"Whenever you find yourself on the side of the majority, it is time to pause and reflect” Mark Twain
In our last post, we discussed our view that a marked pickup in financial market volatility was imminent - arguing that the dominant cross asset theme throughout global financial markets in 2018 (and arguably prior) has been declining volatility. Since this post - at the end of April - there has been a deterioration in the global geopolitical order with trade talks between the US and China collapsing, tensions rising with Iran and North Korea resuming missile testing. From a macroeconomic standpoint there has been a secondary deterioration in the Chinese economic trajectory after the (targeted) stimulus induced bounce that was obvious in the May data. However, while any of these events on their own could be expected to generate a significant rise in the level of underlying volatility, so far at least the combined impact of a series of significant events has been minimal. Instead of taking the view that markets will revert to contracting volatility, to quote Linford Christie we are more of the opinion that this is simply the B of the Bang.
"Renege, affirm and turn their halcyon beaks” William Shakespeare, King Lear
Just over a week ago, it appeared to all intents and purposes that a US-China trade deal was a ‘done-deal’. However, following some mild rumours of impasse into the NY close on Friday 3rd the subsequent weekend witnessed a notable tweet. President Trump stated that that the trade deal with China was continuing too slowly and threatened higher tariffs as early as Friday. As the week progressed, it became clear that the talks had broken down as China had sought changes to the ‘agreed text’ in IP protection and theft, technology, financial services access and competition policy. This deterioration in Sino-US (and global trade) relations dominated sentiment and flows across all asset classes.
However, market volatility, and thus contagion, was damped in the first instance by China state funds propping up Chinese equities after the hit from US tariffs (and in the second instance the China Statistics Bureau stated that there was relatively big room for macro-policies to support growth immediately after the release of weak April economic data Tuesday morning). Furthermore, just as equities began to turn lower yesterday, headlines were released suggesting the the US would postpone its proposed auto tariffs for six months ahead of the imminent deadline.
Volatility, from a monetary perspective, has also calmed predominantly as a factor of the Fed. After the near dramatic (multi-stage) dovish pivot from the Fed from November through to March, the most recent commentary from the Fed - most notably vice Chair Clarida who has seemingly been the lead protagonist on defining the policy direction - has been more balanced. Indeed, Clarida’s latest speech offered a more comfortable tone "the US economy is in a good place” and gave a vision of near term stability for US rates as the global economic backdrop evolved.
From our perspective global financial markets are still moving towards a necessary regime shift in underlying volatility. We are firmly of the view that the current calm of the Sino-US impasse must by default be a transitory state. Either there is resolution, that is likely a positive for the global export dynamic or deterioration that could have significant implications for global asset prices. Either way, we are of the view that the Chinese economic recovery is more likely to be an L rather than a V (as the most recent data suggests) as the authorities determination to de-lever and de-risk the economy continues.
"Will things ever be the same again?” Europe, The Final Countdown
Elsewhere, there is little or no evidence in volatility markets that the European Parliamentary Elections will cause any disruptions or complications - despite the fact that some polls suggest that up to 200 of the 751 seats could end up being occupied by populist party representatives from across the political spectrum.
And then there is the UK. As the Brexit saga continues without an end in sight it is interesting to note the direction of the debate. Indeed, the European Parliamentary Elections appear to have polarised the discussion even more. On the one side there has seemingly been a movement towards the ‘no-deal’ exit parties such as the new Brexit Party and on the other side a move towards (a more widely dispersed group of) parties such as the Liberal Democrats, Greens and Scottish Nationalists. Both moving away from the compromise deal of the PM and the far from clear position of the Labour Party.
We have stated our view on many occasions that we view the only credible option for the UK as being May’s compromise deal - The Withdrawal Agreement Bill or WAB (the latest form of which we are yet to see) - or no Brexit, as Parliament has made clear its strong will to prevent no-deal by any means possible (irrespective of the constitutional legitimacy or implication). In reality, we still fail to see how no-deal or no-Brexit are anything other than transient states that ultimately end up in a form of compromise agreement - likely not too dissimilar to the WAB. In the meantime. It may be volatile!
"No spring skips its turn” Hal Borland
Over recent months, there has been a notable theme throughout financial markets: Not the uncertainty caused by the global trade dispute between the US and China (and more recently the US and the EU); Not the uncertainty and consternation of the Brexit negotiations; Not the sharp dovish pivot from the US Fed that has seen financial markets price out US rate hikes and price in rate cuts in a short period at the start of the year. The most dominant theme has arguably been that of declining volatility.
In FX terms, volatility over a large swathe of the array of vol surfaces has been at or near historic lows - at least until the start of this week. However, over the last couple of days there has been a notable turnaround. From our perspective this has the potential to mark a significant alteration in the underlying market dynamic. Away from a period of apathy and indifference to a more active global financial market backdrop. Markets look like they are about to get very interesting indeed.
"I want to be what i’ve always wanted to be: dominant” Tiger Woods
Since we last wrote, there has been a notable move lower in the EUR and up in the USD driven by a number of factors. Since the start of the year there has been much focus on the Chinese economy and the impact of its slowdown on the export dynamic and thus the global economy.
In early March, the Chinese authorities embarked on a range of fiscal stimulus measures (targeted tax cuts, credit easing) aimed at providing support to the economy. The significant measures announced at the NPC (National People's Congress) were viewed by markets as a panacea to the woes of the global export dynamic - obviously a Chinese stimulus would boost China’s demand for the inputs to its vast export market, wouldn’t it? Historically this has been the case. However, this time there are a couple of caveats. Firstly, there is a distinct rotation occurring within the Chinese economy, away from the heavy export oriented economic model towards domestic consumption led industries. Secondly, the Chinese authorities have shown a clear desire not only to provide accommodation on a targeted basis, but to limit that stimulus so as to not ‘flood’ the economy with liquidity that is likely to create fragility and or bubbles. At the same time the desire of the China to de-risk and de-lever the economy remains.
These factors are important when viewing the implications of the China stimulus, noty on China, but on the rest of the world. At the start of the month there was a clear rebound in the manufacturing activity in China taking the sector back into expansion. Further, the recent GDP, retail sales and industrial production data all showed significant (if policy induced) rebounds. Historically the market reaction function has been to extrapolate Chinese economic strength into those export oriented economies such as Germany, South Korea and Japan. This time round the market has been disappointed as the China rebound has (at least not yet) driven any noticeable bounce in the global export dynamic. As such the EUR (and notably the Korean Won) has suffered.
"When did the future switch from being a promise to a threat?” Chuck Palahniuk
From a GBP perspective, there has been little progress in the Brexit negotiations. However, it does seem that the threat of European Parliamentary elections, Cooperation with the Labour Party or even a General Election (as rumoured this afternoon) could finally win round enough dissenters to the PM’s withdrawal agreement. If the rumours of its return next week prove true then we will find out. Furthermore, if we are right in our view that the broader financial markets are about to witness a regime shift in the underlying level of volatility, then GBP could become a significant mover in FX.
"I won’t cry for yesterday” Duran Duran, Ordinary World
Much has happened since the last time we wrote. Not just (following on from our last piece) on Brexit, but in the global macroeconomic backdrop. While near term uncertainties over the UK’s future relationship with the EU are significant - particularly for UK business investment - the current decline in the global growth dynamic is potentially both more significant and further reaching.
This week the IMF’s latest World Economic Outlook (WEO), cut its global growth outlook to the lowest level since the financial crisis at 3.3% (from 3.5% in January and 3.7% in late 2018) as "Activity softened amid an increase in trade tensions and tariff hikes between the United States and China, a decline in business confidence, a tightening of financial conditions, and higher policy uncertainty across many economies”. Further, the IMF were clear that risks remain to the downside, citing trade tensions, softness in Europe and a no-deal Brexit”
Wednesday’s agreement between the UK and the EU27 to extend article 50 has reduced the potential for a no-deal Brexit (at the very least until June 1st) and if we are to believe the rhetoric and twitter activity (twitoric?) the Sino-US trade negotiations appear to be reaching the drafting stage of what President Trump has described as the "Granddaddy of all deals”. That leaves the ‘softness in Europe’.
"I hope the tears don’t stain the world that waits outside” Oasis, Where Did It All Go Wrong?
While it may seem like the phrase "delayed not derailed” is a clear reference to the Brexit process, it is actually the new descriptive narrative of choice for the ECB when referring to the convergence of inflation towards target - though at the current juncture it could equally be used to describe the prospect of self sustained growth for the region.
The IMF cut their forecast for 2019 to 1.3% (from 1.6% in January). However, over recent weeks Italian and German institutions have cut their respective growth forecasts to 0.1% (from 1.0% previously) and 0.8% (from 1.9% previously). That puts a lot of pressure on the rest of the bloc to make up for the underperformance of Italy and Germany. Furthermore, with high debt across the eurozone (less so for Germany) and very little room for further monetary stimulus (or come to think of it fiscal stimulus - again ex-Germany), the eurozone economy is acutely vulnerable when downturn strikes.
The eurozone was a key focus Wednesday, as the ECB left rates unchanged as expected. While there was very little change to the statement, there were a couple of notable developments: Firstly, it was clear that the ECB are now openly discussing the implications of its negative rate policy on bank profitability - while stressing that the need for bank consolidation is "very significant”. Secondly, Draghi stressed that there was unanimous agreement from the Governing Council on the use of "all tools available” and even stressed that markets "understood” his commentary - seemingly in relation to lower Euribor and a lower EUR. We continue to believe that the most effective monetary tool that the ECB has at its disposal is a lower currency.
"You can’t always get what you want” Rolling Stones, You Can’t Always Get What You Want
In the UK, Theresa May addressed Parliament earlier today after returning from the EU Summit Brussels in the early hours. Ahead of time there was little expectation that the EU27 would deny the UK an extension to Article 50, as had been formally requested. Essentially, the date of UK departure from the EU has been pushed back to October 31st 2019, although the UK can leave on the first of any month following ratification of the Withdrawal Agreement This was longer then the extension PM May had requested (and it appears President Macron fought for), but shorter than the one year extension President Tusk had proposed. There was also the additional caveat that the UK would have to leave on June 1, if it decided not to participate in the EU Parliament elections in late May.
It was interesting to watch the tone of Parliament at yesterday’s Statement from the PM. Whereas on numerous previous occasions there has been modest support from her own (front) benches and angry attacks from all other angles. Yesterday, the mood was more supportive of her prevention of no-deal and attempts at genuine cross party compromise. The notable critics were the harder line Brexiters who, having voted against the leaving the EU under May’s Withdrawal agreement on three separate occasions now seem furious that the UK has not left yet.
In our last piece we discussed the concept of third time lucky for the PM’s deal. After having been defeated the first time by 230 votes, the second time by 149 votes and most recently a vote on just the Withdrawal Agreement (and therefore not a technically a Meaningful Vote) it lost by 58. We could argue that the PM’s plan - to wear down the ideological objections at either end of the Brexit spectrum towards her compromise deal - is working. While markets appear to have written off the prospect of May’s deal passing, we are still of the view that it could be third time lucky for the Meaningful Vote on her deal - likely at the end of April, after the Easter recess.
Over recent days we have seen some more encouraging data out of China. However, while this is a helpful rebound for equities and risk assets we are far from convinced that this is a sustainable bounce. Indeed we retain the view that the Chinese recovery is more ‘L’ that ‘V’ and that the extrapolated expectations of Chinese growth on the global export dynamic must continue to be corrected - the implications being significant for Germany and beyond. Despite its modest rally over the past couple of days, we expect EUR to continue to remain under pressure.
"History will be kind to me for I intend to write it” Winston Churchill
In some respects, yesterday was a historic day in the UK Parliament, as the successful passage of the Letwin amendment, as it was affectionately known, wrested control of Parliamentary ‘business’ from the government and to Parliament. The net result is a day (Wednesday 27th March) of debate and (indicative) voting on a series of alternative courses of action to break the current parliamentary impasse. There are a series of options that are likely to come under consideration. In no particular order, they are:
(i) The revocation of Article 50. Following on from the weekend’s London protest March (which drew somewhere between 312,000 and 1,000,000 people, depending on who you ask) and the highly publicised petition, there has been a great deal of hype around this option. But while it will prove popular with the SNP, it is unlikely to attain a majority in any vote.
(ii) A second referendum on Brexit. This is potentially a more interesting proposition for parliament, as it is nowhere near as binary as the revocation vote. Indeed, some may favour the use of a referendum as a means of ratifying any Parliamentary decision. However, having been defeated in Parliament already, it is not clear that it should have gained in popularity since.
(iii) No deal. Yesterday, Theresa May effectively took a no-deal option off the table by clearly stating for the record that there could not be a no-deal exit unless Parliament voted for it. The likelihood of this gaining Parliamentary approval is very low.
(iv) May’s deal plus a permanent customs union. Customs union membership is central to the Labour Party’s Brexit strategy, providing it enables the UK to have a say in future trade deals. This is prohibited under EU law, but Labour retain the view that it could be negotiated.
(v) May’s deal plus a permanent customs union plus single market access (alternatively known as common market 2.0, or Norway plus). This is the option that has the most chance of succeeding. Indeed, this may have been a workable blueprint for a transition arrangement (and could be the back-up default for remainers). But it is unlikely to gain traction through indicative votes, as it involves following EU regulations without membership of the entities that create them, in addition to significant EU budget contributions.
(vi) Free trade agreement, or a Canada plus, as many refer to it, would involve the most flexibility to independent trade policy and maximise the benefits of Brexit. However, it does not obviate the need for a NI backstop, and for that reason it too is unlikely to get majority support in Parliament.
(vii) Theresa May’s deal.
"The choice seems to be Mrs May’s Deal, or no Brexit” Jacob Rees-Mogg
Herein lies the irony. Since the government defeat last night that diverted Parliamentary business into the hands of Parliament (and not government), there have been a number of high profile MP’s, who have previously rejected the PM’s deal openly coming to the conclusion that we have stated for many weeks now - that there are only two credible (others are possible, but significantly less likely) options: May’s deal or no Brexit.
We retain this view.
The next few days contain a number of potential pitfalls for the PM and for the government. Should a majority be obtained for an option that is not palatable for the government (revoking Article 50, perhaps) then it is not clear that the Conservative Party could continue, given the internal conflict (resignations) that would likely ensue. This is where the prospect of a General Election appears. It is worth pointing out that now a no-deal Brexit has been all but ruled out, a GE is the most negative situation for GBP, as markets fear a fiscally profligate Labour government. This would be countered in the near term by an undoubtedly softer Brexit strategy, if not a potentially indefinite halt to the proceedings.
"Silence is better than unmeaning words” Pythagoras
Against the deafening silence of the Brexit progress in Europe, last night offered financial markets an alternate topic - the prospects for US monetary policy against the current domestic and global economic trajectory. As it turned out the Fed provided not just an alternate topic, but an alternate view.
Going into the meeting last night financial markets were sanguine about the prospects for any further policy or guidance change from the Fed - recent economic data have been mixed, but set against a backdrop of rising equity markets and a loosening of financial conditions. Minutes from the January FOMC meeting indicated that there had been substantive discussions about the intentions for the balance sheet rolloff and recent rhetoric from Chair Powell made clear that there would be an announcement of new details on the balance sheet "reasonably soon”.
The statement (and accompanying economic projections - or dots), however, could be considered the fourth consecutive dovish pivot from the Fed - this time centered around the assertion that "economic growth has slowed”. The Fed announced that the monthly Treasury roll off would be halved to $15B in May, and tapered thereafter to end in September, and signalled no rate hikes this year and one next year (down from one and one). Further, the negative narrative highlighted expectations of slower household spending and business investment and an upwardly revised unemployment rate at the end of the year.
"From now on, I’ll connect the dots my own way” Bill Watterson
From our perspective it is not clear that the Fed intentionally lurched further in a dovish direction. Rather, we see that there is clearly a conflict in the communication, where the overall narrative remains that the Fed "expect the economy to grow at a solid pace in 2019”, but where concern over global growth warrants a stance that is more accommodative.
While the Fed also suggest that it may be some time before the outlook calls for a policy change - the Fed still see the next move as a tightening while the markets increasingly see it as a loosening of policy - there are two significant implications that we draw from yesterday’s decision from the Fed. The first, from a currency perspective, the knee jerk market reaction to sell the USD on a more dovish Fed is from our perspective the wrong conclusion. Against a backdrop of low currency volatility and a global economic backdrop that is being dragged lower by China and (likely by extension) the eurozone, we would expect EUR to continue to underperform the USD, as EUR remains the likely funding currency of choice for international investors and the US continues to offer significant yield.
Secondly, we feel that this further dovish pivot from the Fed has implications for equity markets and risk assets. We are of the opinion that the Fed has pushed as hard on the accommodative policy rhetoric as is possible in the near term, and that either one of two future outcomes is likely. Either the data on the US economy really does disappoint, which undermines current equity valuations, or the data is not as weak as the Fed and some recent prints suggest, and thus the market has to begin to reprice rate hikes - again undermining equity valuations. While we are more sympathetic to the second scenario, it is also worth considering the current extended level of equity market valuation and the potentially negative technical backdrop that we see currently building.
The Final Countdown?
"Don’t expect to build up the weak by pulling down the strong” Calvin Coolidge
Last week, we discussed the renewed dovishness of the ECB, as Mario Draghi delivered what is likely to be viewed in retrospect as his parting gift to the eurozone economy. The extension of the current system of targeted loan provision (even if on less generous terms) and the commitment to keep interest rates at their current ‘boundary pushing’ level was driven by a sharper, more protracted than feared slowdown in the eurozone growth trajectory - led by Germany. Further, market consensus appears firmly in the camp that a bounce back in the Chinese economy through a natural resilience and the targeted policy stimulus of the PBOC (not to mention a successful resolution to the Sino-US trade spat) will bring about a bounce in the global export dynamic, and thus in the economy. We are less convinced.
Indeed, we are more of the opinion that the Chinese economic slowdown is in fact a more protracted and intentional tempering, and that Beijing is not likely to ride to the rescue of the widening eurozone / US growth gap at any time soon. Added to the continued rate premia, we maintain our view that the risks to the EUR are firmly to the downside vs. the USD.
"There cannot be a crisis next week, my schedule is already full” Henry Kissinger
In the UK, it has been another eventful week. Last Friday we suggested that there likely needed "to be some concessions between the EU and the UK to enable the Attorney General to amend his legal opinion of the indefinite nature of the backstop” in relation to the PM’s pledge to seek legally binding changes to the agreements. As the weekend progressed, however, press commentary in relation to discussions (let alone legally binding changes) were curiously absent - at least until late on Monday evening when it emerged that there had been some agreement to strengthen the commitment enabling the Attorney General to alter his opinion:
"I now consider that the legally binding provisions of the Joint Instrument and the content of the Unilateral Declaration reduce the risk that the United Kingdom could be indefinitely and involuntarily detained within the Protocol’s provisions at least in so far as that situation had been brought about by the bad faith or want of best endeavours of the EU...However, the legal risk remains unchanged that if through no such demonstrable failure of either party, but simply because of intractable differences, that situation does arise, the United Kingdom would have, at least while the fundamental circumstances remained the same no internationally lawful means of exiting the Protocol’s arrangements, save by agreement."
It quickly became clear that while the legally binding changes were an improvement, they were unlikely to be enough to overcome the 230 vote deficit from the Meaningful Vote’s first iteration. It wasn’t. It did, however, reduce that deficit to 149. This reduction and the fact that there were some notable new backers (such as David Davis, and Sir Graham Brady) meant that the PM’s deal, though in need of significant medical attention, was not dead.
As laid out last week, failure to secure a majority for the ‘deal’ meant a contingent (and amendable) vote on No-Deal would take place. Amid much confusion over the whipping arrangements by the Conservative Party, ‘No-Deal’ was defeated - while the motion was not binding, it was a clear demonstration of the will of the House.
Finally, yesterday came the vote on an extension. Like the ‘No-Deal’ vote previously, the wording of the question is important. The government’s motion stated that - If the House of Commons has approved a Brexit deal by 20 March, then it will seek a short technical extension to end-June. If, however, MPs have not approved a Brexit deal by 20 March then the motion states that a longer extension is likely to be required and, with it, the UK would have to hold EU elections.
Yesterday turned out to be a strong day for Theresa May. All wrecking amendments to the vote (a second referendum, a series of indicative votes, and a pause and rethink) were defeated and the question was passed unamended. This is important for two reasons. Firstly it means that the PM and government retain control of the next stage of the process and secondly, the PM’s deal will come back again - potentially with some modest additions (a unilateral declaration?).
"Learn from yesterday, live for today” Albert Einstein
For many months, we have held the view that May’s deal is the most likely outcome. Despite the volatility and uncertainty, we retain this view. We also retain the view from last week that "there has been a significant reduction in the probability of a no-deal scenario”. In fact, the only other credible route for the UK to take is no-Brexit. Next week - the return of the Meaningful Vote, the EU Summit and, on the 25th March, a debate on next steps should the situation remain unresolved - will be key.
From a currency perspective, our views also remain unchanged. In fact, last week saw the negative tail risks for GBP diminish further and the upside potential for GBP, most significantly against the EUR, become less restrained.