Argy-Bargy: [noun informal British] - "noisy quarrelling or wrangling”
There is no doubt that August witnessed a regime shift in volatility in financial markets - despite the fact that the month began in the middle of a week. The transition from July to August was marked by a hawkish cut from the Fed and the escalation of tensions between the US and China, culminating in the threat of further US tariffs on Chinese exports, and subsequently a relaxation of the yuan through the psychologically significant 7.00 level. Then, just as financial markets were beginning to regain some composure from the trade related volatility, EM credit markets were thrown into uncertainty as the presidential primaries in Argentina resulted in an unexpectedly emphatic rejection of the fiscally responsible incumbent.
In many respects, however, the Argentina story is a side-show. While it has caused some localised losses and even some contagion across the LatAm and EM credit space, it was likely in the US Treasury market where the most significant implications lie. The Argentina story, along with the recent deterioration in Sino-US trade progress (and , it seems, some goodwill) has driven significant flows into the global safe haven asset - US Treasuries. This is not to mention the heightened Middle East Tensions, Japan-S. Korea trade dispute, N. Korea missile test resumption, Brexit and the situation in Hong Kong that all exacerbate the demand for safe haven assets.
"It is playing safe that we create a world of utmost insecurity” Dag Hammarskjold
As global investors scramble to place their money in the perceived safe haven of US Treasury bonds, US yields are dragged lower. Against the current backdrop, the demand for longer dated US bonds has outstripped that for shorter dated securities, and thus the US yield curve (notably between the 2 year benchmark and the 10 year benchmark) has inverted. Herein lies a circularity for financial markets. Every 2s10s inversion since 1956 (according to DB) has seen a recession follow. Thus, the logic in this instance is that the threat of a default in Argentina, alongside the imposition of tariffs on Chinese exports to the US, will send the US economy - until this point running at above potential rates of growth, with employment below the level considered ‘full employment’, with equity markets near record highs (even after the horrible day yesterday, where the Dow Jones -3.05%) - into recession. Former Chair of the Federal Reserve Janet Yellen proclaimed that "the yield curve may be a less reliable signal at the moment”. We would likely agree with this sentiment.
Historical analysis suggests that the median length of time between the point of inversion and recession is 17 months. That puts our best estimate of the impending US recession in 2021 - there are a great deal of global events to take place between now and then. Some would argue that the mere fact that the US curve is inverted (irrespective of the reasons) will drive wider credit spreads, slower business investment, faltering productivity and/or hiring and ultimately a recession. We are not suggesting that the markets are wrong in being cautious about the global economic and political backdrop, nor are we suggesting that there will not be a negative cyclical deterioration for the US at some point, but simply that at current levels, the world’s safe haven asset may not be all that safe in price terms (not in any sense in terms of the credit risk of the US).
"Patience is not simply the ability to wait - its how we behave while waiting” Joyce Meyer
In the UK, the underlying economic data has continued to beat expectations. This week has seen UK headline inflation rebound above the 2% target (on strong pricing power in computer games no less), wages rise at their fastest pace in over a decade (real wages still accelerating), and retail sales beat expectations for a second consecutive month in July. However, all of the UK headlines remain focussed on the political backdrop.
We remain of the view that the Johnson administration will continue to push a hard line until Parliament returns, on the 3rd September. The critical point for this strategy is likely the G7 meeting in France (24th/25th August), where there will undoubtedly be a meeting on the sidelines between Johnson and Juncker (and possibly also with Merkel and Macron).
The near term picture remains unclear for the UK and for GBP. However, a resilient consumer, very promising signs of an accelerated trade deal with the US and still the prospect of a compromise between the UK and the EU suggests that the upside potential for the GBP in terms of sentiment change and the correction of its significant current undervaluation remains substantial.