"Exuberance is better than taste” Gustave Flaubert
In 1996, the then Chairman of the Federal Reserve, Alan Greenspan delivered the phrase "How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions…” during a speech on the challenges of central banking. Against the current global macroeconomic backdrop where the challenges to central banking are as acute as ever, yesterday was the current Chair of the Federal Reserve, Janet Yellen’s ‘irrational exuberance’ moment.
In the semi-annual testimony to congress yesterday, Janet Yellen’s Fed gave two very clear messages. Firstly, as Yellen painted a cautious and uncertain view of the economy, highlighting the momentum loss in the labour market and weak investment amid slow economic growth, she made it clear that the Fed is not in any hurry to enact further monetary normalisation.
Secondly (and from our perspective most significantly), the accompanying Federal Reserve Monetary Policy Report highlighted that "forward price-to-earnings ratios for equities have increased to a level above their median of the past three decades.” and while admitting that equity valuations may not appear rich to current Treasury yields "equity prices are vulnerable to rises in term premiums to more normal levels”. We have argued for several months now that equity prices are overvalued as a function of forward discounting and fully expect that the sentiment offered by the Fed this week will be viewed historically as a the beginning of a (perhaps historically significant) correction in equities.
"We’re one, but we’re not the same” U2, One
One of Europe’s five Presidents, Mario Draghi, also spoke yesterday. His message was threefold. Firstly Draghi aimed to calm market concern, by making assurances that the ECB stands "ready for all contingencies on Brexit”. Secondly, aiming to calm economic concern, Draghi stated that ECB action has put the recovery on a more "solid footing” and that "further stimulus is in [the] pipeline” - by this he is referring to the stimulative impact of the nascent Corporate QE programme (CSPP), and the imminent TLTRO II auctions (where banks are effectively being paid to borrow money, under certain criteria), NOT preparing markets for further stimulus. Thirdly Mario Draghi reiterated his call for national governments to implement structural reform, stating that the "ECB alone cannot make [the current] cyclical recovery structural”.
He went on to suggest that the monetary union is "incomplete and fragile”. This is not a good platform to deal with the possibility of Brexit (whatever probability you place on such an outcome). Brexit would likely represent the next phase in the eurozone’s rolling crisis, alongside the as yet unsolved economic, debt and migrant crises.
The ECB really is a central bank that faces challenges (to paraphrase Mr Greenspan): not only has it reached the point of diminishing (or even diminished) returns on its monetary policy toolkit, Mario Draghi’s cries for fiscal help are failing to convince 18 member nations - with varied and disparate national problems - of its merits.
"Success listens only to applause. To all else it is deaf” Elias Canetti
Against the current backdrop, however, the notion that the Fed may consider equities overvalued or vulnerable, or the notion that the ECB is out of monetary ammunition while its members fight their own (fiscal) battles have had little or no direct impact on financial markets. The reason for this is the Union Jack painted (bemused faced) elephant in the room. Brexit.
Sun stands still
On Monday, the annual summer solstice (from the latin solstitium, or sun stands still) coincided with another celestial event, the strawberry moon - a once in a lifetime event. The UK Referendum, whatever your viewpoint, is also a once in a lifetime event. It is possible that the ‘Leave’ campaign would describe the summer solstice as a day of ‘never ending sunshine possibilities’ and the Remain campaign as ‘the nights are drawing in; we must prepare for the harsh winter’. The electorate remain split
"I guess there is no one to blame” Europe, The Final Countdown
Today, a large percentage of the UK population may be more concerned about exit from the Euro 2016 Football tournament than from the EU, however, with just a week to go until the historic Referendum, the Brexit debate is taking centre stage on a global scale. Moreover, Brexit is not just a source of uncertainty among investors and forecasters, but increasingly it has been used as a (convenient) source of blame for global policy makers.
The Bank of Japan left policy unchanged this morning, as was broadly anticipated (some had looked for further policy easing) - a decision that saw the JPY soar to its highest level in almost two years. While Kuroda stated that he "would not hesitate to take action if needed” he highlighted that the BoJ was in close contact with the BoE, amid Brexit concerns - inferred as the dominant force behind the ‘safe haven’ bid in the JGB market.
"With so many light years to go” Europe, The Final Countdown
In the US, the FOMC also left policy unchanged, and while the statement omitted explicit reference to international factors, the Q&A referred to the Brexit Referendum and the "great deal of uncertainty” associated with it. While the Fed left rates unchanged, the latest Summary of Economic Projections (SEP’s) highlighted a sharp downgrade of growth and interest rate projections (the ‘dots’). From our perspective, herein lies the important issue for markets. The Fed’s reduction in medium term growth expectations and the significant downward shift in the expected path of interest rates (albeit to levels still significantly above market expectations) highlight the more secular nature of the low growth, low inflation backdrop.
Furthermore, Yellen was clear to point out that there are a number of factors keeping interest rates (and interest rate expectations) low, including the lower (and probably declining) term premium, which she suggested was likely further impacted by asset purchases by the ECB and BoJ. A lower (and flatter) US interest rate curve should in our view undermine the USD. However, against the current backdrop where JPY, EUR and GBP all have their own real and imminent concerns, expressing this view is more complex than usual.
There is, however, one area that we see as increasingly clear, rather than increasingly complex, and that is the overvaluation of equities. Irrespective of our view that the US is behind the curve on interest rates, high valuations and shrinking earnings question the near record levels for equity markets (particularly in the US).
"Will things ever be the same again” Europe, The Final Countdown
In the UK, the Chancellor and PM have been widely criticised for the scare tactics of ‘project fear’. However, if we take a step back from the coalface of the global macroeconomy, it could be argued that things are not as bad as policy makers would lead us to believe. The US is growing at a solid, if unspectacular, 2-2.5% range, with a 4.7% unemployment rate, yet real interest rates are firmly in ‘crisis’ mode at around -1.0%. Japan has one of the highest GDP per capita rates in all developed market economies, yet its central bank remains fixated on attaining a 2% inflation target - at all costs.
In Europe, negative interest rates have demolished the business models of banking and insurance industries, ironically the sector upon which it relies for the transmission of its non-standard monetary policy activism. As the options to stimulate growth and reduce debt in the eurozone become increasingly narrow, it is likely that the most effective route (though in some sense most complex) is through fiscal measures and structural reform, and no longer through monetary channels. Tighter fiscal unity within the eurozone places a UK with its exemption from ‘ever closer union’ increasingly on the outskirts, even if it votes to Remain.
"And still we stand tall” Europe, The Final Countdown
As we enter the final countdown for the EU Referendum proselytising, polls (and interestingly the bookmakers odds) have clearly ebbed towards a ‘Leave’ vote. The connotations for financial markets are mixed. Uncertainty and illiquidity are likely to increase over the coming days. While the further dovish evolution of the Fed should undermine the USD, against GBP, EUR and JPY - at these levels - it is not clear that US dynamics will be the dominant force.
"What you risk reveals what you value” Jeanette Winterson
This morning, the 10 year German Bund yield fell below 0.00% for the first time. The concept of lending the German government money for 10 years… for nothing, was until recently an absurd concept - particularly when we consider the wide debate during the global financial crisis fallout (ironically largely by the Germans) about what should constitute the risk free rate, the cornerstone for global credit markets. A negative risk free rate makes little conceptual sense.
Against the current, nervous backdrop, it appears that every headline describes market moves as being a function of Brexit-induced risk aversion. The fact that Danish homebuyers can now borrow money for 30 years at cheaper levels than the US government surely hints at wider global economic imbalances than simply the threat of the UK leaving the EU. However, perhaps the increased focus on the possibility of Brexit has led to the beginnings of a revaluation of assets. We have long been advocates of a lower equity market, and while the focus has shifted towards the UK, global equity markets are quietly faltering - a continuation of this decline remains our strongest conviction.
"There can be no democratic choice against the European treaties” Jean-Claude Juncker
The Sun became the first national newspaper (Britain’s biggest by circulation) to come out in favour of ‘Leave’ and in doing so highlight an important British character trait. From a psychological perspective, patronising or arrogant threats are likely to have the opposite of desired effect. "The Remain campaign, made up of the corporate establishment, arrogant Europhiles and foreign banks, have set out to terrify us all about life outside of the EU.” [The Sun]
From an economic standpoint, Cass Business School professor David Blake published his own analysis of the Treasury (Long and Short term) models that predicted GDP per household would be £4,300 lower by 2030 in the case of Brexit. Professor Blake highlights a number of inconsistencies in the longer term model including the fact that UK’s share of exports to the EU fell from 54% to 44% between 2006 and 2015, while the single market was deepening. His analysis suggests that the same model would also predict that the UK would be better off joining the euro and that if Scotland left the UK its trade with the rest of the UK would fall by 80%.
There’s the risk you can not afford to take; there is the risk you can not afford not to take” Peter Drucker
When it comes to the short term model, professor Blake’s analysis highlights that it is the underlying assumptions that dominate the Treasury’s results. Their assumptions are that the economic shock would be equivalent to 50% of the shock of the global financial crisis, and that this would remain constant throughout the 2-year period after Brexit, cutting UK trade with the EU by 50%. Yet we will still be in the single market during this period. The Treasury model also assumes that there would be no policy response. Prof. Blake concludes "In short, the Treasury’s reports are completely unbalanced because they consider only the benefits of staying and the risks of leaving - but not the benefits of leaving and the risks of remaining.”
"The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge” Stephen Hawking
As this week progresses, it is likely that volatility continues to increase (VIX - or the volatility index for the S&P 500 index - has risen sharply over the past 24 hours to its highest since the equity market turmoil of February). FOMC, BoE and BoJ meetings are likely sideshows, with all expected to hold fire. The result of the UK Referendum on the 23rd has profound binary implications for policy in the UK and US and significant implications for monetary policy in the rest of the globe. It is likely that statements this week try to walk as neutral a line as possible.
"I don’t believe in everything I see” Oasis, All Around the World
The World Bank published its latest economic updates earlier this week, the main message being that the global economy is struggling to regain momentum with growth faltering in many major economies. The balance of risks is tilted to the downside.
The World Bank also highlights a growing fragility in the global economy, in the form of private sector credit, especially in the corporate sector, since 2010. Corporate earnings are fragile (EPS fell by around 8% in the US and ~20% in Europe and Japan in Q1) and it is possible that declining profit margins are one source of weakness in hiring (as highlighted in yesterday’s JOLTS employment data).
"And the lies you make me say, are getting deeper every day” Oasis, All Around the World
It is very interesting, therefore, that the ECB expanded its extraordinary monetary accommodation stance directly into the corporate arena yesterday. Its purchases included multinational powerhouses such as Siemens, Renault and RWE, but also sub investment grade rated Telecom Italia (Moody’s Ba1 since 2013). It could be argued that as a very liquid peripheral company, it is exactly the kind of borrower the ECB should be targeting. At the same time, while the ECB reiterated last week that it would not ‘dump’ its holdings if ratings fell below the initial purchase criteria, with the impact of global central bank easing significantly diminished, it could be argued that the ECB are increasing their downside (balance sheet) risks disproportionately to boosting their upside (economic) risks.
The RBNZ kept rates unchanged last night, disappointing expectations of a rate cut and a reinforced dovish bias. Instead, Governor Wheeler expressed "financial stability concerns” over accelerating house price growth and a faster than expected rebound in headline consumer prices. Despite (admittedly watered down) protestations about the strength of the currency, NZD rallied sharply in the face of the hawkish (or at least less dovish) surprise. Interest rate differentials, however, continue to suggest a significantly lower NZD over time, as does the global economic risk backdrop.
"What you gonna do when the walls come falling down?” Oasis, All Around the World
The problems facing the world’s central bankers were further emphasised in South Korea overnight, as the BoK surprised markets by cutting rates, highlighting the difficulties of reviving an economy with excess savings.
Global monetary policy is at (or very close to) the point of diminished marginal utility, and the balance of risks is tilted to the downside. In this regard, it is interesting to note our recent sentiment being mirrored by George Soros who, it has been suggested, "has returned to trading, lured by opportunities to profit from what he sees as coming economic troubles” [WSJ]. Mr Soros emphasises the troubles of the eurozone (and EU) in particular, where he suggests that there is "a good chance that the European Union will collapse under the weight of the migration crisis, continuing challenges in Greece and a potential exit by the UK.”
"Take me away, ‘cause I just don’t wanna stay” Oasis, All Around the World
We have recently stressed the point that the risks to the EUR are underpriced (at the very minimal relative to GBP and the UK). Soros added that "If Britain leaves, it could unleash a general exodus, and the disintegration of the European Union will become practically unavoidable”. It is hardly surprising that bureaucrats across Europe (elected or not) have thrown their weight behind the Remain campaign.
In the markets, with the ‘Fed on Hold’ theme back in favour, bond yields are tumbling everywhere (10 year Germany now within touching distance of 0.00%!). In the US, real yields are at their lowest levels in over a year, weighing on the USD on a trade weighted basis, and liquidity across the currency space is increasingly diminished.
"Q2 picture is incomplete” Lael Brainard
On Friday we stated our expectation that the headline payroll number would disappoint, but not by enough to prevent the unemployment rate itself from falling further. A significant drop in the participation rate, however, meant that both the payroll number and the unemployment rate fell more than anyone expected (with downward revisions to the previous months’ payroll gains) and employment slowed to 1.7% y/y. While disappointing, that may, in conjunction with a rebound in GDP in Q2, boost productivity, which has been curiously absent so far in the global economic recovery.
Herein lies the dilemma. The ‘data dependent’ Fed have left it so long before pulling the normalisation trigger, despite the admission of Chair Yellen last week that "a rate hike in coming months may be appropriate”, that the data is starting to show signs of losing momentum. Last night Yellen pointed out that she sees "the economic positives outweighing the negatives” and, in being "cautiously optimistic that overseas headwinds are now fading”, that she believes the US is "now close to eliminating labor market slack”.
However, the Fed (as directly implied by Brainard, Rosengren and Yellen) will need to be sure that the May unemployment report was a one off, which means that a June hike is all but off the table. July, and September remain possibilities, however, they are now dependent on a resumption of labour market stability (strength) and a smooth passing of the EU Referendum and its impact on global economic confidence. And then there is the US Presidential elections!
The ‘taper’ (after the tantrum) and the first US rate hike both eventually came in December after a whole year of expectations and speculation. Putting our views as to how far the Fed are already behind the curve to one side - this year may not be any different.
"The 50:50-90 rule: Anytime you have a 50-50 chance of getting something right, there is a 90% probability you will get it wrong” Andy Rooney
Now that the prospect of a June rate rise from the Fed has all but been put to bed, there is one dominant focus for financial markets for the next couple of weeks - ‘Brexit’
Last night’s price action in GBP was a timely reminder that volatility and liquidity risks will become increasingly heightened as we approach the 23rd. The sharp (5am) 1% rally, without any obvious trigger also serves as a warning that the directional risks to GBP are not singularly to the downside.
Furthermore, from a technical standpoint it is important to consider the activity in the options market and its implications. Due to the potential severity of the impact of a Brexit on the value of GBP, coupled with the advance warning, it is unlikely that any corporate or exposed individual would consciously leave any exposure unhedged. The simplest (not necessarily cheapest) way to achieve this is through the options market. If we then consider that those options purchased as protection (insurance) against an adverse move in GBP will not likely be hedged (prior to the event in any case) then this leaves those who have sold these derivatives (market makers) net short of gamma (and volatility) as the only ‘hedgers’. This is important, as hedging a short option has a ‘negative gamma’ or the need to buy when spot rises and sell when spot falls. In essence, this dynamic will increase the volatility of GBP.
"Fragility is the quality of things that are vulnerable to volatility” Nassim Taleb
"Success is going from failure to failure without loss of enthusiasm” Winston Churchill
Yesterday’s ECB meeting provided very little that we didn’t already know (an unchanged EURUSD exchange rate after the press conference is testament to that), however, there were a number of subtle implications that are worthy of note. Effectively, this was a holding pattern from the ECB as they await the impact of the ‘kitchen sink’ policy actions of March, especially those which have not yet been implemented such as the CPBB (Corporate Bond Buying Programme) and TLTRO II (the Targeted Long Term Refinancing Operation).
Mario Draghi maintained that the ECB retains ample flexibility and room for further monetary expansion (not surprising given the market reaction to his admission that interest rates are at the lower bound in March), maintaining the explicit easing bias / forward guidance. Furthermore, the staff projections pointed to higher growth and inflation for this year, yet unchanged inflation and lower growth at the 2 year ‘policy relevant’ horizon. This supports our view that the recovery in eurozone activity in the near term is cyclical and that structural long term weakness remains.
Draghi was clear that euro area growth prospects were being damped by subdued emerging market prospects, Brexit risks and slow structural reforms. However, he also explicitly reignited the currency issue with the reiteration of the ECB lower for longer mantra in conjunction with the statement that the EUR exchange rate is "important for price stability” and, "reflects the relative difference of [monetary] policies”.
From a technical perspective there are a number of signals that indicate the potential for renewed downside risks to the EUR, even excluding the potential impact of a Brexit. The basic balance (the sum of the current account, FDI and portfolio flows) remained fairly stable throughout 2015 as large portfolio outflows offset the current account surplus. However, a recent acceleration in FDI outflows and outward M&A provide a deteriorating backdrop that should ultimately weigh on the EUR.
"...all the virtues I dislike, and none of the vices I admire” Winston Churchill
In the UK, the Brexit debate is hotting up and with less than three weeks to go, the polls (and even the bookies’ odds) have narrowed. Unfortunately, the quality and content of the debate has deteriorated into almost caricatured politicking. For the ‘Remain’ camp, Britain is not just stronger in the EU, but could never leave as the implications would be too catastrophic (a stance for which Cameron appears to be coming under increasing criticism for). For ‘Leave’, the EU is the source of all the UK’s exaggerated woes.
Both sides risk patronising and alienating their respective support. ‘Project Fear’ have so far singularly failed to address any of the risks to the UK economy from remaining in the EU (particularly given the almost inevitable push for political and fiscal union within the eurozone - leaving the UK in the EU but to all intents and purposes out of the loop). ‘Vote Leave’ have also failed to address what the plan would be should they achieve their goal.
"One does not leave a convivial party before closing time” Winston Churchill
With the polls narrowing, time elapsing and the politics heating up we expect the debate to gain increasing prominence in financial markets over the coming weeks. In the regard we would expect volatility to pick up, UK equities to begin to underperform, and GBP to become vulnerable in FX markets once more.
For today, however, the focus of financial markets lies with the US employment report for May.
Corporate profit drag (and strike action) and GDP weakness are likely weigh on the headline figure which we expect to dip below the 150k mark. However, this pace of hiring is likely still enough to nudge the unemployment rate lower and does nothing to damp the impressively resilient US labour market expansion.
"I’m just preparing my impromptu remarks” Winston Churchill
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