"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
As the sun continues to shine on the UK, the political landscape certainly appears to have become heated. Following the softer stance of the Brexit proposals emerging from the Chequers agreement the Tory-rebel, pro-Brexit ERG (European Research Group), fronted by Jacob Rees Mogg, tabled 4 amendments to the Customs Bill in the House of Commons - all (albeit marginally) carried in the House. The most contentious of these was the reciprocity amendment to border tax collection, is seen by some as negating the Facilitated Customs Arrangement (FCA) proposed in the Chequers Agreement. Subsequently, the Tory rebels (now on the pro- remain side - keep up!) threatened to vote against the government to tie its hands further in the negotiation and effectively keep the UK in ‘the’ (not ‘a’) Customs Union. Oh, and according to the (yet to be labelled fake news) press, the Leader of the Conservative Party, Andrea Leadsom, and the International Trade Minister, Liam Fox, have threatened to quit if there are further concessions towards Remainers or the EU. Theresa May is now not only running between the spinning plates of her party’s varying demands - but it appears now that the plates are indeed made of chocolate... and the sun keeps shining.
The former president of the European Council (and victim of the infamous "Who are you?” tirade from Nigel Farage in the European Parliament), Herman Van Rompuy, said of Brexit that it will likely end up being sorted at the 11th hour, deep in the Autumn, when a choice has to be made - between a deal and no deal. It will be sorted at the "last moment, with your back against the wall, the abyss in front of you and a knife under your throat”. It appears that this logic also applies to the passing of legislation within the UK Parliament, if the reports of threats, nervousness and the subsequent ex-post complaints are anything to go by. Interestingly, and perhaps ironically, Michael Fabricant, in the Telegraph this morning, downplays the suggestion that recent heated sessions have been unpleasant, recalling the debates over the Maastricht Treaty in the House of Commons in the early 90’s as being "even rougher waters than these...far more unpleasant”.
We discussed last week the view that the Chequers compromise was likely the sensible option in order to ease the transition, and while Theresa May is likely learning the 50:50-90 rule first hand at the moment, we continue to believe that the UK will be more than fine outside the political construct of the EU. As UK Parliament heads towards a recess (Tuesday afternoon), the focus of attention should now shift towardes negotiations with the EU, not within the Conservative party
"Like I Would[n’t]” Zayn, Like I Would
In a week with little on the data calendar, the political and geopolitical agenda has held greater focus. The US - Russia Summit in Helsinki on Monday, while bizarre in many respects, was undoubtedly a positive step (albeit a very tentative and small step) away from global confrontation - Trump’s ex-post clarification from would to wouldn’t aside! Equities and risk assets have performed relatively well this week as a result.
On the economic front, however, the backdrop has been less supportive of broader risk appetite. Firstly, the IMF released revisions to its World Economic Outlook (WEO) earlier this week, and while they left their global growth forecasts for 2018 and 2019 unchanged at 3.9%, there were some notable downgrades and warnings. Indeed, lower growth prospects for the eurozone (Germany, France and Italy in particular), UK, Japan, Turkey and Brazil came amid warnings that "financial markets seem broadly complacent to global risks” and that "asset prices face sudden repricing if growth, profits ebb”.
"If you fell down yesterday, stand up today” H.G. Wells
Furthermore, in the semi annual testimony of the Fed Chair to the House and Senate (‘Humphrey Hawkins’ in old money), Powell maintained the ‘strong economy, gradual tightening’ stance of the June statements and Minutes. Initially, there was a dovish market interpretation on the use of the narrative "for now” around the suitability of maintaining the path of gradually raising rates. However, the hawkish argument also fits the narrative and is, in our view, much more likely - particularly if we are right in our expectations of the emergence of more protracted inflationary pressures.Finally, the UK is where the concentration of economic data is, this week. So far, we have had better than expected employment data and marginally weaker than expected inflation data - ahead of tomorrow’s retail sales data. Despite the inflation print disappointment and the (perceived) uncertainty of Brexit, we continue to expect the BoE to raise rates by 25bps on the 2nd of August. For the currency, while near term sentiment remains weak, we retain the view that GBP is significantly undervalued, and thus we retain a positive bias relative to both expectations and valuation. As the wider market finds its preferred stance on the dominant backdrop for risk, we also expect the USD (and ultimately JPY) to outperform from current levels.
"Everyone has a plan, until they get punched in the face” Mike Tyson
This week has in many respects signalled the start of Summer Markets. Global uncertainty, sparked by trade, Brexit and geopolitics have likely accelerated the reduction in participation. A lack of conviction and an abnormal supply of sunshine have also clearly played their part. Against this backdrop, the signal-to-noise ratio in financial markets is low and correlations are reduced as positions are unwound. For much of the day yesterday, EURUSD traded within a 1.1670 - 1.1680 range (with extremes of 1.1650 and 1.1695) - in the ‘olden days’ that could have been a trading spread, not a daily range. As the mid-month data lull (ahead of ECB and Fed meetings at the end of the month) coincides with this low point of participation, we may be in for a more protracted period of summer market inactivity. There are however a couple of very important, market moving, themes that underlie the current backdrop - trade and Brexit.
Following the concessions of the Chequers Agreement and the resignations of Messrs Davis and Johnson, yesterday the UK government finally released the White Paper - The Future Relationship Between the United Kingdom and the European Union - formalising the basis for the proposed future arrangement. The document itself is 100 pages long, prefaced by PM May as "comprehensive. It is ambitious. It would ensure that we leave the EU, without leaving Europe”.
"Never tell the truth to those unworthy of it” Mark Twain
In short, the White Paper proposes a "common rulebook for goods” with the "phased” introduction of a "new Facilitated Customs Arrangement” and "new economic and regulatory arrangements for financial services” (with reciprocal recognition of equivalence). The whole thing would be formalised under the umbrella of an Association Agreement (as is currently in place between the EU and Ukraine). Likely most critical for the UK is the end-state of the agreed position on regulatory alignment (goods) and how effectively that enables the UK to strike external trade deals. This afternoon, Donald Trump’s commentary on this will be keenly watched, following initial soundbites suggesting the UK’s position might preclude a UK-US trade deal. Comment from a Foreign Office minister this morning that the mood at the Trump dinner was "fantastically positive” suggests otherwise. Lets see.
"Sat on a fence but it don’t work” Under Pressure, Queen
Our view on global trade has been consistent throughout. We retain the view that the current trade war rhetoric is a distraction from the ultimate position of lower global tariffs and freer trade.
In the long term if we are right in this view, then it will be of significant benefit to the UK. In the near term, the US response is significant. The Trump - May press conference this afternoon will be a key focus, before he takes tea with the Queen early evening and then retires to his Scottish Golf course for the weekend. On Monday he will face Vladimir Putin at the US- Russia Summit, before heading back to the US. At the NATO Summit he joked that perhaps the Putin meeting will be the easiest. If he is as late for the Queen as he was for the PM last night then the coldest reception may well be from Windsor.
In the near term, market apathy or disenchantment may distort valuations. But in FX we retain our views of USD and ultimately GBP outperformance.
Parthian Shot: A light horse military tactic made famous in the West by the Parthians, an ancient Iranian people. While in real or feigned retreat their horse archers would turn their bodies back in full gallop and shoot at the pursuing enemy. Wikipedia
It may have gone to the political equivalent of extra time and penalties (perhaps even with the several VAR interruptions) but Theresa May appears to have just about squeezed both the Conservative Party and its ‘softer’, more closely aligned (at least in terms of trade in goods - thus alleviating the customs problem and by extension the Irish problem) than anticipated, Brexit ‘third way’ through to the final round. By which I mean an audience with Barnier and Brussels: ironically just as the England football team makes every effort to reach a battle with France or Belgium in the World Cup Final at the weekend.
Following the Chequers agreement on Friday, there has been much focus in the UK press on the backlash from the more hard-line Brexit advocates within the conservative party and beyond, but very little on the welcoming approach from the ‘rebels’ at the other end of the spectrum that now appear firmly behind the PM. Even less has been made from the concessions of May’s detractors, that she could still obtain the desired result - David Davis’s resignation letter stated that May "could well be right”.
"Destiny is the invention of the cowardly, and the resigned.” Ignazio Silone
Steve Baker (also in his resignation letter), stated "I believe this country is on the cusp of catalysing a transformation in world trade. If we can combine a comprehensive EU tariff-free trade deal, together with accession to the Pacific Rim CPTPP, with a US bilateral deal and a new platform agreement for financial services, then we will improve the prosperity and prospects of hundreds of millions of people”. If May can achieve, as she has maintained, "a new business friendly customs model with freedom to strike new trade deals around the world” then perhaps she should be given a chance. An alternative - something that continues to be distinctly lacking from her detractors - remains illusive. Furthermore, continued fractures of the Conservative Party would increasingly risk a Labour Party in the negotiating seat and with a leader seemingly at odds with much of his party about the way forward - just with higher deficits and nationalised industries.
This is where the detail of the White Paper (that we still expect to be released in Thursday) and the subsequent negotiations become critical. How likely, is the EU to accept the ‘third way’ and how prepared is the May Cabinet to offer further concessions? Failure of the former likely pushes the UK closer to a no deal Brexit scenario, failure of the latter likely pushes May closer to her own political cliff edge. The release of the White Paper will be the next critical point for May and the prospects for the ease of transition to a future trade deal. If ever there was time for May to re-enact the ‘Parthian Shot’, this is most certainly it.
"No matter what time it is wake me, even if it is in the middle of a Cabinet meeting” Ronald Reagan
For financial markets, the reaction in GBP has been very limited, so far. The core focus - outside of the idiosyncratic issues of Turkey (nepotism in the Cabinet) and the UK (dissenters in the Cabinet) is likely still global trade. However, while a glance at the Hang Seng may tell the story of global trade concern, other traditional barometers of risk, such as the JPY, give a more sanguine impression. Summer markets appear to be with us and while all eyes will be on Trump’s actions at tomorrow’s NATO meeting (US withdrawal?), and on his visit to the UK this week, price action likely remains muted. The one risk to this scenario from our perspective is in the event of a higher than expected US inflation print on Thursday. A 3.0% y/y headline number is not beyond the realms of probability and would likely send a shockwave through US rate markets and risk assets should it occur
Today is a very significant day for financial market risk sentiment across a number of economic, political and geopolitical inputs. As the US and China draw swords on the first round of trade tariffs, the UK Cabinet begin a 12 hour locked door negotiation at Chequers (the PM’s country residence) to resolve the ‘hung balance’ of the UK’s position on a future trading relationship with the EU. Furthermore, following on from last night’s FOMC minutes (June 12th,13th) the economic trajectory of the US will once more become a central focus, with the employment report for June - at some point after this it is very possible that the attraction of the World Cup quarter finals (not to mention the sunshine and tennis) reduces participation and liquidity into the weekend close.
"Clowns are the pegs on which the circus is hung” P. T. Barnum
Last week we discussed the significance of the European Council Meeting (on the 28th and 29th of June). Its significance in terms of a solution to the increasingly urgent and politically fractious issue of migration and asylum in the EU. Its significance to the agreement, guidance and direction of the UK’s position on future trade with the EU. Its significance for the take-up of the Macron plan for the coordination and restructuring of the eurozone. In reality, it produced none of the above.
However, in the UK, today’s Cabinet ‘lock-in’ at Chequers will dominate the press headlines but little, if anything, is expected before financial markets close for the weekend. Ahead of the meeting, it appears that the PM’s "third way” commits the UK to accepting "European harmonised standards” on manufacturing goods, potentially (though this is disputed) limiting the potential of the UK to strike external, post Brexit trade deals - notably with a currently keen US. The debate is likely to be heated, not just by the weather but unlike last week, it must arrive at a conclusion, a position, a plan. In our view it is unlikely to be the long run end state for the UK outside the EU, but it it is increasingly clear that there will be some form of compromise.
From an economic perspective, however, the UK appears to be proving some of the doomsayers wrong (again), with an upgrade to the initial reading of Q1 GDP to 0.2% q/q, and with stronger manufacturing and service sector activity implied by the PMI data, it is possible that Q2 growth returns to the heady heights of 0.5% q/q. This, along with the above target inflation path has focussed market expectations around a 25bp rate rise on the 2nd August - the market implied probability of which is now above 80%.
"...rapidly and irresistibly we are drawn to our doom” Nikola Tesla
On the geopolitical front, the imposition of US trade tariffs on Chinese imports was met immediately by "retaliatory tariffs on US goods”, but while the swords appear drawn, markets appear calm. We maintain the view that the end-state of the global trade conflict is one of lower global tariffs and freer trade. In the near term, however, there are two concerns. Firstly, there is a non zero probability that Trump, as pledged, adds further (and substantially larger) tariff measures as a function of the Chinese retaliation - China can not continue to match such an escalation. The second is that Trump increasingly turns his attention to the EU and its tariffs and barriers to US (and other non EU) imports. Sadly this brings us back to headline watching - over the weekend in particular.
Last night’s FOMC meeting minutes (June) highlighted a concern over risks from trade war by business contacts. However, from our perspective the minutes were a further hawkish iteration of Fed policy - at the very least relative to the rest of the G10. The description of the economy as "very strong”, with "fiscal policy an [additional] upside risk” continue to provide a healthy backdrop. If we are right, and the ultimate resolution of the current trade conflict is positive for all, then US monetary policy looks too loose, and the USD too low.
"We are each but a quarter note in a grand symphony” Guy Laliberte
This afternoon, markets will turn their focus to the USD employment report for June. Central expectations are for a headline payroll gain of 195,000 leaving the unemployment rate unchanged and for average hourly earnings to edge up to 2.8% y/y. For us it is the relationship between the unemployment rate and the earnings figure that is key.
For years now, economists have been perplexed by the breakdown of the relationship between labour market slack and wage inflation - a process described by the Phillips Curve (PC) - as highlighted by the decline in the unemployment rate from around 10% in 2009, following the financial crisis, to 3.8% in May, while wage inflation has remained below pre crisis levels. We retain the view that we are likely approaching a kink in the PC, or the point at which wage inflation starts to accelerate. Indeed, last night’s FOMC minutes were clear to point out the view that members saw "US fiscal policy as an upside risk”. In conjunction with, recent evidence that US corporates are stepping up share buy-backs and capital investment both the near term (wage inflation) and long term (higher productivity and even higher potential growth) prospects for the US remain strong. We retain our upside bias for the USD.
Lastly, markets will likely turn their attention to Russia and the quarter finals of the World Cup - the participants being a clear outlier to the global phenomena of subdued wage growth. While Saturdays fixtures may be more tentative, nervous affairs, today’s games are likely to produce enough goals to distract the attention of many - headlines, around trade or otherwise could therefore have heightened impact.
Summit and Nothin’?
"That ain't workin' that's the way you do it” Money for Nothing, Dire Straits
The European Council Meeting on Friday, likely marks an important milestone for both the UK and for the eurozone. For the Eurozone, the Council must tackle the issue of migration (centred around the Dublin Regulation - that prevents the secondary movement of those seeking asylum) that has rapidly become a significant social and political issue - not least for Angela Merkel ahead of the deadline for her immigration based ultimatum from her junior coalition partner the CSU. Indeed, If Merkel does not attain a solution at the EU level she faces a difficult decision: unilateral action, or a potential fracturing of the coalition.
As the EU heads of state come together this week they also aim to address the EU’s deteriorating relations with the US and to ratify steps towards closer eurozone reform and integration - despite what have been reported as "profound differences among EU governments, political parties and social groups”. Long overdue reform in Europe may well now be in train. Let’s hope so.
"Better three hours too soon than a minute too late” William Shakespeare
For the UK, this Summit, and a further two between the 28th of June and the 12th July has a very different agenda. The needs to make some significant headway on the future trading relationship, sufficient to calm the rising disquiet of multinational corporations and UK exporters - predominantly at the moment in relation to the customs requirements or border controls. From our perspective the risks for the UK, and by extension GBP are increasingly skewed to the topside.
Last week, we highlighted the positive progression, for the UK and for GBP, of the economy and the process towards monetary normalisation. The Bank of England’s more positive assessment of the economy (and the transience of the Q1 slowdown) were further highlighted by today’s CBI sales data which surged sharply in June. This is also supportive of our view of the UK consumer and its correlation to the sunshine, as we also outlined last week: "If a royal wedding can push up champagne and food sales, then surely more sunshine and a decent performance in the World Cup group stage can do the same for beer, tv’s and therefore retail sales data”. Despite the drag from a carbon dioxide shortage, we would expect the continued good weather and the fact that England are guaranteed to still be in the world cup for the whole of June, likely bode well.
Whatever you may think of Donald Trump and his confrontational approach, the issues that he is confronting are not US centric, they are the same issues that are facing the UK, the eurozone, and much of the developed world. In many respects the fact that trade and migration have become a core, open global debate should be a long term positive for the UK quest for an more progressive agreement with the EU on both issues, but trade in particular. Over the coming trading sessions ‘headline risks’ are, we feel, more balanced for the global economy, at not singularly negative.
"End of a century, oh, it’s nothing special” Blur, End of a Century
Last night, eurozone governments agreed to give Greece a final cash loan of 15 billion euros, in addition to the almost 100 billion euros that it already owes (some 180% GDP), and granted a further 10 year grace period for interest and a 10 year extension to the loans - a process referred to as ‘extend and pretend’ at a more sensitive time for the Greek debt crisis. After 8 years, it has now been proclaimed that "the Greek crisis ends here” by EU Economic Affairs Commissioner Pierre Moscovici last night.
In many respects, this beggars the question why couldn’t this issue have been resolved a long time ago? On the other, are the measures really enough to resolve the problem indefinitely? Unlikely in our view. However, in terms of market sentiment, it is part of a wider ebb of sentiment back towards the positive over the past 24 hours. EUR (and perhaps risk-on currencies more broadly), may well see a further bounce in the near term, but in our view it will struggle to maintain this against a growth, interest rate and sentiment deficit that appears persistent.
"When the water starts boiling it’s foolish to turn off the heat” Nelson Mandela
This morning’s Eurozone PMI data was a further positive to EUR sentiment and in the near term a negative for the (fast money at least) market positioning that likely got a bit overextended following the combined implications of relative monetary policy trajectories from the ECB and the Fed. Median expectations were for a lower preliminary activity reading in June - maintaining concerns over the extent of the economic slowdown in the eurozone. The bounce, that is subsequently suggestive of stabilisation of the growth trajectory on a more sustainable plane, has forced the capitulation of some short term market positioning, likely further encouraged by the new lows below 1.1510 yesterday morning.
The wider market tone, or risk sentiment has also been lightened by the suggestion that there are ongoing cooperative discussions between the US and China over the past 24 hours - outweighing the EU implementation of retaliatory countermeasures, against the US steel tariffs, that went into force this morning. Indeed, the risks going forward - at least in the near term - are likely on the positive side as Trump has intimated an announcement of new trade deals (not tariffs) "soon”.
"...they think it’s all over…” Kenneth Wolstenholme
In the UK, the latest policy meeting from the Bank of England also ebbed back towards a more positive assessment of the economy as policy makers became "more confident that the Q1 slowdown [will prove] temporary”, and thus "ongoing policy tightening remains appropriate”. While the policy rate was left unchanged at 0.50%, hawkish dissent increased, with the vote 6-3, concentrating market expectations of a 25bp rate rise around the August Quarterly Inflation Report, as opposed to November.
On a further hawkish yet technical note the BoE intimated that it will begin reducing its balance sheet assets, accumulated under QE, once the base rate hits 1.50% (previously stated 2.0%). It could be argued that this may be a function of a lower expected neutral Bank rate as much as an increased confidence in financial stability, however, the net result is likely positive. Any progress on the clarity of the UK’s position on future trade or the Irish question, set against this more constructive backdrop for UK rates, will likely see a more sustained period of GBP strength. As we have mentioned a couple of times recently, that is not to mention the increased domestic sentiment driven by sunshine and football - thus a win for Panama over the weekend could put paid to this week’s positive assessment from the BoE!