"Try to hold on” Try, Try, Try, Smashing Pumpkins
Over the last couple of weeks we have focussed on the three main topics outside of the UK: (i) escalating global trade tensions, (ii) US monetary normalisation, and by extension the tightening impact on global capital markets and, (iii) the idiosyncratic concerns of Turkey, which are essentially a combination of i and ii amid conflicting economic and political ideologies. This week, the Turkey story has been dominant in headlines, as well as on financial market screens, across asset classes.
From the market open on Friday to its close on Monday, the Turkish Lira (TRY) fell more than 30% - to put this into perspective, GBP fell just over 10% in the days following the surprise referendum vote to leave the EU in 2016. From the start of 2018 to the extreme of this week’s decline, the currency had fallen close to 90% against the USD. In an economy with significant external financing needs and extremely limited FX protection from official reserves, the currency collapse has caused inflation to surge (now likely above 20%), investor confidence to diminish and a Presidential call for national unity against the US and its "weapons of economic war”. Local bonds have also fallen sharply. However, surprisingly, considering the acute divergence of costs to income/assets as a result of the currency decline and higher US rates, Turkish equities have remained surprisingly stable, for now at least.
Technical measures by the Turkish Central Bank (CBRT) to limit / prevent speculative shorting of the currency have given the TRY some respite this week. However, it is difficult to see how the process of limiting liquidity and market function will have anything but a negative near term implications on foreign investment, funding and ultimately the economy. From that perspective we would expect volatility to remain high. The Turkey story, while idiosyncratic, was so dramatic that perhaps the most surprising thing was the minimal contagion.
"I’m fixing a hole where the rain gets in” Fixing a Hole, The Beatles
From our perspective, the core driver of financial markets remains that of higher US rates and ultimately the extension of US rate rises beyond current expectations as a function of higher inflation, a view we have held for many months now. The underlying economic, inflation, rate differentials continue to favour the USD in FX markets, we think. However next week’s Jackson Hole Symposium is likely a key barometer of this view. The conference entitled ‘Changing Market Structure & Implications for Monetary Policy’ will be keenly watched for any signs that the volatility in emerging markets (although relatively contained to Turkey and to a lesser degree ZAR) will have any bearing on the commitment of the Powell Fed to continue normalising monetary policy. We do not expect any policy delay, filip or doubt from the Fed against a US economy boosted by the pro-cyclical fiscal stimulus, tight labour market and resurgent consumer and business investment. There is still room for the USD to appreciate.
Trade may also return to the fore next week as the US and Chinese (counter) tariffs on $16 billion of goods go into practice from next week, just as the Jackson Hole Conference begins. While there may be a further stage of escalation over coming weeks, we retain the view that the end result will be freer, fairer global trade.
"Steal the warm wind tired friend” Black Hole Sun, Soundgarden
Lastly, in the UK (much like in Turkey), we may have reached the pinnacle of uncertainty as far as Brexit is concerned. The suggestion in the press this week that Brussels is concerned a ‘no-deal’ Brexit would be more damaging to the EU in the near term (due to the size, inflexibility and single member veto of the ratification procedures, as opposed to the UK, who could adapt rules, regulations, procedures quickly and responsively), was backed up by a more cooperative stance from Chancellor Merkel yesterday. There is still a long way to go in the negotiations, and the Salzburg EU Summit will be the next important milestone, but we continue to see GBP as significantly undervalued and the balance of risks shifting back in favour of the pound.
"Dig the trench…” This Means War, AC/DC
Last week, we wrote about the potential implications for the financial markets from the effective Quantitative Tightening (QT) in the US as the Fed balance sheet reduction meets the USTR expanded issuance calendar, as a result of the Trump Administration’s fiscal stimulus - "On The QT?”. This week, it is the data calendar that is ‘on the quiet’. Against such a backdrop, financial markets are taking their cues from one major geopolitical theme and a couple of dominant idiosyncratic stories.
The major geopolitical theme is of course the increasingly concerning threat of a trade war. We have for a long time now argued that the the most likely end result of the Trump Tariffs is lower global tariffs and freer trade. This is still our central scenario. Indeed, the concessions and pledges to work towards zero tariff, zero non-tariff barriers and zero subsidies that emanated from the Trump - Juncker meeting was a step in that direction. However, the situation with China is threatening more confrontation, and thus has more sinister implications for the global economy.
This morning, rumours circulated in the market that the Chinese authorities are planning a further targeted Reserve Requirement Ratio (RRR) cut - a measure to free bank liquidity and stimulate lending and the broader economy. Furthermore, while there has been debate about the imminence of a Chinese fiscal stimulus for a while, this morning it was suggested the the amount of this (imminent?) stimulus could be up to CNY 16 trillion. To put this into perspective, this is four times the stimulus that the PBOC provided after the financial crisis in 2008. On the face of it, this huge stimulus should be a sharp positive for equities and risk assets as the injection boosts liquidity, lowers rates and reduces risk premium.
However, from our perspective, it is not as simple as that. Such a huge stimulus, following on from three (targeted) cuts to the RRR already this year, is likely more indicative of a preparation for a negative shock or protracted economic deterioration. A trade war?
"For every action, there is an equal and opposite reaction” Newton's Third Law
Perhaps the most immediate idiosyncratic story, at least from a financial market perspective, is that facing Turkey. As President Erdogan, and his son in law, now finance minister, appear to have revoked (or at least temporarily overpowered) the central bank’s independence and embarked on a tit-for-tat sanctions spree with the US, Turkish local financial markets are in disarray. Interest rates are too low (but political directive is currently a barrier to more appropriate monetary settings), inflation is rampant, while bonds (10 year yields above 20%) and the currency have gone into relative freefall. So far, there has been little contagion, but wider risk sentiment is becoming more fractious.
"Compromise is the best and cheapest Lawyer” Robert Louis Stevenson
In the UK, the dominant idiosyncratic story is also obvious - Brexit. Heightened rhetoric around the likelihood of a ‘no deal’ scenario has undermined sentiment and pushed GBP back to its recent lows. Continued presentation of commentator forecasts as ‘facts’ only add to hyperbole and uncertainty, but we retain the view that there will be some concession from the EU that will get the UK somewhere near the Chequers Compromise… eventually. From the point of view of political unity, this as an end result may not be a game changer. For GBP, we would argue, it would be. Our quant models suggest that GBP is significantly undervalued. An agreement, even one that is not ideal to anyone, removes the origin of uncertainty.
This morning’s announcement that the UK is said to see the Brexit deal deadline slipping to the end of November is interesting, but perhaps not unsurprising (David Davis had suggested this before his departure). It has been confirmed that Brexit is on the agenda for the EU mini-summit in Salzburg, on the 20th September, and we expect that there will be signs of the possibility of flexibility from the EU. In this regard, as Lord Hague discussed in the Telegraph today "France is the key to a credible Brexit deal, and it is in Macron’s interest to make it happen” - hence the full court press from May, Hammond and Hunt over recent days. Despite his plummeting popularity at home, we would agree that he is likely the key figure in the Brexit debate.
The first release of the Q2 GDP figure for the UK will likely show that the UK grew faster than the eurozone over the period - contrary to the claims of many commentators. We are not so bold as to suggest that there are no risks for the UK or for GBP at this stage, but from our perspective, the balance of those risks is increasingly out of line with popular perception and increasingly edging towards the positive.
"On the qt” [19th century British origin]: meaning - on the quiet
Over the the course of this week, we have had monetary policy updates from the Bank of Japan, the Federal Reserve and the Bank of England and an escalation of the global trade spat - which is now concentratred on the relationship between the US and China, following the Juncker concession last week. However, we would argue that it is none of these factors that have dominated the tone to FX markets this week. From our perspective, it is the near subliminal process of Fed balance sheet reduction (albeit this does not currently require any selling of bond holdings) and the announcement this week of the (significantly larger than expected) US debt issuance figures. The increase in bond supply and Fed balance sheet reduction add up to quite a significant Quantitative Tightening (QT), even if it is essentially on the qt.
Following on from the Bank of Japan, which we discussed earlier this week, market expectations going into the Fed meeting were very low. They were not disappointed. Outside of the date and voting members, there were just two minor adjustments to the text. The first was a modest upgrade to the assessment of strength of household spending and a marginal upgrade to the confidence in the labour market.
However, the USD is in something of a win-win-win scenario against the current backdrop. While the market focus is aimed at the macroeconomic backdrop, the US growth and by extension interest rate differentials are clearly in favour of the US. If that focus shifts to the fiscal backdrop, the US issuance story likely adds to pressure on US rates, at best shielding the USD from the negative connotations (at least while growth is accelerating - Atlanta Fed nowcast puts the current growth trajectory of the US economy at 5.0%). If focus turns to geopolitics and trade, then while a deterioration likely sees safe haven USD flows, a resolution likely sees lower trade tariffs that would benefit the US disproportionately. Nothing in a financial market sense is ever that simple or without risk. However, we are increasingly positive the USD.
"Walk this way, talk this way” Aerosmith, Walk this way
In the UK yesterday, it was the turn of the Bank of England and Mark Carney. On the face of it, one may have expected the announcement of a 25 bp rate hike to be something of a non-event, after all, markets had centred their expectations on a rate hike to such an extent that the implied probability had exceeded 90% - duly delivered. The fact that the vote was 9-0 in favour of raising rates would have raised an eyebrow or two, and the improved forecast for growth in 2019 was a further positive progression. GBP rose modestly. And then came Mark Carney.
Having previously been described as an unreliable boyfriend for seemingly misleading markets with mistimed, or misplaced prophecies, Mark Carney’s testimony following the rate rise was closely watched. Despite noting the fact that UK construction is currently expanding at its fastest pace in 2 years, retail sales expanding at their fastest pace in 3 years, not to mention reduced slack and the lowest level of unemployment in 42 years, Mark Carney was notably (intentionally?) downbeat. He said that the pace of rate rises in the UK need to "walk, not run”. However, as the BoE walk rates up, Carney appears intent on talking the UK economy, and GBP down.
For today, the main focus for financial markets will turn back to the US for the July employment report. Following the stronger than expected ADP report earlier in the week, expectations are for around 200k headline job gains and for the unemployment rate to edge back below 4.0%. However, as we have increasingly noted over recent weeks, inflation is, in our view, the biggest potential driver for the USD and for FX going forward. Expectations for the wage inflation component are to remain steady at 2.7%. As labour market slack continues to erode, we expect this number to rise above 3.0% over coming months. Underlying inflation pressures in the US may be acting on the qt at the moment, but we expect them to become a lot more audible. Perhaps very soon.
"Governors compete...People and businesses decide” Doug Ducey
Last week, we discussed the fact that in the fixed income markets there had been another dominant dynamic - outside of the movements in underlying sentiment towards risk - impacting global yields. On the basis that reports had emerged that the Bank of Japan (BoJ) may modify its yield curve target at its upcoming meeting (31st July), the response of markets had been synonymous with the prospect of the BoJ moving towards monetary normalisation. However, we were clear to point out that this was not our view. Indeed, we went on to state that any change to policy would more likely be "an adjustment to policy that enables continued (or even extended) monetary easing, rather than the first step on the path to tightening policy”. In essence this is what the BoJ delivered.
Retaining the pledge that interest rates would remain very low for an "extended period of time” (adding forward guidance), the BoJ and Governor Kuroda, pledged to double the "flexibility” of the 10 year 0.0% yield target - but to act promptly in the case of a rapid rise in yields. Furthermore, the BoJ offered concessions on bank profitability concerns by reducing the amount of bank capital to which the negative interest rate applies and addressed capacity constraints by further diversifying / increasing ETF limits towards Topix, from Nikkei. Kuroda added to the dovishness of the adjustment by refuting the inference to "the limits of monetary policy” and stressing that the combination of amendments increases the commitment to easing policy longer. Forward guidance, it seems, will be used as a tool to deny any exit speculation.
With no press conference after the FOMC meeting tomorrow night it is unlikely that there will be noteworthy amendments to the Fed policy statement or commitment to gradual monetary normalisation. It is likely therefore that the US yield curve will be influenced to a greater degree by this weeks PCE (Est. 2.3%, upside risks?) and employment report (where signs of wage pressures are long overdue). Upside surprises in the eurozone inflation data this week may be a precursor to broader price pressures. The difference being that with growth in the US running above 4%, the sensitivity of interest rates is far greater than in the eurozone where growth is closer to 1% (on a similar basis) and disappointing expectations.
"People’s minds are changed through observation not through argument” Will Rogers
In the UK, the Bank of England may bring action where others bring words, as a 25bp rate rise to 0.75%, is almost fully priced by the market. The perennially dovish Mr Carney is unlikely, however, to offer overly enthusiastic projections for growth and inflation going forward. While the rate rise is made possible by further evidence of the transience of the Q1 economic slowdown, recent inflation data has shown the pass through effects from FX have ‘passed through’ quicker than expected - thus tempering the urgency of a follow up rate move.
From a political perspective, we retain a positive bias - increasingly, relative to the declining sentiment / expectations over recent weeks. However, the suggestion that Barnier has softened his objections to a financial services deal based on equivalence (proving access to the Eurozone markets on a similar basis to that of New York, Singapore or Zurich) is a clear positive. We anticipate that there will be some further positive movement towards a deal over coming weeks. GBP, having been undermined by the falling sentiment is likely to find a firming footing in FX.
Last week, we also discussed the earnings release disappointment from Facebook and suggested that the market response (falling somewhere in the region of 20%) was significant enough that it is likely to be remembered as a significant watershed. Today, after the US equity market close (around 21:30 UK time) we get the Q3 earnings report / guidance for Apple. The business model, tangible earnings flows and huge cash generation of Apple mean that that a drop akin to that of Facebook (where valuations are in large part based on extrapolated user growth / monetisation projections) is extremely unlikely, but a disappointment will resonate. In light of our view that inflation outperformance (US led) and subsequently more protracted US interest rate hiking cycle, equities are likely to underperform in H2. It may be less Apple Pie and more Face ‘plant’ but equity valuations are a key risk to watch going forward, from our perspective.
In a foreign exchange context, there are some interesting connotations from this week’s events, releases. While the bounce in USDJPY is justified by our views on the relative divergence of respective monetary policy trajectories, the backdrop for risk assets is more troubling. Therefore, we would be more comfortable selling into rallies above 112.00 in USDJPY, that being outright long. Ultimately our views of USD (and GBP) outperformance remain - outside of the potential distortions of month end rebalancing flows. Signs of US inflation and / or a more troubling backdrop for equity markets, however, would likely see the USD on the front foot on a more protracted basis.
"I must be cruel only to be kind” Hamlet, William Shakespeare
After a relatively quiet start to the week, things are beginning to hot up - and I’m not talking about the uncharacteristic UK summer. Tomorrow, market focus will return to economics, and the growth trajectory of the US economy, with the Q2 GDP release. Amid an economic growth spurt, exacerbated by the procyclical stimulus and resultant business investment, official expectations range as high as 5.4% - levels not seen (and even then only briefly) since Q3 2003. Central expectations are for a more modest (in a way that is very much the envy of the developed world) 4.2% annualised. From our perspective, the risks to the upside for US growth, inflation and the USD are underpriced by the markets at the current juncture.
Last night, the President of the European Commission, Jean-Claude Juncker, met the President of the United States, Donald Trump, with the aim of resolving (at least the EU-US leg) of the current global trade spat. It was clear from the press conference that one President was happier with the outcome than the other, but essentially the meeting could be deemed a success for both. In essence, it was agreed that there would be no further escalation of tariff or non-tariff barriers - at least while discussions are ongoing - with the aim of reaching agreement in a few key areas.
Firstly and most significantly, the Presidents agreed to work towards zero tariffs, zero non tariff barriers and zero subsidies on (non-auto) industrial products, in a move Trump declared as a "victory for free and fair trade”. In addition, the EU agreed to import more US soybeans and invest in the infrastructure to import US LNG, a "strengthening of our strategic relationship with regard to energy”. Discussions would also extend to reform of the WTO, and the active assessment of areas to further reduce tariffs and trade restrictions (as well as seek opportunities to further reduce the trade deficit between the US and the EU).
In many respects, the biggest implications from last night’s EU, US meeting outcomes are not for the EU or the US, but for China. The repositioning of the EU from the shoulder of China to the clubhouse of the US is in itself significant. The pledge to work with the US to reform the WTO - with specific reference to IP rights, fair trade and overcapacity - is likely more stinging. From our viewpoint, China talks and concession will likely follow soon.
In that regard, ECB President Draghi was clear to state that it was too early to comment or assess any progress in global trade concerns as a function of the Trump / Juncker agreement. Indeed, as far as ECB meetings are concerned, today’s offered very little from a market perspective. The commitment from the June meeting to taper asset purchases into the year end and maintain interest rates at current levels through the Summer of 2019 remained unchanged. Draghi’s urging of national governments to enact structural reforms, remained unchanged. In fact, other than the insight that the ECB see underlying (or core) inflation at current levels (sub 1.0%) for the rest of the year and the reference to above trend growth at the start of the year as due to an "unusual performance on exports”, were the only modest moot points. The ECB and the EUR are likely a static function. The key focal point for markets should likely be the US trajectory and the implications of relative growth and interest rate differential paths.
"Additional easing might be needed…” BoJ Harada (July 2018)
Lastly, in the fixed income markets there has been another dominant dynamic - outside of the movements in underlying sentiment towards risk - impacting global yields. Last week, reports emerged that the Bank of Japan (BoJ) may modify its yield curve target at its upcoming meeting (31st July). The response of markets has been synonymous with the prospect of the BoJ moving towards monetary normalisation. This is not our view. If Governor Kuroda signals any change to policy (and it is not clear that he will), it is more likely that it is an adjustment to policy that enables continued (or even extended) monetary easing, rather than the first step on the path to tightening policy. If we are right, then JPY and Japanese yields likely become vulnerable.
"Can the end be at hand?” Face[book?] in the Sand, Iron Maiden
While the Trump, Juncker meeting signalled a ceasefire (at least temporarily), the positive implications for equities and risk assets was muted by the disappointing and unexpected weakness of Facebook’s earnings release (unexpected at least by some - though substantial share sales by Zuckerberg and several board members over recent months argues that not everyone was surprised). Shares fell by up to 24% in after-hours trading as sales and user growth numbers were hit by a "Failure to safeguard private data and changing rules for advertisers”.
From our perspective this is likely to be remembered as a significant watershed. The FAANG stocks have been the core driver of equity (and even US equity relative) outperformance over recent times, just 3 of which account for 70% of 2018 YTD gains. The fact that lower earnings guidance can induce a drop of a quarter of the stock value (more than $150 billion) in 1 day, will raise more than just eyebrows. Our view remains that the dominant force in financial markets for the rest of 2018 is that of higher US rates, underpinned and reinforced by rising inflation. Against this backdrop, and the portfolio revaluations that will land on a number of desks this morning (or on line for individual investors), we expect a more cautious, defensive, even negative tone to equity markets to evolve. The start of the end of the equity market rally?
Casus belli: (Latin) - an act or event that provokes or is used to justify war
For financial markets, there is a very ‘summer market’ feel to proceedings. Participation, conviction and implied volatility remain low and unresponsive. However, there are a number of undercurrents - political, geopolitical and economic - that continue threaten potentially seismic (although hopefully not literally) impacts. We would argue that it is still a little early to start tying knots in your handkerchief just yet.
"I’m free to say whatever I…” Whatever, Oasis
In the US, the President Trump’s foray into US monetary policy late last week was, on the face of it, a worrying development. The recent decline in the Turkish Lira (TRY) is testament to the negative connotations (and implications) of questioning central bank independence. It could be argued that the boundary between fiscal and monetary policy remits was blurred by the financial crisis and resultant QE policies and that the process of normalisation will have fiscal implications. Trump’s complaints are likely to hold little sway with a Fed that under Powell appears to be more confident and mechanical in returning rates to neutral, amid a current growth trajectory of around 4%. However, he is also unlikely to be the last political leader to question their central bank, as the rest of the world begins to normalise. His comments on currency wars are likely to ruminate further.
Over the weekend, the G-20 (finance ministers and central bankers) meeting in Buenos Aires came hot on the heels of Trump’s threat to impose tariffs on $500B (essentially all) Chinese imports to the US, not to mention the accusations of currency manipulation aimed directly at China and the EU (though I presume this meant the eurozone and the EUR, and not necessarily Sweden SEK, Denmark DKK or the UK GBP too). However, while the threat of trade war and by extension currency wars is a non zero probability event, it is certainly not our central scenario. Indeed, the mainstream global press were so busy reporting on the confrontational and protectionist rhetoric that they omitted the fact that the US opening offer to the G20 (not for the first time) was a ‘free’ trade deal (it seems to little response) - and that investors should not be worried about a currency war.
In the UK, the Brexit debate continues to take centre stage, following a poll in the Sunday Times which suggested that the public support for Theresa May’s ‘Chequers Plan’ was viewed as "Good for Britain” by just 12% of respondents. Perhaps more significantly, the poll suggested that 38% of respondents would vote for a new party on the right that was committed to Brexit. We do not view the more aggressive approach from Dominic Raab (no trade deal, no exit payment) appearing on the same day as the poll’s release as a coincidence.
From an economic standpoint, while many commentators noted the disappointing retail sales print for June, fewer noted that the from a quarterly perspective the gain was its biggest in over 10 years in Q2. With the employment rate up to its highest level since comparable records began and the public sector finances in their best state since before the financial crisis, the Bank of England appear set to raise rates 25bps at the Quarterly Inflation Report (QIR) month meeting, on the 2nd August (market pricing is over 85%). GBP is still significantly undervalued on all our valuation metrics.
While we are of the view that the recent decline in CNY is more the market dynamic than intervention the price action of the CNY is having a significant (extrapolated) impact in FX markets and risk assets as it is driving both risk and USD sentiment. In the medium term, we think it unlikely that China will desire, let alone facilitate, a weaker CNY, and once the psuedo-easing implications of measures taken to ease stress in the Chinese credit markets, CNY will likely begin resume its underlying positive bias vs. USD.
As the week progresses, markets will pay keen attention to the eurozone PMI data ahead of the meeting between Trump and Jean Claude Juncker (and the ECB on Thursday). Lets hope there is more focus on the prospect of free trade and no casus belli.