"Infamy! Infamy! … They’ve all got it in for me” Kenneth Williams, Carry on Cleo
The week since we last wrote, has been the epitome of Harold Wilson’s ‘long time’. At the time, at the start of the parliamentary debates on the Withdrawal Bill we were of the opinion that MP’s were "beginning to converge (reluctantly from many corners) around the May deal”. While the eventual vote on the deal resulted in the biggest government defeat on primary legislation in history (202 vs. 432), and a subsequent and successful defence of a no-confidence in the government, we are still of that opinion. We retain the view that the only way forward is for Parliament to converge around an amended form of the deal.
Following the successful defence of the no-confidence motion in the government last night, Theresa May has stepped up her commitment to reach across all parties (this time inclusive of the leaders of the main political parties - although Jeremy Corbyn has thus far declined the offer) in order to find a ‘plan B’ that could get the support of the House. However, at this stage at least, it seems that Theresa May’s offer is one of open discussion but not of concession - her pledge to honour the result of the referendum means that opposition party suggestions of another referendum or another election likely face short shrift.
Perhaps the most interesting development development in the Brexit saga, however, occurred this morning. The Leader of the House of Commons, Andrea Leadsom has told MP’s that the government will table a motion setting out its proposed next steps - as required by the ‘What Next’ amendment to the Brexit motion that the government lost last week (308-297) - on Monday 21st. Further, Leadsom announced that the debate on that motion, and the following votes on plan B options, will then take place on Tuesday January 29th. This, and the fact that the motion will be ‘amendable’ means that MP’s can table amendments and that those amendments will be voted on - essentially the process of indicative votes that many have been asking for, and that could ultimately narrow the debate to ‘passable’ options only.
"Avoid popularity if you would have peace” Abraham Lincoln
Last night put paid, at least in the near term, to one of the most concise demands from one side of the House - a General Election. The other demand, that dominates any debate in the House is the prospect of a second referendum. This morning’s updated ‘business’ announcement provides the potential for an indicative vote on the prospect of a second referendum. We think that such an amendment would fall well short of a majority. If this proves to be the case, and the next couple of weeks remove the threat of a General Election and a second referendum, then ‘all’ MP’s will have to start to focus on a way forward - not a way back. It is at this point that we feel there will be a more meaningful convergence around a deal.
Lastly on the UK, the recent survey from YouGov makes interesting reading - unless you are Jeremy Corbyn - showing that the Labour leader’s popularity has sunk to just 20%, while PM May’s has risen to 38%. Despite her (at times overwhelming) defeats she appears to be doing something right in the eyes of voters. Corbyn is now less popular than May with ‘Remainers’ and less popular than an alternative to Labour voters (46%). As he struggles to find a Brexit strategy that does not alienate the pro and anti EU halves of his electorate it is likely that he becomes more marginalised in the debate. Peak Corbyn may well have been the 2017 election campaign.
Amid the Din from Parliament Square, there were some significant comments from Europe yesterday. ECB President Draghi opened the rhetoric with the assertion that "uncertainties, especially global risks, remain prominent” that there is "no room for complacency” and that "significant stimulus is still needed”. In addition to these broad comments, Draghi was also clear in the narrative that while the euro area is not heading to a recession, the expansion is happening at "lower and lower growth rates” and that the slowdown could be longer than expected.
With Banque de France Head Villeroy stating that the recent protests are likely to have a big short-term impact on the French economy and proclaiming that the US economy is more resistant than markets think, EURUSD extended its decline from the risk rally highs above 1.15. In the near term, we are sympathetic to the view that equities and risk assets can remain supported by the recent dovish pivot of the Fed - likely restraining this theme. However, such sentiment, particularly in light of our more medium term cyclical views that the US economy continues to grow above trend and that monetary normalisation resumes. EUR underperformance can also resume - both against the USD and, once the near term uncertainties calm, GBP.
"Defying the laws of gravity” Don’t Stop Me Now, Queen
It is perfectly possible that we are already past the acceptable period for wishing all a very Happy New year but I will do so anyway, and so far, at least as far as risk markets are concerned, it has been happy indeed. Since the turn of the year, the Nasdaq and Italian FTSE MIB have risen close to 5%, and the Brazilian Ibovespa - fuelled by excitement for the prospect of credible and determined reforms - around 6.5% (to record highs). Oil, aided by the implementation of the OPEC production cuts has risen over 20%, into a Bull market! If we look back at last year, 2018 began with a sharp rally in risk assets reflecting optimism over a more concerted global growth trajectory, a procyclical US fiscal stimulus and contained inflation backdrop. It ended with concerns of concerted global economic slowdown, declining earnings forecasts, and fears of excessively restrictive US monetary policy just as Sino-US trade tensions had already dented the global export dynamic.
As we begin 2019, there is one dominant story - the dovish pivot from the Fed. In our last post in 2018, the Fed, had just raised its Fed Funds target rate to 2.25% - 2.50%, accompanied by a barely changed statement and a press conference, where Powell maintained a bullish descriptive narrative of the (then) current economic momentum. While the Fed cut its projection of the expected rate path (median dots suggested 2 hikes in 2019, down from 3 in September), this marginal lowering of the terminal funds rate was nowhere near the dovish pivot that the market (spurred by Trump and a number of famed investors) had expected - S&P fell a further 10% over the following few days.
"There is a pride in speaking this language” Bernard Pivot
However, last Friday, following a very impressive US employment report for December and a RRR cut from China, Fed Chair Powell delivered the dovish pivot that the market had been hoping for on December 19th (the S&P is now back to the level it was on that day). So what happened?
Yesterday saw the release of the minutes from the meeting, and despite the dovish headlines released by the newswires - "many officials felt the Fed could be patient on further hikes… saw extent, timing of future hikes as less clear...a few officials favoured no rate hike at Dec. meeting… some officials noted downside risks may have increased” - the full minutes highlight a very strong economic backdrop. (labor market conditions continued to strengthen... real GDP growth was strong...Survey-based measures of longer run inflation expectations were little changed on balance... Job gains were strong... The national unemployment rate remained at a very low level of 3.7 percent… Industrial production expanded, on net, over October and November...Household spending continued to increase at a strong pace in recent months... Real PCE growth was brisk...Growth in real private expenditures for business equipment and intellectual property looked to be picking up solidly in the fourth quarter after moderating in the previous quarter…).
However, the minutes do highlight a rising concern of the financial situation - "Investors’ perceptions of downside risks to the domestic and global outlook appeared to increase over the intermeeting period, reportedly driven in part by signs of slowing in foreign economies and growing concerns over escalating trade frictions.” This is the core of the issue. There is a clear dichotomy between the financial cycle and the economic cycle. This issue is not going away.
In the near term, we expect the bounce in risk assets to continue, as positive progress from the US China trade talks continues, as the most uncertain Brexit scenarios become less likely (more below) and a more dovish global monetary iteration supports liquidity and risk. In the medium term, we expect the continued economic strength in the US to drive tighter monetary conditions and for worsening valuation metrics to weigh. In short, we see risk assets as a sell on rallies, and the USD a buy on dips - but not just yet.
"A week is a long time in politics” Harold Wilson
In the UK, we are approaching peak volatility - at least in terms of political headlines. However, we are also, from our perspective, beginning to converge (reluctantly from many corners) around the May deal. Over recent days we have seen the government defeated in two votes (plus the non-binding Grieve amendment) that effectively put paid to the credibility of a no-deal Brexit - at least by design (though it could still happen by mistake).
At the same time, there has been a rise in the discussion, if not the likelihood, of a second referendum, and even a general election. While we maintain that both of these events remain unlikely, the combination of factors will at least at the margin edge some of the (less committed) backbench Tory Brexiteers towards the relative safety of May’s ‘compromise’ deal. Furthermore, following the Brexit speech from Jeremy Corbyn this morning that clearly stated the Labour policy of a General Election at any cost, followed by the pursuance of a Labour Brexit (soft, but still a Brexit - not remain or a referendum) by means of "urgent negotiation” with the EU, based on remaining in a customs union, it is possible that some Labour MP’s that represent ‘Leave’ constituencies may also align with May’s compromise.
The words of Harold Wilson may never have been more pertinent as we approach (at least the first iteration of) the Withdrawal Bill vote on the 15th. Debates will be diverse, vigorous and if recent sessions are a guide, conducted well below the minimum level of decorum one should expect from the House of Commons. GBP upside remains significant, but in the near term volatility remains high.
"...after a while i stopped to rebel” Biggest mistake, Rolling Stones
Since our last post, there has been something of a rotation of the dominant factors driving the global macroeconomy. The predominantly political factors that have heightened attention and volatility over recent months have remained, but as we move towards the end of a very complex and diverse year for financial markets, the past week has been dominated by the monetary policy trajectory of those central banks deemed most dominant for global financial markets - and more specifically how that trajectory has been altered by the evolving economic and geopolitical backdrop.
Last week we discussed the latest assessment of the internal and external backdrop from the ECB and how despite stating that the balance of risks were "moving to the downside”, that the ECB confirmed their plan to end their QE programme in 2018. Over the coming months, markets will be closely assessing whether the ECB’s decision to end the monetary accommodation of its QE programme into a near concerted global slowdown was a policy misstep.
In the buildup to last night’s US rate decision, there had been a near crescendo of rhetoric from analysts, high-profile investors and even President Trump, suggesting that it would be a mistake for the Fed to raise rates, despite the fact that the market implied probability for a rate rise was around 70% going into the event. The premise of the argument against raising rates was varied. President Trump emphasised the implications for the equity markets - long heralded by his administration as a barometer of the success of his economic policies. From other corners, however, the warnings were more credible: from the sharp deterioration of the global export dynamic to rising tensions in credit markets, not to mention the deflationary impact of the recent very sharp decline in oil prices. A slowing global growth dynamic, it was argued, had seen sufficient tightening of financial conditions (higher credit spreads, lower equities and a stronger USD) and thus rates should be put on hold.
"Till I reach my highest ground” Red Hot Chilli Peppers, Higher Ground
From our perspective, however, we were - and still are - a little way away from a Fed pause. Powell acknowledged that inflation was ending the year more subdued than expected and that some cross currents have emerged since the September FOMC. However, Powell signalled that those developments had not fundamentally altered the outlook. Indeed, while the FOMC projections (the ‘dots’) show a modestly lower path for Fed Funds than in September (2 further hikes in 2019, from 3 in September), the lower dot plot should support the continued "strong economy”.
If global economic deterioration and weakness in credit and equity markets continue, we would anticipate that the Fed will pivot further towards pausing policy. However, the worst thing the Fed could do would arguably be to adopt an immediate dovish bias based upon the extrapolation of the current (and in many cases only very recent) weaknesses. That would only act as to increase volatility. Indeed, if, as we expect, the idiosyncratic weakness in Germany and Italy are corrected in Q4/Q1 and the impending China fiscal stimulus has a positive effect early in 2019, then the global economy will appear on a much firmer footing.
Further, the Fed have reiterated their determination to get rates to, or as close to an immeasurable target as is possible, before becoming more fully data dependent - which may or may not imply a pause when they get there. For us, that is at the very least after a further 25bp hike in March - and possibly another in June. In the approach to equilibrium the Fed are clearly trying to give themselves greater optionality around monetary policy, removing forward guidance, widening the gap between the IOER and the top of the target range. With strong growth, inflation at target, a tight labour market and rising productivity and wage growth, the mistake would have been not raising rates.
"Help them fall back in this cycle” End of the Beginning, Thirty Seconds To Mars
"Power is like being a lady... if you have to tell people you are, you aren't.” Margaret Thatcher
After realising that I hadn’t posted for a couple of weeks, and rereading the most recent posts, perhaps the biggest surprise is that while there has been an intensification of focus around familiar points, little has changed.
From a geopolitical standpoint, the dominant factor for the global macroeconomy - specifically the global export dynamic - remains the China - US trade debate. It could be argued that the situation has progressed from standoff to negotiation, and the reality is that there are more clear pledges from the Chinese authorities, not just to row back on the confrontational and emotive ‘Made in China 2025’ strategy, but also to work to resolve the trade surplus through increasing imports from the US. However, from an economic perspective any changes will likely take some time to filter through into increased global trade flows (and more balanced - US recorded its biggest trade deficit since 2008 in October). From a financial markets perspective, the improved risk sentiment as a function of Sino-US cooperation has been undone by further clarity of slower global economic momentum.
In the eurozone, the progress made in the Italian / EU disagreement on fiscal prudence - which now appears to have reached the compromise of a 2.04% fiscal deficit target for 2019 - has been countered by the French movement in the opposite direction, as Macron rolls back reforms and tax hikes in the face of the ‘gilets jaune’ movement. Theresa May appears under intense pressure in the UK parliament, but her public approval rating is significant more than twice that of M. Macron.
"Everyone thinks of changing the world but no one thinks of changing himself” Leo Tolstoy
Which brings us neatly onto Brexit. Regular readers will likely be aware of our thoughts on this matter - that the Theresa May deal is likely the only possible way to deliver Brexit. As Philip Hammond said in the Parliamentary debates on the matter, Theresa May’s deal "minimises the economic disruption and uncertainty, while maximising the opportunities for our nation”. These debates, however, were subsequently suspended to allow the PM (after a brief detour to rebuff a weak coup attempt) to seek greater assurances from the EU over the transience of the backstop within the Northern Ireland protocol.
From our perspective, the overriding issue is one of compromise and reality. Under the current Parliamentary arithmetic, Theresa May’s plan - the agreed Withdrawal Agreement and Political Declaration on the Future Partnership - have two distinct groups of detractors from within government and its allies. The first is the Brexiteers, who favour a clean break from the EU and subsequent FTA negotiation. The issue here is the potential for near term disruption (not least for UK and global financial markets - WTO would be the worst possible outcome for the city of London), and for this reason, such a plan will not attain sufficient support to pass through Parliament. Secondly, there are those who unwaveringly support a second referendum - predominantly with the view to engineering remaining in the EU. This plan does not have the numbers to pass through government (however, it is possible that it could command a majority of Parliament). Lastly, the official stance of the opposition is to leave the EU, but only far enough to commence a fiscal loosening so large (and potentially so damaging) that it would not be allowed under EU rules - for all other practical purposes, including the inability to enter into external trade deals, the UK would still be ‘in’ the EU. May’s deal remains the only credible, passable deal on offer. She may need a tangible concession or assurance from the EU on the transience of the backstop in order to give conservative MP’s the ability to compromise, but we remain of the view that this will be the ultimate outcome.
"Let me show you the world in my eyes” Depeche Mode
From a global monetary perspective, there has also been little change over recent weeks. Towards the end of November, financial markets reached the consensus that the US Federal Reserve had pivoted towards a more dovish monetary stance, the rationale being based on the fact that the US is approaching the equilibrium level of interest rates, against a backdrop of a slowing global economy. We agree with the argument to this point. By extension, and given the rhetoric suggesting a more data-focussed Fed, the market began to price out expectations of future rate rises. At the margin, we may have agreed with this sentiment if markets had at that point been pricing a similar amount of rate hikes that the Fed itself expected to invoke (25bps in December, and another three 25bp hikes in 2019). In reality, the market is now pricing in only 14bps of rate hikes for the Fed in 2019 (against Fed expectations of 75). Further, if the Fed focus shifts towards more data dependence, we are of the view that US economic momentum is sufficient to to warrant hikes in December, March and June, before potentially pausing or slowing future expectations. Against this backdrop and a significantly more subdued market risk appetite, we continue to favour the USD in FX markets.
This afternoon, it was the turn of the ECB to give its latest assessment of the internal and external backdrop facing the eurozone. Draghi edged the ECB assessment of the risks faced by the region lower, stating that the balance of risks were "moving to the downside”, while continuing to be "broadly balanced”, amid "somewhat slower growth momentum ahead”, and a lower inflation trajectory. The balance of lower inflation and downside growth risks (softer external demand) remain a negative for the EUR. However, considering the fact that financial markets have now all but priced out ECB rate rises over the current cycle, there is likely minimal market impact in the near term.
The one specific development from the press conference was the introduction of enhanced forward guidance (EFG) that accompanied the process of ending asset purchases (as scheduled) at the end of this year. The EFG in its current state is the pledge to reinvest maturing assets (maintaining existing denomination) until beyond the point that rates rise. While this is new for the ECB, it is nothing new if we look at the precedent set by other central banks - both the Fed and the BoE pledged to maintain the stock of QE assets until interest rates have / had started to rise. Against this monetary and global macroeconomic backdrop, we expect the EUR to resume its underperformance into Q1 ‘19 against the USD and, if a compromise is found, most significantly against GBP.
"If only I don’t bend and break” Keane, Bend and Break: Hopes and Fears
Against a backdrop of rising uncertainty and falling asset prices, there are a surprising number of significant focal points for financial markets at the current juncture. At the forefront of sentiment and headlines in the UK, the Brexit debate appears to be reaching a crescendo. While the backbench revolt from the ERG through the 1922 Committee has, for now at least, come up short of the 48 letters required to attempt to remove Theresa May, the next few days are crucial to the continued premiership of Mrs May, the lifespan of the Withdrawal Agreement in its current (if modestly amended) state, and perhaps even the reign of the Conservative Party.
Writing in the Telegraph today, Dominic Raab highlighted the three points that he felt he could not be party to - the same three points that a broad array of MP’s (from all corners of the House) have specific concerns with. The first is the Northern Ireland backstop, that if used could see Northern Ireland facing additional regulatory requirements compared to the rest of the UK. What we would argue however, is that under such a scenario, NI would also have a greater access than any other part of the UK to both markets and thus its designation as a Special Enterprise Zone could perhaps balance the loss with a (potentially significant economic) gain. The second is the fact that the exit from transition without the invocation of the backstop requires mutual consent - effectively giving a veto to the EU on UK plans to exit transition.
Thirdly, Raab points to what he describes as a late concession in the text setting the basis for the Future Relationship to "build on the single customs territory” set out in the backstop. While we have specific concerns with the first two points, there are some signs that discussions may ultimately include a technology-based alternative to the backstop - not to mention the fact that it is unlikely that the EU would wish to retain the UK in a position where it would effectively maintain its access to the single market while not complying with the four freedoms. The third point is potentially more troubling, however, and the detail or context is key. Our interpretation of Chequers was that it aimed to provide a mechanism for medium term change, initial convergence followed by managed gradual divergence through a ‘common rulebook’ - accepting that divergence may come at a cost. If this is the ‘starting point’ then it can still be deemed compatible with Chequers. This was referred to in the House of Commons (PMQ's) today as "balancing market access today with freedom to diverge tomorrow".
"So much of design is context” Steve Madden
From our perspective, the Political Declaration is key, not just to deciphering the starting position and intended direction of travel, but also the commitment of both sides to reach an end point that avoids the backstop and all the negative connotations that this brings. French demands for access to UK fishing waters and Spanish demands over Gibraltar are unlikely to derail proceedings. A failure of the Declaration to allay the three concerns above are a significant concern. However, we remain of the opinion that the Withdrawal Bill will ultimately pass through parliament and in order to do that it is critical that the PM / Brussels demonstrate sufficient mutual interest to prevent the UK from being left in a ‘vassal’ state or addendum to the EU indefinitely.
On a wider UK context, ex-Bank of England MPC member David Miles gave an interesting account of proceedings this morning in suggesting that the order of magnitude of the economic implications of Brexit medium term are ~ /-2-3% GDP (though we would argue that the longer-term positives are higher), but that the economic implications of not addressing the UK’s productivity challenge are more likely in the order of magnitude ~ /- 20% of GDP.
This week, the IIF’s Robin Brooks published an interesting paper that challenges a dominant view on financial markets about the eurozone current account surplus and its implications for the relative valuation of the EUR and thus its theoretical forward bias. "Many see the Euro Zone current account surplus as a sign the Euro is too low & should rise. But the surplus reflects large output gaps on the periphery. Once you adjust IMF gaps for that and factor in recent Euro strength, the current account is negative!” Robin Brooks, Twitter
The implication of this analysis is that the EUR is over, not under-valued. Against the current backdrop of a (potentially troubling) slowdown in eurozone growth momentum, this reinforces our near term negative EUR bias - particularly vs. GBP.
"I hope the tears don’t stain the world that waits outside”
Where Did It All Go Wrong, Oasis
Last week, we suggested that through the noise and hyperbole from participants and commentators, fuelled by the emotive and binary nature of the context, that we continue to believe that there will be a deal between the EU and the UK on the Withdrawal Agreement. This week, with the full focus of the world’s financial markets (and other interested parties) upon the UK, the PM attempted to agree a procedure for facilitating transition and avoiding a no-deal Brexit. While this was never going to be an easy task, the situation that followed was disappointing on many levels.
Following the agreement between UK and EU negotiators on a basis to underlay the process for negotiation of a future trading agreement - the Withdrawal Agreement, the Cabinet meeting to ratify the deal ended in an incredible display of criticism and discourtesy from both sides, and later from all corners of the house. "It is clear, Mr Speaker, that Brexit is bad for Britain” echoed from the chamber. From our standpoint, however, it is the political process (and perhaps even its protagonists) that are acting in a way that is ‘bad for Britain’. All but a few questions criticised May’s plan to enable talks on a future trade relationship. None offered credible alternative.
"When you strip away the detail, the choice before us is clear: this deal, which delivers on the vote of the referendum, which brings back control of our money, laws and borders, ends free movement, protects jobs, security and our Union; or leave with no deal, or no Brexit at all.” - Theresa May
We have no overwhelming concerns with the proposition as it appears. However, the concerns of Parliament (and the source of several resignations, including Brexit Secretary Raab) are threefold (i) that the backstop (if entered into at all) requires NI to comply with certain regulations of the Acquis covering goods, that are seen by some as placing a de facto regulatory border between NI and the UK and thus undermining the constitutional integrity of the UK. Personally, I think that is a exaggeration of the reality. (ii) that in the Backstop arrangement (again, if it is ever used), the ECJ oversight is dominant in dispute and regulation, and thus not consistent with the objective to ‘take back control’. Lastly (iii), and most importantly, the fact that the decision to leave the arrangement or terminate the backstop is a decision that must be reached jointly and thus, it is suggested, it could lead to an indefinite period of transition (under ECJ rule EU regulatory compliance).
"They only seem to come and go away” Stand By Me, Oasis
Between now and the EU Summit on 25th November, the UK and EU will engage in intensive negotiations to attain a political agreement on the future framework. While this cannot yet be in the form of a legal text (as the UK cannot enter into a legal agreement with the EU of which it is part), May suggested that it will form a comprehensive framework of intent.
Nobody claims that the framework that the PM is offering is ideal. By definition, the wide spectrum of national opinion was never going to be satisfied concurrently in a single strategy. However, the plan provides continuity, stability, and in broad terms the delivery of all the stated objectives (albeit for some, far too slowly). Furthermore, with no credible, deliverable alternative proposition from either side of the House, we retain the view that May’s deal will ultimately pass the House. In addition, it is worth bearing in mind that the broad tone of the response from UK business is positive, at the very minimum in respect of it removing uncertainties.
The elephant in the room here is that May must still be around in order to deliver on her plan. There is the potential for, perhaps significant, volatility and uncertainty in the short term but beyond that, in our view, the outlook is for the UK and for GBP remains positive.