"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.