"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.