates.
In reality, it seems unlikely that Macron fails to secure the Presidency from this point, but without established political party backing it remains unclear that Macron will have the platform for change upon which he will likely be elected. In that regard, the parliamentary elections in June may be more significant.
For now, the financial markets have breathed a sigh of relief, with equities and risk assets sharply higher, intra-eurozone sovereign spreads narrower, and implied volatilities lower. In many regards we are completely comfortable with this market reaction, as ‘insurance policies’ against the worst potential outcomes are unwound. However, we would caution against any extrapolation of the ‘Macron effect’. France has a deeply troubled economy, in need of stark structural reform. Following the apparent rejection of the establishment, Macron has a relatively short term to bring about change: he must raise employment, growth, productivity - reduce the size of the state (French government spending as a percentage of GDP is higher than that of Greece, at ~56%), national debt, disquiet. Failure may lead to a more extreme candidate next time.
"The only thing that hurts more than paying an income tax is not having to pay an income tax” Thomas Dewar
Now that the intensity of the French political focus subsides (for a week or so at least) the attention of the market likely turns back to the US and President Trump. On the fiscal side Trump is expected to announce an outline, at least, of the much awaited Trump tax plan as soon as tomorrow, with White House officials briefing Congressional Republican leaders today. Press reports suggest a dramatic cut to just 15%, from the current 35%. In the short term, this would likely be a strong fillip for corporate America generating a substantial repatriation of US corporate holdings abroad (profits, divestitures, capital,...).
In the bigger picture, however, a corporate tax cut of this scale could cost the Treasury around USD 2 trillion, at a time when Federal budget deficits are expected to keep rising. More imminently, at a time when the US’ "continuing resolution” that funds government expires on Friday, it risks a government shutdown, by adding more complexity to the debt ceiling debate.
On the trade front Trump has turned his attentions towards back towards the North, reportedly pledging to impose a tariff on lumber imports from Canada of between 3 and 24.1%. Rather unsurprisingly, Canada has condemned the "unfair and punitive duty” while threatening legal action in response.
Hold One’s Horses!
On Thursday, the ECB monetary policy decision and press conference will draw the markets attention. While some commentators have suggested that Mario Draghi may adopt a more hawkish tone at the press conference following the market friendly French vote, we would suggest that he maintains a more cautious ‘steady as she goes’ approach this week, at least until Macron actually crosses the line. In that regard, it is likely that he avoids the direct question of timing of rate hikes relative to the timing of QE programme completion, instead focussing on the continuation of modest recovery, amid maintained downside risks.
On the data front, GDP data from the UK and US (as well as France and Spain) will be key focal points and, with the current near binary risk profile of financial markets in focus, the Bank of Japan meeting will also likely hold sway.
"Politics is the art of choosing between the disastrous and the unpalatable” John Kenneth Galbraith
A few days before the UK Referendum on EU membership, Barack Obama appealed to the UK electorate to back ‘Remain’. In an appeal that was likely a political favour to David Cameron, Obama threatened the UK with the "back of the queue” for any trade deal with the US in the event of a ‘Leave’ vote. Given the lack of success in that instance, should we be worried by the apparent backing that the former US President gave Emmanuel Macron for the French Presidential elections in a telephone conversation last night?
Recent polls (and the bookmakers) have seen the second round margin of victory for Macron over Le Pen widen. This trend led to a relief rally in the EUR and bund yields yesterday. However, while it may seem clear (to the pollsters at least) that Macron would beat Le Pen in round 2, it is not yet clear that either is certain of a place in the final. In fact, Macron, Le Pen, Fillon and Melenchon are all currently polling far too close together to be able to rule out any combination or permutation for the run-off, in two weeks time.
"I have no ambition to surprise my reader” Anthony Trollope
The most concerning combination for financial markets would clearly be a Melenchon / Le Pen run off. Both are posturing towards France leaving the EU, or at the very minimum renegotiating the relationship. Melenchon, while arguably more moderate in some areas of policy than Le Pen, favours (among other eyebrow-raising policies) a 90% tax band and a 32 hour work week. With either candidate in power it is unlikely that France would balance its books at any time soon, something that it has failed to do since 1974.
On that basis, the ‘good news’ would be a Macron / Fillon run-off in round 2. However, while it may seem good by comparison, it remains very unlikely that either candidate could enact the change needed for a resurgence of French economic power. Macron, as an independent, would have no party support in government and as such is very unlikely to be able to enact anything but moderate, modest reform - not the dramatic, serious reform the country needs. Fillon, dogged by scandal, would surely now lack the political capital to force through his pledges of spending cuts and deregulation.
Polling stations will close between 7pm and 8pm (local time) on Sunday evening, and it is likely that we will have a clear picture of the first round result by around midnight (or 11pm in the UK)
"The challenges for Europe right now are mostly political” Pierre Moscovici
After a week of very limited economic data releases, this morning has brought modest focus back towards macroeconomics with eurozone PMI surveys reaching a six year high and UK retail sales disappointing. Interesting though these releases are, we would caution against extrapolating the momentum of either. While the French survey data is currently benefitting from the cyclical rebound in global activity, its economic sentiment will likely be shaped to a greater extent by its political developments (likewise, though perhaps with less divergent forces, in Germany). Furthermore, the UK retail data will have been distorted by the timing of the Easter bank holiday (which fell in March last year and April this year), which anecdotal evidence suggests was a strong period for UK retailers.
Yesterday’s rally in the EUR was in part tempered by the release of a poll showing a closer margin of victory for Macron. It was also in part tempered by the suggestion that the US is in the process of bringing forward its timetable on the much anticipated (and likely crucial to the resumption of the reflation trade) tax reform.
"You miss 100% of the shots you don’t take” Wayne Gretzky
The option of a seat on the tube this morning served as a reminder that the UK labour market is not yet back to full capacity after the long weekend. The lack of data seconded the notion. However, what the financial markets may be lacking in people and / or data points, they are arguably more than making up for in political and geopolitical developments.
After the rising global geopolitical tension over the weekend (lessened somewhat by the failure of the North Korean missile test launch), the political focus took a sharp domestic turn yesterday morning, with the announcement of a General Election on the 8th June - contingent on the agreement of a two thirds majority in the House of Commons today (as a function of the Fixed-term Parliaments Act 2011).
PM May stated that a general election was the only way to "guarantee certainty and stability for the years ahead” in the face of "political game playing” by Labour, the Liberal Democrats, the SNP and unelected Lords - all of whom she accused of seeking to frustrate the negotiations and undermine the ability of the government to deliver the best possible outcome from Brexit. The favourable economic backdrop, and the sharply divided opposition, likely give May a unique opportunity to facilitate the best possible outcome without the threat of an election looming as negotiations reach a conclusion (and the threat of holdout this may encourage).
Furthermore, an increased Tory majority would reduce the sway of the ‘hard Brexit’ extremities of the Conservative party (perhaps enabling an earlier compromise over some key issues) and in many other regards strengthens the mandate and negotiating stance of the PM. Provided, that is, that she wins. Game theory is the study of mathematical models of conflict and cooperation between intelligent rational-decision makers. May is thus banking on the rationality of the electorate.
"Every reform movement has a lunatic fringe” Theodore Roosevelt
Regular readers will be well aware of our positive bias for GBP over recent months. We retain this view. Indeed, the pragmatic, though not without risk, approach of the PM may well allow further positives for the UK in the form of a wide ranging policy agenda beyond Brexit such as a new strategy for the NHS, or simplification of the tax code, as well as a strategy to boost competitiveness and reduce income inequality.
In addition to the political developments, anecdotal economic evidence suggests continued upside momentum. Retail analysis suggests that both footfall nationwide ‘in-store purchases’ surged over the long bank holiday weekend, and online transactions for the period rose by around 26% on last year according to some estimates.
A weaker GBP has also contributed to UK retail in general, as foreign bargain hunters flock to UK high streets and online retailers. One recent report went as far as to say that "Brexit has led to a huge boost in luxury sales” and that the UK is "the cheapest market in the world to buy luxury goods”.
Essentially, we view the bold approach of the PM as materially reducing the "crash risk" of Brexit negotiations, as well as strengthening her hand in pursuing an orderly withdrawal. These reduced downside risks are also complimented by increased upside risks as UK economic resilience continues to confound expectations.
With the first round of the French elections approaching fast, the polls are still some distance from clarity on the eventual outcome, at the very least for the first round, on Sunday 23rd April. Le Pen and Macron hold a modest lead, with Melenchon and Fillon stubbornly holding on in there.
It is interesting that the broad consensus view is that Macron is good for the currency on the relief that it is not Le Pen or Melenchon (both of whom have stated their desire to review their relationship with the EU and the eurozone - one albeit more aggressively than the other).
However, while a Macron victory may bring about a relief rally in French and eurozone assets alike, it is not clear that it will be all plain sailing from there. As an independent, parliamentary support for any meaningful reform is not a given, and his stance over the weekend in criticising the German trade surplus as being bad for Germany and for the eurozone will do little to help set (arguably) the most important eurozone relationship off on the front foot.
"... and i just can’t hide it” The Pointer Sisters, I’m so excited
In another key announcement yesterday, the IMF raised its forecasts for global growth in a set of upward revisions that IMF chief economist Maurice Obstfeld said were "hard not to be excited about”. Revisions were led by modest upgrades to China, Japan and the eurozone and a sharp rise in the expectations for UK GDP growth in 2017 (the second such upward revision in succession).
"Threat is in the eye of the beholder” Mohamed Elbaradei
Last week we discussed the prospect of a weaker USD, driven by a global investor hunt for yield as narrow ranges in nominal yields drove appetite further out the curve. Since the end of last week, the sharp rise in geopolitical concern has kept US yields under pressure across the entire curve, as investors seek the safe haven of the US Treasury market. These heightening geopolitical concerns have also facilitated the highest levels since November for gold and for JPY, and while at this stage the USD has been on the back foot (in line with yields), it is likely that any escalation of the situation could reverse that (except vs. JPY).
Last night the VIX, Wall Street’s so called ‘fear gauge’, jumped to its highest level since the US Presidential elections (a sharp rebound from all time lows just three weeks ago) as North Korea threatened a nuclear retaliation to provocation. The spike in volatility came as a response to a presidential tweet that "North Korea is looking for Trouble” and that the US "will solve the problem”. It is incredibly surreal that the world could potentially come to the brink of conflict via social media. The fact that North Korea started to block most forms of social media in April of last year to all but government use perhaps suggests Trumps warnings may have a very small but focussed audience in North Korea. Either way, the Korean response was that it would retaliate with a nuclear attack on the US.
"Fear is stupid, so are regrets” Marilyn Monroe
In the UK, there are still plenty of commentators and economists that appear to be downplaying the UK data almost indiscriminately - this notion is misplaced from our perspective. The weaker BRC retail sales data earlier in the week are a case in point as many economists pointed to the onset of an inflation-induced consumer squeeze. It is more likely that the dip is a function of the late timing of the Easter holiday period this year. This morning’s UK employment data highlighted the continued strength in the labour market, coinciding with evidence of a "notable upturn in financial services recruitment activity in London” (from a headhunter firm) in Q1, contrary to the suggestion of a mass exodus.
In France the momentum of Melenchon is adding a layer of complexity to a presidential race the market had seemingly got more comfortable with. This complexity has been reflected in a sharp widening of the French / German bond spread and greater reluctance of the EUR to appreciate, despite the broader pressures facing the USD.
"Only my application brings me success” Isaac Newton
In the world of FX, all of this translates into broad caution for USD as the current safe haven Treasury bid pushes yields and the USD lower. However, as we note above, a further deterioration in geopolitics or an escalation in action would likely lead to a sharp reversal for the USD. Relative yields suggest little support for USDJPY this side of 108, and it is also unlikely that the USD finds support if things go from bad to worse between the US and North Korea. Indeed, at the risk of sounding like a broken record, we continue to favour GBP outperformance against the EUR.
"Taking no quarter” Led Zeppelin, No Quarter
The first quarter of 2017 ended with S&P up 5.5%, the USD index down 1.8% and the oil price down 5.8%. These three indices provide significant illustration of a number of themes in global financial markets so far in 2017. Most glaringly is the potentially worrisome dichotomy between the sentiment driven (or soft) data in the US and the hard data, for which the divergence between equities and oil is a primary exponent. In reality, it is likely that supply - and not demand - was the driving force behind a lower oil price in Q1’17 and, similarly, it was likely that the low rate environment (in addition to reform and fiscal stimulus hopes) drove capital flows into equity markets. However, it remains significant that S&P had its best quarter since 2015 and oil its worst. It is unlikely that this divergence can be maintained.
Secondly, the lower USD index (after a strong rally from Q2 2016) is likely indicative of the growing perception that congress will provide a greater-than-envisaged resistance to Trumponomic policies, in addition to further evidence of a more stable global economic backdrop. From an interest rate perspective, the backdrop mirrors the USD index (arguably the key component in driving the dollar valuation dynamic) with breakeven inflation rates, and forward inflation swap rates, all following a similar path. As ECU Global Macro Team member Kit Juckes notes this morning, the concern for the USD is that "the longer nominal yields remain in their current range, the greater the pressure on investors to buy longer dated bonds”. A flatter yield curve may not be entirely to the Fed’s liking at this point in the monetary cycle either.
"Experts often possess more data than judgement” Colin Powell
On the data front today brings with it service sector activity and private sector employment reports in the US. However, the main focus will be on this evening’s release of the Minutes of the 15th March meeting where the Fed Funds target rate was lifted 25bps to 0.75% - 1.00%. There will be two key areas of focus (at least of the known unknowns): any indications of when the Fed may start to unwind its balance sheet, as well as any signs of a more hawkish bias beyond the three 25bp hikes in 2017 currently envisaged.
"There is no stability without solidarity and no solidarity without stability” Jose Manuel Barroso
In Europe, the modest cyclical bounce in economic activity continues with strong service sector PMI data this morning (albeit a little weaker than expected in Italy and France). However, we retain our negative bias towards the EUR (particularly with reference to GBP) as political concerns and negative interest rates detract from the outlook for economic progression and currency gains. Indeed, an article in the FT earlier this week points out that "Central banks are dumping euros amid concern over political instability, weak growth and the ECB’s negative interest rate policy - and favour sterling as a long-term, stable alternative.” The report cites a recent survey of reserve managers at 80 central banks who are together responsible for investments worth almost EUR 6 trillion, noting that "the stability of the monetary union is their greatest fear”.
Last night’s French Presidential TV debate did little to alter the polls, despite the best efforts of Jean-Luc Melenchon to establish himself as a front-runner. Betting odds continue to suggest Macron as the clear favourite for election on the 7th May. We have two comments in this regard: Firstly, we noted a long while before the Presidential campaigns kicked off in earnest that the rising acceptance and popularity of Le Pen will, by default, drag the rest of the candidates to the right. Last night’s debate saw a large number of candidates pledging renegotiations of France’s relationship with the EU - if not a referendum on membership. Secondly, it is widely debated that Le Pen (should she manage a surprise victory) would not have anything like a parliamentary majority, and as such would be unlikely to pass legislation. As an independent candidate, Macron may well have similar difficulties.
"Some people are so busy learning the tricks of the trade that they never learn the trade” Vernon Law
In the UK, this morning’s bounce in the service sector activity index for March was a welcome development. We remain of the opinion that the recent ‘airtime’ of a dip in the economic momentum was overplayed by the press - perhaps those who continue to prophesise Brexit-induced UK economic collapse. On that topic it is interesting to note that today London plays host to a meeting of the Alliance of European Metropolitan Chambers (AEMC). The AEMC is comprised of chambers of commerce from the major cities of Europe that collectively represent hundreds of thousands of firms and employ millions across the continent. Let’s hope that the requirements and desires of those who trade are the driving force behind progress towards mutually beneficial solutions and agreements when the negotiations formally begin - not politicking.