"The prospects are bright while the challenges are also grave” President Xi Jinping
As China’s 19th Party Congress gets under way, the tone so far has been positive, yet pragmatic. President Xi highlighted the progress of the past five years in areas as diverse as poverty reduction, improved security, lower pollution and the ‘belt and road initiative’ and laid out his long term agenda for China to be a "modern, socialist power” by 2050 On the economy, he says the liberalisation of both interest and exchange rates will continue as "the door China opened will not close but will open wider and wider" with a greater focus on the quality as well as the efficiency of growth (which delivered a further upside surprise overnight). We retain a positive bias towards China growth and a more relaxed view of the credit / debt / leverage related concerns that appear to be the general market consensus. Near term global risks likely lay elsewhere.
The UK and GBP have been centre stage this week, with inflation data (not as high as many had feared), employment report (disappointing job growth but encouraging wage growth), and retail sales data (disappointing expectations but maintaining solid annual gains). Despite some underwhelming pockets of economic progress this week, the data has done nothing to deter the firm market expectation of a 25bp rate rise from the Bank of England on the 2nd November (Super Thursday). Ahead of the BoE, the most significant driver of GBP emanates from the ongoing Brexit negotiations, most imminently the tone to emerge from the EU (27) meeting today and tomorrow.
While press reports state that EU leaders refuse face to face talks with PM May and that Donald Tusk has said there will be "no breakthrough" at this week’s meeting (though he has conceded that progress could be made in December), there are a number of developments to be more positive about from a UK perspective: (i) New data suggests that London remains by far the most dominant destination for Fintech capital, attracting more than USD1 billion in venture capital funding so far this year (more than double the amount last year and significantly more than the rest of Europe put together); (ii) Germany is reportedly working on a proposal for a "comprehensive free trade accord” with the UK - which is in line with our view that once negotiations get past the heavy politicking of the ‘Bill’, (mutually beneficial) trade negotiations could be much quicker than markets and commentators currently expect; (iii) The President of the European Council, Donald Tusk has said that he would use the meeting of the EU leaders to recommend they begin "internal preparations for talks on the transition and future relationship”; (iv) The Head of the London Stock exchange, Xavier Rolet said yesterday that taking back euro trading into the eurozone would "increase systematic financial risk” through impaired global risk monitoring and deteriorated risk concentration. He added that the current "system of global regulatory standards... protects taxpayers and reduces the cost of capital”. PM May is set to address her European counterparts at a dinner in Brussels this evening pledging further commitments to citizens’ rights and stressing the benefits of moving discussions on to the ‘future relationship’.
However, the biggest secession story (and arguably near term risk profile) at the moment is Catalonia, not Brexit. As the Catalan representation plans its next steps carefully, after suspending its claim for independence, a Spanish cabinet meeting has been called for Saturday to discuss the potentially explosive invocation of article 155 (effectively, removing the powers of Catalonia).
"A man who views the world the same at fifty as he did at twenty has wasted thirty years of his life” Muhammad Ali
Today is also the 30th anniversary of the Black Monday stock market crash of 1987, when global geopolitical uncertainties (then centred around Iran), high and rising interest rates and frothy overvalued equity and broader asset markets unwound spectacularly - exacerbated for the first time by the new wave of algorithmic and electronic hedging orders designed to protect investors from the very move they helped to generate. The one day drop in the Dow Jones Industrial Average was a frightening 23% (the average daily move in recent months has been more like 0.23%!), a bigger fall than the 1929 drop that essentially instigated Great Depression.
At the start of 1987, the Dow Jones topped 2,000 for the first time, and thus it is perhaps not surprising that current valuations (above 23,000 in the index) have led many to caution over the potential for sharp price corrections in the near term. But can also argue that the negative similarities of both geopolitics and valuations, low rates, flat curves and (arguably more importantly) ‘credible’ forward guidance - pledging a slow and gradual pace on monetary normalisation - argue in favour of a continued gradual equity market rally… unless something changes!
Over the next couple of weeks Trump is expected to announce the next Fed Chair (after interviewing the final candidate, Janet Yellen, today). Many have argued that the Fed chair is only one member of the committee (with 11 voting members when at full capacity) which seems a very reasonable assumption. However, the risk associated with the appointment of John Taylor are arguably asymmetric. We would argue that such an appointment would imply political desire for more rules based monetary policy (the ‘Taylor Rule’ would currently suggest US rates in the region of 150bps - 250bps higher than their current level) removing the forward guidance that has arguably been the biggest contributor to the current record low financial market volatility and even the Greenspan/Bernanke/Yellen ‘put’ that has underpinned global equity markets for years. In this (certainly not the most likely) scenario, you could make a strong case for sharply lower equity markets. Maybe not 23% in one day, but worth keeping an eye on.
Japanese for beginners
Kore, sore, dore:- this, that, which
Kono, sono, dono:- this, that, which
Koitsu, soitsu, doitsu:- this, that, Germany! Twitter post (Japanese/English translation)
This weekend also brings the Japanese General Election. Our central view however is that the LDP will maintain a majority and Abenomics will be reinvigorated - perhaps even renewed. As the above Japanese conjugation lightheartedly infers, Germany can at times be a law unto itself. Overnight NZD fell sharply on the news that the ‘swing’ party in the coalition talks pledged their support for Labour. In Germany, yesterday marked only the start of coalition talks - despite the NZ and German elections being held on the same weekend.
Ultimately, global politics remain dominant for broad financial markets. In this regard we will be watching closely the developments in the various areas of ‘risk’ in China, UK, EU, Spain, US, NZ, Germany and Japan... Economics may have to wait a little longer!
"Compromise, conformity, assimilation, submission" Know Your Enemy, Rage Against the Machine
This week, the UK and GBP return to centre stage. Last night’s meeting with the ‘enemy’ (as Chancellor Hammond unwittingly and unfortunately referred to the remaining EU27) in the shape of Jean-Claude Juncker and Michel Barnier was proclaimed "constructive and friendly” (bear hug between Davis and Juncker included), yet failed to highlight any material progress - other than the joint statement that "efforts should accelerate over months to come”. The dinner itself was apparently limited to a strict 90 minutes… in footballing terms it was effectively a 0-0 draw.
Furthermore, it seems (this side of coalition talks at least) that Chancellor Merkel is holding a firm line on negotiations and insisting that the EU27 see the colour of the UK’s money before allowing discussions to move on to the topic of trade. Herein lies the deadlock. The ‘bill’ is almost entirely a political issue and at EUR 20 billion (where we believe the UK calculate their ‘legal’ obligations), or even EUR 60 billion (where the EU see their moral entitlement) the amounts are of little long term significance - to either side - in reality (~1%-3% GDP). Politically, the EU need to assert their authority in order to dissuade other members following the UK’s path and the UK have a responsibility to its people to get a ‘good deal’ before placing a monetary value on it. David Davis is scheduled to update parliament on Brexit talks this afternoon (c. 13:15 BST)
"No nation was ever ruined by trade” Benjamin Franklin
More significant for both sides is the economic issue - the future trade relationship. In this regard, we are significantly more positive than the consensus. Chancellor Hammond yesterday insisted that the EU talks were at "a critical phase, not an impasse”, that it is the ‘process’ itself that is the biggest sticking point, and that the UK are in a "good position to go” once uncertainty is cleared. We are increasingly of the view that the progression of the trade negotiations will be quicker and more smooth than the markets (and certainly many commentators) currently expect, even if the progression to those trade talks is proving the opposite.
This morning was the start of the the barrage of UK data this week, with an inflation print almost exactly in line with market expectations (3.0% y/y headline inflation, 2.7% y/y core inflation), falling just short of the level requiring Carney to write an open letter to the Chancellor, explaining the failure of the Bank’s monetary policy settings to guide inflation to target. Still to come this week is the employment report for August (Wed.), retail sales for September (Thu.) and public finances for September (Fri) all in addition to the testimony of BoE gov Mark Carney, and MPC board members Ramsden and Tenreyro to the Treasury Select Committee today.
Overall, GBP is likely to be contained in the near term as we remain in a ‘critical phase’ or ‘impasse’. However, we are becoming increasingly positive on GBP in the medium term. Market expectations for the Bank of England meeting on November 2nd are near unanimously pricing a 25bp rate rise (~83%). However, we would expect the accompanying statement (forward guidance) to be dovish and emphasise the very gradual ‘foot off the gas’ approach to monetary policy while Brexit uncertainties remain acute. In this regard we would caution against buying GBP simply as a function of expectations of a rate rise that are nearly fully priced by interest rate markets. Beyond that however, we retain the view that GBP is significantly undervalued and as such remain focussed on opportunities to buy pounds.
"Integrity has no need of rules” Albert Camus
On a broader basis, the IMF / World Bank meeting at the weekend delivered positive message on the global economic recovery (admittedly with warnings about elevated debt levels and interest rate risks). The economic backdrop remains positive, even if political risks remain.
In the US, as the interview process for the next Federal reserve Chair continues, there were reports that President Trump was impressed by John Taylor - inventor / formulator of the Taylor Rule. With just incumbent Janet Yellen left on the interview schedule, it appears Taylor is the new market favourite. This is significant, as the formulaic Taylor rule would likely place interest rates considerably higher than the current level (and the level likely under any of the other more qualitative interviewees) - If we assume a 2% neutral rate and a 4% NAIRU, the Taylor rule would suggest a current level of rates around 150bps higher than their current level.
Tomorrow is the start of the 19th National Party Congress in Beijing. Essentially, this is where the President sets out his economic, social and strategic policies for the next 5 years.
While it is unlikely that the revelations from the Congress are market moving, the evaluations of growth, debt and leverage (credit expansion) - and the policy focus and direction going forward - will be of global significance in the medium to long term.
In short, this week is likely to be filled with interesting and important information. As such we are inclined to retain minimal positioning before and to be responsive after.
"Yeah I’m free, free fallin’” Tom Petty, Free Fallin
Amid an unusually complex macro and socio- economic as well as an insecure geopolitical backdrop, the foreign exchange market appears to be at something of an impasse. At the centre of which the USD. Essentially, after a prolonged period of depreciation, the USD has rebounded somewhat. Currently the market is trying to assess whether the USD bounce is a bounce within the context of a broader rally, or a turn.
The absence of inflation in goods prices and wages (though not asset markets) is starting to put a question marks around the validity of the Fed’s inflation model and by extension, monetary policy. As the economic backdrop continues to strengthen and broaden globally, the ‘gradual’ pace of US growth and monetary normalisation is too pedestrian to prevent a narrowing economic (and monetary) differentiation - and thus a ‘gradual’ USD decline. However, the proposed Trump tax plan has the potential to tip the balance in favour of both consumption and, in the longer term, perhaps productivity (through efficient business investment). This would most likely put the USD back on the front foot in foreign exchange markets.
"We do not want a traumatic break… we want a new understanding”
It is not just in the US that economic and political volatility complicate concepts of relative value and flow. The above comment is not an excerpt from Brexit negotiations but followed the (debated) Catalonian Independence Referendum held over the weekend. We will reserve comment on the politics, but it is worth pointing out that Spain without Catalonia would have a debt-to-GDP ratio of more than 116% (currently 99.4%) and a budget deficit of nearly 8% (currently 4.5%)
"Well, I won’t back down” Tom Petty
In the UK, there are increasing signs of economic stabilisation in many areas of the economy. Underlying growth appears to have stabilised and threatens to push back higher in the second half of 2017. Furthermore, encouraging signs from retail sales, consumer incomes and business investment all point to a stronger H2. The political backdrop, however, while likely past ‘peak uncertainty’, is far from clear.
This afternoon, Liam Fox, David Davis and Boris Johnson all speak at the Conservative Party Conference. The content of their discourse will be keenly noted by financial markets and I’m sure EU negotiators alike. Key will likely be Boris Johnson’s proximity to the narrowing party line on key Brexit objectives.
As a slight aside it is interesting to note the global proliferation of populist political policies that have countless and undeniably credible economic counterarguments of late. The Corbyn, McDonnell economic plan of nationalisation, pay caps, rent ceilings and substantial debt raising are perhaps the most troubling from an economic standpoint, but the extension of ‘help to buy’ announced by the Chancellor yesterday has questionable economic credibility (targeting demand when the issue is predominantly supply). Furthermore, protectionism in the US, neglect of structural reform in the eurozone also err towards populism over economic theory. This is a trend worth watching.
However, for the first time in the Brexit negotiations it does appear that there is some concession from the EU to the concept that trade only occurs where it is of mutual benefit. Speaking this morning Michel Barnier stated that the EU want an "ambitious trade deal with the UK post-Brexit”... once they can agree withdrawal terms. If the UK can assuage the insecurities of the EU27 (fear of further ‘leavers’ and or financial loss), the the backdrop for the UK may well be increasingly positive.
"You can’t always get what you want” The Rolling Stones
Elsewhere, AUD dipped overnight after the RBA left their policy statement largely unchanged. However, while the market focussed on the statement that a higher AUD may weigh on output and employment, we would caveat that the labour market is exceptionally strong historically and "indicators point to solid employment growth ahead”. With "more consistent signs of non-mining investment picking up” and inflation picking up gradually, we retain the view that the RBA will likely get a higher AUD, whether they like it or not.
Despite the Tory infighting, and the threat (albeit still a remote possibility) of 1970’s socialist economic policy, GBP remains good value from our perspective and we are watching markets increasingly closely for levels to rebuy GBP. In the US, until or unless we can be convinced otherwise we retain the view that the current bounce in the USD, is a bounce rather than a turn.
"There’s one for you, nineteen for me” Taxman, George Harrison (The Beatles)
If there has been one dominant theme or dynamic in global financial markets this week it has undoubtedly been that of the Trump Administration’s tax reform proposals - and the markets disjointed process of pricing in the likelihood and impact. The measures are idealistically aimed at providing a stimulative tax cut to the middle class, rather than fiscally neutral tax reform. The objective is to boost growth above 3%, thus raising GDP, federal tax revenues and thus offsetting the impact on the (already huge) US deficit.
On the face of it, US tax reform and simplification is undoubtedly a positive - except perhaps for the country’s many local accountants (90% of the US population seek professional advice to complete their tax returns). Add in the desire to make the simplification benefit the middle earners as well as the very poor (through raising the tax free threshold), the lower (and simplified) corporate tax rates and the technical adjustments to encourage both repatriation of overseas profits and their subsequent reinvestment… these are undoubtedly positive.
On the flip side I have heard the argument that the nominal impact of the tax cuts are likely small relative to those of the Reagan administration (not the largest tax cut in US history as Vice President Pence suggested overnight) but there can be little doubt about the direction.
The key uncertainties from our perspective lay in the passage of legislation through Congress - a process that so far has halted almost all Trump election pledges, removed market confidence in reform and thus unwound the ‘Trump trade’ in all financial products (except arguably equities). Furthermore, assuming clean progress through Congress, it is not clear that Corporate US will boost investment in a way that targets productivity or efficiency gains, rather than quarter profitability metrics or dividend payouts. Lastly, the biggest difficulty may well be overcoming the outlook for the US deficit - irrespective of bipartisan support for the concept.
"In a successful negotiation, there are no losers” Daniel Hannan
Following UK PM May’s speech in Florence last week, this week’s Brexit negotiations appear to have taken a new, more progressive, dynamic. Indeed, in the closing press conference Michel Barnier replaced the cynical critique of the UK’s position with a more progressive stance. "...we will keep working in a constructive spirit until we reach a deal on the essential principles of the UK’s orderly withdrawal” - Michel Barnier
It appears that the concession from the PM that no remaining member state will receive less, or pay more as a result of Brexit (in the current budget round - ending 2020), struck a welcome note in Brussels and beyond. On this point, it is interesting to note the Macron vision of ‘more Europe’, calling for a new wave of EU budget centralisation, powers of taxation, a single Finance Minister and a ‘bigger’ contribution by member states - all points that the UK continuously opposed during its membership.
"Monetary union must not divide the monetary union” Wolfgang Schaeuble
Last night Angela Merkel stated that the Macron ideas will enter into German government forming talks. While the prospect of a Jamaica coalition in Germany (CDU/CSU, FDP, Green) is accepted to be the most likely outcome, it is not clear that there will be a change of heart from the FDP, who have demonstrated their objection to further integration - specifically through higher German contributions. In other smaller member states, the ‘more Europe’ idealised by Macron is unlikely to be any more popular, despite the recent growth pickup.
Both Macron and Merkel have also been outspoken against the protectionist policies of the Trump Administration. However, this stance does not necessarily hold true with the French nationalisation of STX and their current consideration of nationalising L’Oreal (presumably while officials decide if they are worth it!), hardly a strategic national asset.
"Its risky, but no more risky than driving a car” Cory Lidl
Lastly, Mark Carney offered further commitment to a November UK rate hike on Radio 4 this morning as the Bank of England "think about taking their foot off the accelerator”, in part because the "new speed limit may be slower”.
The most emphasised economic negative from the anti-Brexit popular press is that the consumer is being squeezed by falling real incomes (as wages rise slower than price levels). Thus it is interesting to note the revisions to the Q2 GDP data this morning which highlighted real consumer income growth of 1.6% for the period, in addition to encouraging signs from net trade, business expenditure and an upward revision to Q1 economic activity.
"I am extraordinarily patient. Provided I get my own way in the end” Margaret Thatcher
Over the summer months market sentiment was undoubtedly positive. The global economy was in a rare period of unanimous growth. Downside risks from deflation and debt burdens seemed to have lifted. Low rates and even lower volatility were a supportive backdrop for risk assets. The near concerted monetary policy filip from central bankers at the Sintra conference in June was judged not as a warning of tighter monetary conditions ahead, but of an economic backdrop strong enough to warrant a move away from emergency monetary policy settings - albeit gradually and cautiously.
In the last couple of weeks, however, market sentiment seems to have turned a little more cautious, a little more nervous, as politics returns to the centre stage. Following the German general elections over the weekend, sentiment towards the EUR has certainly been dented - leading to a broader positional unwind of the significant USD short accumulated by the market over many months. The performance of the AfD party in the weekend election - becoming the first far-right party to enter the German Bundestag since 1960, just 3 days after Jean-Claude Juncker proclaimed that Europe had "seen a rejection of far right forces” - has likely been key.
The German election left Merkel with a sharply diminished share of the vote (41.5% in 2013 to 33% in 2017 - with the AfD taking 13%) and the prospect of courting the FPD and Green parties (in what is being referred to as the Jamaica coalition - due to the party colours being the same as those on the Jamaican national flag). The FDP are against a Eurozone Treasury, common pooling of debt and any further EU integration. Thus, the immediate implications point to a peak in EU integration, no fiscal union and no banking union.
The FDP will also likely demand the top job at the finance ministry, leaving Wolfgang Schauble and Emmanuel Macron - who set out an ambitious vision of integration and reform at the Sorbonne yesterday (including a shared budget) - the biggest losers from the weekend events. Ironically, it is also possible that the dismal performance of the SPD - whose leader Martin Schulz would likely have pushed for a harder line on the UK in Brexit negotiations - means that one of the winners from the weekend is the UK.
Off! The Cliff.
On Friday (ironically just hours before Moody’s downgraded the UK’s rating to Aa2), PM May gave a speech in Florence. While it was delivered to a largely British press pack, it was clearly targeted at the EU27 with the intention of progressing the seeming impasse in the Brexit negotiations on the size of the exit bill. May made a number of concessions, from honouring monetary commitments to maintaining security cooperation and neutrality in dispute resolution. PM May was also clear that the UK position is to seek a ‘transition deal’ - the single most consequential issue for British businesses.
While both sides would likely agree that a deal on transition is essential for a smooth path from divorce negotiations to trade talks focussed on the future (special) partnership, granting a transition deal at this relatively early stage (at least from the EU27 perspective) potentially favours the UK far more than the EU27. This "Big call” for the EU27 is a topic that the FT focusses on this morning.
From our perspective, not only are we at ‘peak EU’ for the EU, in our view we are at ‘peak uncertainty’ for the UK. Going forward we remain strongly of the opinion that GBP outperforms in FX markets.
"... a riddle wrapped in a mystery inside an enigma” Winston Churchill
With politics high on the market agenda, Japanese PM Abe formally announced the (very poorly kept secret) ‘snap’ general election for October 22nd. With opinion polls showing the ruling LDP is supported by 44% of voters, this strategy is not without risk. However, with the suggestion of a marked change of tack on fiscal focus (demographics - Japan’s "largest challenge”- Abe) and with a sales tax hike funded period of "intensive investment” and with a JPY 2 trillion economic stimulus package, likely necessitates popular approval. Such a stimulus strategy is also not without risk, as the last time they raised the sales tax it pushed the Japanese economy into recession.
Last night Fed Chair Janet Yellen reaffirmed the stance of the FOMC (unsurprisingly less than a week since the last FOMC meeting), emphasising the symmetric nature of the inflation target and current policy around a central expectation of gradual rate rises. The focal point of the speech was the categorisation of the recent inflation shortfall as a "mystery”, in a cautiously hawkish reiteration of Fed policy.
In the US, the biggest impact on Fed policy, and thus the equity, bond and FX markets, likely comes from President Trump, not from the escalating ‘name calling’ between him and North Korea, but from his success in passing stimulative tax reform in the US. We are promised further news on progress in that regard this evening. The USD will be paying acute attention.
Last night, the US FOMC left interest rates unchanged (as expected), left the statement content broadly unchanged (as expected) and formally announced the commencement of its programme of unwinding the balance sheet assets accumulated under QE (as outlined in July and, thus, as expected). The market reaction, however (adjusted for the recent lower baseline volatility), was suggestive of a hawkish policy iteration - or at least a hawkish interpretation. We are comfortable with the market interpretation of Fed policy driving bond yields moderately higher (path dependent on the evolution on growth and inflation). However, for FX, the picture is less clearly sustainably or uniformly positive for the USD.
Though policy was left unchanged, the detail of the statement and the accompanying economic projections are worth a closer look. The balance sheet unwind is perhaps better thought of as a simply a lower pace of reinvestment (the process by which the Fed maintains the overall stock of assets as shorter dated instruments expire). Thus, at this stage at least, there is likely to be little if any physical selling of bonds, and thus no external force pushing up bond yields. Furthermore, to begin with the amounts by which the balance sheet will be unwound per month are very small.
Perhaps the most interesting part of the release came with the dots and the SEP’s. Despite the more audible dovish leanings of some on the FOMC recently, the ‘dots’ or projected path of interest rates were barely changed. The median expectation of one further rate hike in 2017 (December) and three hikes in 2018 remained unchanged - this was interpreted as a (moderately) hawkish progression by the markets. However, the long term, or equilibrium fed funds rate projection was revised lower to 2.75% from 3.0%, which may reflect a more cautious view on inflation. Indeed, during the subsequent press conference, Chair Yellen offered an upbeat view of the economic progression of the US in terms of growth and employment, yet remained circumspect with regard to inflation, warning that a "persistent inflation shortfall would impact monetary policy”
"Metaphors are much more tenacious than facts” Paul de Man
Overnight, it was the turn of the Bank of Japan, who also left policy unchanged, emphasising the importance of its Yield Curve Control (YCC) easing policy and re-emphasising their aim to "tenaciously keep up powerful easing”. Outside of the sporadic impact of global geopolitical risks, we would expect the JPY to begin to underperform in FX markets as its central bank sticks to its aggressive monetary easing stance while others test a more hawkish footing.
Elsewhere the Norges Bank kept rates unchanged at 0.50% (as expected) this morning. However, in doing so they raised their forecast for the repo rate path from 2018, in a slightly more hawkish evolution. With strong domestic demand growth and sharply reduced oil price reliance (but not discounting the recent stronger oil price) Norway and the NOK are worth watching. Likewise, the release of the Riskbank policy meeting minutes revealed that "several members highlighted [economic] overheating risks”. This is a point we have raised several time before - the extreme level of monetary accommodation in Sweden is increasingly incompatible with the level of growth, inflation and SEK
UK press reported in the week that France has failed to get a single UK business to move to Paris, despite the hard push by President Macron and PM Phillipe. However, in this regard, this morning’s press contains several warnings from financial services firms that commitment to a transition deal is needed (by the end of this year) to prevent the forced relocation of some functions into the EU.
With Davis and Barnier seemingly reaching a deadlock in the EU Brexit negotiations, PM May is scheduled to speak in Florence tomorrow. The weekend press reported that May will commit to a payment of ‘at least’ 20 billion EUR in order to facilitate the progression of talks to trade and the future relationship. This seems like a sensible approach. We will be acutely focussed on the speech tomorrow, and the implications for GBP.
"Progress is not created by contented people” Frank Tyger
As the global financial markets step back and assess the implications of monetary policy progress, it is likely that there was little ‘new’ in the news from the past 24 hours. Ultimately, we would expect US rates to continue to drift higher, though with 10 year yields at only a modest discount to the Fed’s expected equilibrium rate, it is harder to argue for curve steepening. The real interesting connotations from our point of view are for the FX markets.