"Many an optimist has become rich by buying out a pessimist” Robert G. Allen
Earlier in the week (and last week) we discussed our view that the US and UK are approaching a potentially significant pivot for inflation (wages and prices), economic sentiment, monetary policy expectations and ultimately currency valuations. Events of this week warrant revisiting this viewpoint.
In the UK, the economic data has been encouraging. The mainstream financial press continue to express the bias of their views towards Brexit by adding "despite Brexit…” and/or the caveat, ‘but we expect the situation to deteriorate as a result of Brexit’ after any positive economic iteration (given the negative bias, it is perhaps unsurprising that almost half of the UK population think the UK is in recession - Nielsen). However, this week we have seen a lower than expected (headline and core) inflation rate, higher than expected wage inflation and stronger than expected retail sales data (admittedly with some downward back revisions). From our perspective, not only is the market too negative in its view of the UK economy (and thus GBP) is is also looking in the wrong place.
UK rate expectations are a currently bimodal distribution. The first ‘mode’ is centred around expectations of a near term UK rate rise as a function the near term inflationary impact of GBP’s sharp fall since the UK referendum on EU membership. The second, is a function of the proximity of escape velocity for the UK economy, or where growth and demand driven inflation warrant a more sustained process of monetary normalisation. From our perspective, the value of GBP should be less driven by the focus on whether inflation (justifiably in our view) invokes a near term rate rise in defense of the credibility of the inflation mandate, but about when, where and how the start of the tightening cycle should be.
If we reflect on our recent statements that we see an impending sharp pivot for "inflation (wages and prices) economic sentiment, monetary policy expectations and ultimately currency valuations” (as discussed over recent weeks), and the fact that the SONIA (Sterling OverNight Index Average) curve implied probability of a rate hike is not fully priced by the market until March 2019, then interest rates and GBP are significantly undervalued according to our current assessment of the UK.
Going forward, business investment is key in the trajectory of productivity, wage inflation and growth. We are of the opinion that we have now passed ‘peak uncertainty’ in relation to muted business investment. Over recent days, Hilton have announced it will open 30 new UK hotels over the next 2 years, Amazon have announced a further 1000 new jobs (in addition to the post Brexit pledge of 5,000 new jobs by the end of this year), manufacturing exports recorded their strongest sales increase since the end of 2014, both mortgage lending and first time buyer activity rose significantly in June and the Job availability in London is up 27% y/y and 17% m/m.
There are two rules to success:
Never reveal everything you know… Poster slogan
From a political perspective, yesterday the government released the first of many position papers ahead of Brexit negotiations, declaring their intent to instigate a consultation with industry ahead of the negotiations. Clearly prefaced as aiming to set out "key issues which form part of the Government vision for that partnership, and which will explore how the UK and the EU, working together, can make this a reality” - specifically in relation to the UK’s potential options for its future customs relationship with the EU27. The mainstream press were perhaps unsurprisingly critical, yet the response from business was far more upbeat.
"Every custom begins with a broken precedent” Will Durant
It is interesting to note the criticism of the government paper on the basis that some its suggestions are untested or have no clear precedent. The paper clearly points out that "While the government has looked at precedents set by customs agreements between other countries, it is not seeking to replicate another country’s model and will pursue the approach that works best for the UK”. Presumably in just the same way that Norway did when it came up with ‘the Norway Model’, similarly Switzerland, Turkey and even Canada. Why is it so unthinkable that there could be such a thing as the ‘UK model’?
"Three things can not be long hidden: the sun, the moon and the truth” Buddha
Last night also brought the release of the minutes from the 25th/26th July FOMC policy meeting. Effectively, there was little new information in the release of the broader debate behind the statement. In essence, the discussion highlighted a greater concern over the recent softness in the inflation data and thus, on the face of it, this was interpreted dovish for rates and the USD.
However, if we look at the dispersion of the viewpoints on the likely progression of inflation, there are broadly three camps. Firstly, those who feel rate hikes are off the table until or unless inflation makes a convincing move higher. Secondly, those who are of the view that the traditional Phillips Curve relationship between jobs and inflation remains and that the current soft patch in price pressure is transient. Thirdly, there are those who feel that the current extent of labour market strength justifies further (gradual) normalisation in itself.
"Today marks the start of an intensification of our preparations for our exit from the EU.” David Davis
This week, apart from the transient diversions of the monetary policy meeting minutes from both the FOMC and the ECB (Wednesday and Thursday), it is all about the UK. Following this morning’s inflation data (which showed both headline and core inflation unchanged at 2.6% and 2.4% respectively), we have the release of retail sales data for July and the June employment report. Perhaps more importantly for GBP and for sentiment towards the UK, however, is the steady release of government papers, outlining what David Davis described this morning as the "new deep and special partnership the UK wants to build with the EU” and setting out the "key issues for the government’s approach to that partnership”.
As Parliament returns from the Summer recess this week, the government is under no illusion that clarity, direction and a united, cohesive approach to the proceedings is desperately needed. The secretary of state for exiting the European Union, David Davis, sets out the strategic intentions of the UK in this morning’s City AM (ahead of a series of "future partnership papers”), where it is clear that his jottings are intended for many distinct audiences and issues.
The article begins by stressing the desire for a new "deep and special partnership”, and to draw on the expertise of external parties - addressing criticisms of isolationism and the involvement / inclusion of UK businesses. Davis also addresses (i) the freest and most frictionless possible trade (ii) the development of policy to build a stronger, more prosperous, more outward looking UK than ever before, with (iii) no return to the borders of the past between Ireland and Northern Ireland. Not to mention greater clarity over the government’s desire for a transition period during which the UK would be part of a "temporary customs union”.
Davis went on to state, in a subsequent interview, that "constructive ambiguity” is vital for negotiations. In part we agree with this sentiment, it is after all a negotiation (and a very significant and important one). However, due to the significance and importance of this negotiation it is critical (at least from this point forward) that constructive ambiguity does not stray (back?) towards disruptive uncertainty… or worse.
"Paying good wages is not in opposition to good productivity” James Sinegal
Last week, we discussed our increasingly confident view that the UK (and the US) are likely closer to wage inflation and thus a very significant pivot point for price pressure, expectations, interest rate structure and monetary policy. We maintain that view. Indeed, if the uncertainty surrounding the Brexit negotiating position is clarified (even very modestly) by the government papers scheduled to be released this week, the implications are potentially very significant.
"So comes snow after fire, and even Dragons have their ending” J R R Tolkien
There is a very interesting dynamic in global financial markets at the current juncture. One which we firmly believe will see volatility spark back to life, over the coming weeks or months - despite the rising global geopolitical tensions, this view has nothing (at least not directly) to do with North Korea. This may sound like a vague time period for a prediction of sharply higher volatility and in a sense that is the essence of the problem.
In a world where money is looking for ideas and more significantly looking for yield, the distortion of global zero interest rate policies, yield curve flattening and non conventional monetary easing has driven capital into relatively few areas globally. If we add in the recent low (but importantly positive) growth / low inflation backdrop, capital flows have been concentrated further. Long equities, long bonds and essentially short volatility trades are in our view becoming an increasing market vulnerability.
Sayings such as ‘picking up pennies in front of a steamroller’ and ‘the straw that broke the camel’s back’ are both likely to be heavily utilised and sagely descriptive after the event. In these analogies, what constitutes the ‘pennies’ is fairly obvious. What ultimately constitutes the ‘straw’ is less clear.
If only there were a way to improve the attractiveness of jobs!
Tuesday afternoons release of the US JOLTS job report effectively showed that the gap between job openings and actual hirings is at its widest ever. One interpretation (likely favoured by the Fed) is that it is a result of a tightening labour market that will ultimately result in higher wage pressures (presumably then narrowing the gap). However, at the moment there appears to be something of a Mexican Standoff as firms are keeping wages at levels that do not attract new workers at the desired pace. The arch dove on the FOMC Neel Kashkari’s take on the issue of companies struggling to find staff is refreshingly direct - "If you are not raising wages, then it just sounds like whining?”
A very similar dynamic is evolving in the UK. Despite what the Bank of England describes as an "increasingly uncertain environment”, British companies are having greater difficulty hiring workers, as unemployment has fallen to its lowest in over 40 years. The latest BoE business survey reported an increase in recruitment strains, which are "gradually broadening across sectors and skill areas”. The Bank also noted that investment intentions were "modestly positive overall”, but that uncertainty around the trading environment was weighing on some firms’ longer term spending plans. One result of the uncertainty is that employers’ pay growth expectations remain fixed around 2-3% per annum.
"The issue isn’t just jobs... the issue is wages” Jim Hightower
In the UK, the failure to attract staff, or more specifically the lack of (ability or) desire to raise wages is due to the "persistent uncertainty over Britain’s future relationship with the EU” as the FT was eager to point out this week. In the US, the ‘uncertainty’ is likely more a function of fiscal policy (tax and healthcare implications) as well as concerns over the underlying strength of the consumer, public finances, and growing geopolitical concerns.
From our perspective, the potential for an acute market pivot are growing substantially. In both the UK and the US we are approaching levels where currency valuation accounts for no monetary tightening over the policy forecast horizon. Even a modest reduction in the uncertainty surrounding US fiscal progress or compromise, presidential credibility (admittedly seemingly less likely) or signs of employers paying up for staff would have a potentially dramatic impact on US yield curves and the USD. In the UK, any clarity on the intention of the government’s EU negotiating stance, or agreement on transitions would likely have a similar impact.
"Nothing rises quicker than dust, straw or feathers” Lord Byron
In equity markets, we are also of the view that markets are very keenly priced, relative to our view of increasing risks of an acute pivot in the USD, GBP and their respective yield curves. Corporate action on wage levels in the UK, US, in this regard, could be a game changer for inflation expectations, monetary policy and the respective currencies, in our view. The straw that broke the camel’s back? Either way we expect volatility to rise, perhaps significantly.
The ‘jolt’ to the USD from the JOLTS data was significant, if tentative, in highlighting this - and damped by the significance of Trump’s Fire and Fury comments in creating another, far more worrying Mexican standoff. However, if employers blink first, we expect a sharp bullish pivot for the USD and for GBP.
"I’ve been the lull, and I’ve been the storm and also somewhere in between” Karan Johar
Last week we discussed the dominance of political developments on financial market interactions. This week, with the summer lull in full swing and a very light data calendar, we may find this theme extended. The one data point of note since our last piece was the US employment report for June, and it is important to note that the main pillar of strength in the US economy - the labour market - put in another impressive month. July marked the second consecutive payroll gain above 200,000 and another incremental reduction in the unemployment rate to just 4.3%. What continues to fall absent, however, is inflation in both wages and, more broadly, in prices.
From a financial market perspective, while inflation remains absent, monetary policy normalisation in the US likely remains a glacial iterative process. Against this backdrop, and in conjunction with a modest recovery in global economic activity (one where downside risks have diminished), the resultant hunt for yield has driven demand for bonds, equities and emerging markets. In turn this has pushed yield curves lower and flatter (arguably further denting inflation expectations), boosting the attractiveness of equities.
In FX terms, the low volatility, risk positive, low inflation, low (but positive) growth backdrop, it is likely that the USD remains on the back foot. In fact, in order for this to change or for the USD to make gains in FX, it would likely require a negative exogenous risk event, a sharp pickup in US growth or a notable pickup in US inflation.
"Recent data question if inflation returning to target” James Bullard
In that regard, it is interesting to note the testimony of Messrs Bullard and Kashkari last night, neither of whom hold much hope for a resurgence of inflationary pressure anytime soon. Indeed James Bullard, while advocating the activation of the balance sheet unwind process, provided little explanation or hope for a reversal of ingrained low inflation in the US - concluding that the "best policy would be to leave rates where they are”.
FOMC voting member (and dissenter to the June rate rise) Neel Kashkari reiterated his view that "it matters that inflation has been coming up short”, a sentiment that contributed to keeping US yields subdued and yield curves flat.
"...but some animals are more equal than others” George Orwell, Animal Farm
In the eurozone, however, there have been some interesting monetary policy developments. We have noted on a number of occasions that one of the motivating factors for the ECB in considering its path towards monetary normalisation is the increasing scarcity of German debt to purchase (in line with the policy equality of the capital key - accounting for the relative sizes of economies, and thus capital markets, within the eurozone). The most recent data shows clearly that the ECB purchases of German bonds were for amounts below that implied by the capital key for the fourth consecutive month. Furthermore, the German shortfall appears to be increasingly utilised to buy Italian debt.
This process of favouring one member state over another (if sustained) raises significant questions about the eurozone construct and the equality of the transmission mechanism for monetary policy. We would expect to expand further on this topic over coming months, suffice to say that if this is a conscious policy target, then its connotations are (perhaps much) less positive for the EUR.
In the near term however, despite the summer lull in data, activity and participation, we would expect the USD decline to remain the dominant force. With US CPI the next significant macro data point, eyes will be focussed on that. Until then the IAAF Athletics World Championships perhaps offers a welcome distraction
"The secret of getting ahead is getting started” Mark Twain
The focus and scrutiny of financial markets yesterday was on the ‘Super Thursday’ releases from the Bank of England. As expected, the Bank left the Asset Purchase Facility (APF) unchanged with a unanimous vote and interest rates unchanged with two members (Saunders and McCafferty) dissenting in favour of a 25bp rate rise. The debate among forecasters was whether chief economist Andy Haldane would place his vote in favour of a rate rise to keep the split unchanged from the June meeting (5-3) following the departure of Kristen Forbes’ dissenting voice. While the analysis of the split is interesting, it is not the core driver of GBP or UK interest rates at the current juncture.
The Quarterly Inflation Report (QIR), whose simultaneous release makes BoE Thursday ‘Super’, brought marginal reductions to the Monetary Policy Committee’s (MPC) growth projections (cutting 2017 GDP forecast to 1.7% from 1.9% previously and to 1.6% in 2018 from 1.7% previously) and lowered its expectations for wage growth in 2018 to 3.0% from 3.5% previously. However, in our view this is not the core driver of GBP or UK interest rates at the current juncture either. Particularly as the Bank’s updated growth forecasts are still above the central market expectation.
Furthermore, the QIR analysis lowered the Bank’s forecast for the potential (or trend) growth rate of the UK economy, which in turn led to the statement that, if the economy progresses in line with BoE expectations, then the Bank "rate may need to rise more than markets currently imply” (as a function of above trend growth) - currently around two 25bp rate rises over the next three years, starting in Q3 2018.
However, from our perspective the negative reaction of GBP and UK interest rate markets to the ‘Super Thursday’ revelations were specifically a function of the fact that the Bank explicitly pointed out the negative connotations of the uncertainty of the Brexit negotiations and in many respects the relatively unknown direction of travel of the talks. Carney was clear in emphasising the fact that "growth remains sluggish in the near term”, specifically due to lower business investment as a function of Brexit uncertainty and its negative impact on wage growth and productivity growth.
It is interesting to counter this negative view of the near term growth prospects of the UK from the BOE with that of the National Institute for Economic Social Research, NIESR who said earlier in the week that "Britain’s economy will surge back to life in the next six months following its slow start this year”. The NIESR said "a boom in exports after the fall in the pound and a return to bumper wage rises next year would be enough to increase GDP growth to almost 2% and convince the central bank to increase the cost of borrowing”.
"It may be the biggest problem that the modern world has ever faced… This will create a nightmare for every area of life, in every region... ” Gary North
As firms and individuals try to understand and calibrate the implications of Brexit it is perhaps increasingly important that the government play a role in reducing uncertainty and countering fear wherever possible. The above quote, taken from The Economist, perhaps sums up the potential for negativity of uncertainty. The author of the quote, however, was not fearful of Brexit, but of the ‘Millennium bug’!
The key point here from our perspective is that the specific point holding up business investment, and thus the UK economy, is the uncertainty that the government has generated in its negotiations, strategy, and communication. The ‘marketing’ of the Brexit plan has been nothing short of shambolic and as such has propagated a cautionary delay in business investment that has, in turn, weakened the government position and promoted a fear that exaggerates the negative and ignores the positive. Perhaps the PM needs new PR?
"It wasn't a lie, it was ineptitude with insufficient cover” Don Draper, Mad Men
On a wider note, the political shenanigans in the US are becoming increasingly audible, as is the concern in financial markets - with one notable outlier. Over recent months, the inadequacies of the Trump administration have effected the removal of all expectation of US fiscal stimulus from growth and inflation forecasts - lowering interest rate expectations (flattening the curve) and denting the USD. Over recent weeks, the political concern has heightened further, culminating in last night’s announcement that (US special counsel) Robert Mueller has enrolled a grand jury in Washington as part of the Russia probe.
Ironically, the exception to the heightened concern (and indeed volatility) is the US equity market. It is likely that the fall in the USD is helping global profits. There is a point, however, where the political backdrop becomes sufficiently weak or uncertain as to undermine the equity markets. It seems, however, we are not there yet.
From the perspective of the USD, we are increasingly of the view that the prospects of a capitulative sell off in the USD are rising - failure to find strength in some aspect of this afternoon’s employment report may well be the trigger.
"Scaramouche, scaramouche, will you do the Fandango” Queen, Bohemian Rhapsody
Last week we outlined our views of the key macroeconomic undercurrents driving financial market flows at the current juncture. At the centre of this debate is the influence of the US and the USD. "[T]he slow yet positive growth in the US, combined with reduced global risks and narrowing interest-rate and growth differentials, keep the US dollar on the back foot. Furthermore, this relative stability drives investors in the US into a search for yield that ultimately pushes equity markets higher and longer-dated yields and volatility lower. The lower (flatter) yield curve [further] undermines the USD at the same time that the prospects of near-term US fiscal stimulus have all but disappeared, and Trump shenanigans add to the USD risk premium.”
As financial markets await the next instalment of employment data (arguably the economy’s trump card) from the US later this week, political concerns (which equate to a perceived reduction in the likelihood of fiscal stimulus) are back front and centre. Last night, the revelation that Trump is said to have dictated his son’s statement on the ‘Russia meeting’ and that Trump sanctioned the removal of Anthony Scaramucci as White House press secretary, after less than 10 days in the job, only add to the detraction.
"The policy of being too cautious is the greatest risk of all” Jawaharlal Nehru
While the USD has been losing out in FX, there have been some notable winners. As the non-mining / commodity sectors of Canada and Australia have achieved significant rebalancing alongside a resurgent China and a (relatively modest) bounce in commodity prices, CAD and AUD have benefitted significantly from central banks that have changed monetary course (albeit more tentatively in the case of the RBA)
Perhaps the most striking mover of late has been the CHF. With the SNB maintaining its ultra dovish monetary policy settings as the ECB appear to be moving towards an, albeit glacial, process of normalisation, and with the Swiss economy stuck in a period of stagnation as the eurozone finds some cyclical momentum - EURCHF has trended sharply higher.
However, from our perspective there is another dimension in considering the prospects from here, particularly of AUD and CHF, and that is risk. With equity markets at record highs and with valuations continuing to be stretched, it is perhaps worth noting that the historic correlation of CHF and AUD to a falling equity market is counter to their recent trends. This is by no means a new idea. What is potentially far more interesting, however, is how the traditional ‘safe haven’ characteristics of the CHF have been altered by the fact that its national central bank, the SNB, has more recently been referred to as the world’s biggest hedge fund, as a function of its huge holdings of international financial assets including USD 80 billion in US equities - unhedged.
If the negative correlation of CHF to the market perception of risk has, in any way, been skewed by the (FX intervention asset) holdings of the SNB, then the case for CHF as dominant funding currency is only strengthened.
"Expect the best, plan for the worst, and prepare to be surprised” Denis Waitley
Lastly, but by no means least, we would like to consider the case for GBP. Last week, we suggested that "over the coming weeks, we feel that there is an opportunity for GBP to rise as high as 1.38 against the USD”. Since last week there has been little to convince us otherwise.
This week is potentially a very significant week for the UK and for GBP. Thursday brings the (dominant) service sector activity survey, the Bank of England’s Quarterly Inflation Report and a Monetary Policy Committee meeting that may deliver a rate rise. (Yes a rate rise). This might sound controversial, and relative to market expectations it is. However, we continue to believe that the market is far too negative on the prospects for the UK economy, which we continue to believe will outperform both expectations and its peers through 2017 and beyond.
This week’s PMI economic activity surveys point to growth nearing 2.0% on an annualised basis, the unemployment rate is at its lowest level in over 40 years (and at or below levels that would historically be expected to push up wages in the near term), inflation is significantly above target, and consumer credit continues to rise at a pace that may begin to draw financial stability concerns if the trend is extrapolated. Furthermore, the removal of the 25bp rate cut that the Bank of England put in place (as insurance?) in anticipation of an economic wobble in the aftermath of the Brexit vote - that never materialised - could be seen as prudent.