"...it is, perhaps, the end of the beginning” Winston Churchill
Over recent months, as the commentariat have lurched from one Brexit disaster scenario extrapolation to another, we have maintained the consistent view that a deal will be done. At the same time, without getting drawn into the hyperbole, we have maintained that it is likely in neither side’s (EU, UK) interest to resolve the negotiations at any time before the very last moment - "None of the protagonists will wish, in retrospect, to have been viewed as not trying hard enough to secure the best deal”.
Over recent days, there seems to have been some movement from both sides towards a common ground that will enable the Withdrawal Bill to be passed to the UK Parliament this year. There are a number of important points in this regard: firstly, as the official Brexit date approaches (29th March 2019) there is clearly a cut-off date at which a responsible government would have to issue (irrevocable) advice to its populace, companies and organisations of measures to be taken to prepare for a no deal Brexit. We are of the view that this is at or around the turn of the year; next, in order to achieve this timeline, the UK likely have to agree in principle with M. Barnier by the end of this week, such that an EU Summit can be called for this month (likely 22nd-28th November); yesterday, PM May held a Cabinet meeting, in which she likely floated the concept of a ‘review clause’ in a UK wide backstop agreement (in addition to the EU concession of some ‘in-market’ customs checks) that is written into the Withdrawal Agreement itself - with the aim of satisfying concerns of an indefinite, vassal state transition.
In itself, this likely satisfies the EU, and more pertinently addresses the outstanding issue of the Northern Ireland backstop agreement. So in essence, this should shift any fears of a no-deal Brexit scenario to the UK Parliament’s ‘meaningful vote’. Here we are also confident on two bases. Firstly, if we can believe there is likely to be a significant outline / intention / structure of a future trading arrangement (as suggested in the w/e press) then I would place a low probability of parliamentary rejection. Particularly, as the (credible in our view) Sunday Times article suggests that there remains a significant scale of possible future relations (say with Customs Union at one end and Canada at the other - Chequers in the middle). That scale must acknowledge that the greater regulatory alignment there is to be, the greater the access (and lower the ‘friction’).
This morning, the FT reports that "Theresa May has ordered her ministers to make a push for a Brexit deal this week, ordering her attorney-general Geoffrey Cox to prepare the legal fix that she hopes will finally unlock an agreement”, while others published a supposedly (though firmly officially denied) leaked plan to ‘deliver’ an agreed plan to the UK public.
"A rose by any other name…” William Shakespeare
We have suggested for many months that our central case for the basis of the future relationship is Chequers. We maintain that view. It is unlikely that it remains in the exact form that Chequers acknowledges, and we would expect that there is a fairly rapid name change as negotiations get under way. However, until there are further technological advances (Blockchain?) that resolve the NI border issue, close regulatory alignment with the EU seems likely - common rulebook or not.
If we are correct in our expectations that we are in the final stages of convergence towards an agreement, and that the agreement offers sufficient prospects of both access and external trade agreements, then we also remain confident that the UK Parliament will ratify the deal. This would be a very significant watershed for the UK and for GBP.
"There are many ways of going forward, but only one way of standing still” Franklin D. Roosevelt
At the Bank of England meeting last week, most notable to us was not the focus of (almost all) journalists on what the Bank would do in the event of a no deal, but the Bank’s own economic forecasts. The monetary policy statement highlighted the upgraded expectations for the closing of the UK output gap - the Bank now sees excess demand from the end of next year at which point the economy will "run hot”. Furthermore, in addition to what we see as a strong macroeconomic backdrop for the UK, the Bank added two further potential upside stimuli. The first, that the Budget (contingent on a deal - and thus no revisions to the Budget maths) "has the potential to be a significant impact” and, secondly, that a Brexit deal "could help unleash pent up investment”.
"A riddle, wrapped in a mystery, inside an enigma” Winston Churchill
Last week we offered a general summary of what we see as the key themes and drivers of financial markets at the current juncture and how the confluence of a range of forces have made for a complex backdrop. Since then there have been a number of developments that are worth reviewing and adding to our overall macroeconomic considerations.
In Europe, there has been little progress in the Italian Budget saga - the coalition government has been given three weeks to review and resubmit the proposal after rejection from the EU for "unprecedented budget deviation”. From this perspective at least, things have calmed, for now. However, at last week’s ECB meeting (where the Governing Council left rates and policy unchanged), President Draghi was clear to point out the "somewhat weaker than expected” incoming data. This morning’s weaker than expected Italian GDP data is both an example of the ECB concerns and a stark reminder to the Italian government that their budget deficit targets are reliant on growth projections that are significantly above the current baseline - admittedly with the intended impetus of fiscal expansion.
Perhaps surprisingly, however, Mario Draghi drew a clear (if questionable) distinction between the current "weaker momentum” as opposed to a "downturn”, thus maintaining the narrative of an "ongoing, broad based expansion”, one in which the "risks to the growth outlook are still broadly balanced”. We are more cautious in this regard. The last in a line of political disappointments for Chancellor Merkel and her center-right CDU has led to the announcement that she will not run for reelection either as head of the party or at the next General Election - potentially leaving a political leadership void at the centre of Europe, just when it is needed most. Macron, the most likely candidate to pick up the mantle within the eurozone construct, has a domestic approval rating in the 20’s. An uncertain political backdrop and fiscal concerns (from Italy and others) are a troubling enough combination. This morning’s Q3 GDP data release showed that the eurozone growth momentum slowed more than expected to just 0.2% q/q. In combination, the current backdrop is likely to test the confidence of Mario Draghi, and that the balance of risks are indeed (at least edging) to the downside.
"Unity can only be manifested by the Binary” Buddha
In the UK, the backdrop is more binary. For now at least the economic backdrop is more stable - the latest GDP data suggested a quarterly economic momentum at around 0.7% and wage growth is at its highest in almost a decade. The main drag on UK economic activity (and arguably also productivity growth) at the current juncture is the sharp drop in business investment as a function of Brexit uncertainty.
Yesterday, the Chancellor unveiled the 2018 UK Budget which essentially utilised an (independent) OBR upgrade to growth and an improved (revised) fiscal backdrop for a statement that pledged that "Austerity is coming to an end, but discipline will remain”. The big winners from the higher spending were the NHS, MoD and "32 million taxpayers”, as the increased basic-rate allowance and higher-rate tax threshold reduction were brought forward. Also notably, the UK became the first major government to announce a plan to tax multinational digital corporations with a new ‘Digital Sales Tax’ - albeit at a modest initial level. Essentially, higher revenue forecasts enabling the government to increase NHS spending and bring forward the promised increase in income tax allowances and still announce a cumulative GBP18.6bn less borrowing over the next five years, and a faster fall in public sector net debt - a distinct and recently rare economic positive. A ‘good’ Brexit deal now would likely put GBP in a significantly stronger position.
"I almost never lose” Donald Trump
Lastly, the big focus of market participants over recent days / weeks has been the decline in equity market sentiment. To put the declines into perspective, from its peak, just a few weeks ago, Amazon has now lost almost a quarter of a trillion dollars. We have two thoughts in this regard. Firstly, while Trump has been keen to blame the Fed for tightening interest rates too fast - and denting equity sentiment - it is likely that the global trade tariffs imposed by the Trump Administration are the key protagonist in equity weakness. However, we expect that a trade deal between the US and China, that would ultimately remove those tariffs, is closer than market expectations. Secondly, we are of the opinion that US inflation is the key risk for the economy going forward, and that if we are correct, then the backdrop for equities is even less supportive, as the yield curve adjusts to a steeper rate path. Against this backdrop, we continue to see support for the USD, even if the outlook for other asset classes remains more complex.
"Peace is not the absence of conflict, it is the ability to handle conflict by peaceful means” Ronald Reagan
Across all aspects of financial markets, at the current juncture, there exists conflict. Forces from geopolitical, trade, financial, fiscal and economic factors have generated a complex backdrop for FX and financial assets. Since we last wrote, there have been some notable developments in this regard.
In the US, the theme of economic outperformance was reinforced by the IMF forecasts last week that outline their expectations of renewed economic divergence as escalating trade tensions and emerging market financial stresses exacerbate the downside risks to global growth outside of the US. We have long held the view that the US economic outperformance and risk premia likely dominate a positive near term outlook for the USD. A backdrop only exacerbated by the emergence of inflation. Thus, in that respect it is notable that in the minutes from the September FOMC meeting there was an increase in the number of participants that saw upside risks to inflation and those noting an acceleration in wage growth. As we edge towards the end of 2018 - not to mention the potential volatilities surrounding the US Midterms (November 6th) - we maintain the view of USD outperformance, with upside risks!
No Time to Spare
In the UK, the conflict is multipolar. The well publicised, differences of opinion within the Conservative Party are, in our opinion, far from insurmountable for PM May, and we maintain the view that a deal will be agreed. It is important to note, however, that it is in neither side’s (EU, UK) interest to resolve the negotiations at any time before the very last moment. None of the protagonists will wish, in retrospect, to have been viewed as not trying hard enough to secure the best deal and this can’t be done by congratulating oneself over ‘stickies in the drawing room’ three months before the deadline. A UK wide backstop solution, even if it lies outside of the Withdrawal Agreement (and even if there is a NI specific backstop to the backstop), is likely enough, if combined with sufficiently positive future relationship intentions to pass the parliamentary ‘meaningful vote’. In our view.
Also from a UK perspective, the current economic backdrop remains significantly better than even the most positive forecasts - particularly given the political noise and negative drag from sharply lower business investment as a function of brexit uncertainties. Outside of the recent surge in wage inflation the Bank of England have been clear in the view that there is little, if any, slack remaining in the UK economy and that if the economy evolves as forecast, they will have to move further on rates. This monetary backdrop, alongside significantly favourable valuation metrics support our strong medium term view of GBP appreciation.
The other dominant focus of the past week has been the Italian budget deficit target progress. At the start of last week the Italian coalition government submitted their draft budget target to the EU, fully in the knowledge that while it remained below the 3% maastricht criteria, that it would breach other fiscal compact guidelines. The resultant (public) debate of the EU about the ‘appropriateness’ and ‘conformity’ of this "unprecedented budget deviation” drove 10 year BTP yields to close to 4%. Ahead of the UK Budget on the 29th October, Italy has sparked a broader debate about the possibility of a more concerted global fiscal stimulus (and likely differentials) at the current economic juncture. Italy is not Greece, that is clear, but this might mean that the EU has a more difficult job of enforcing its rules.
The ECB meeting tomorrow is unlikely to offer any new policy insight, yet will be a keen focus for any inference on the progress of inflation and or sentiment towards, this morning’s broad decline in PMI activity indices. With equities and risk assets on the back foot and emerging markets spooked by further fiscal slippage in South Africa, our central expectation is that those looking for a quiet end to the week will be disappointed.
"All human excellence is but comparative” Samuel Richardson
In our last post, we discussed the likely evolution of US monetary policy (or at least the evolution of market expectations of US monetary policy) following the rate rise on the 26th September. The Fed raised rates by 25bps to a new target range of 2.00% - 2.25% and removed their reference to "accommodative” policy, while continuing to highlight further strength in the labour market and economic activity, albeit amid relatively subdued inflation and inflation expectations.
At the time, there was a clear commentator bias towards the view that the removal of the term "rates remain accommodative” was indicative of a Fed approaching its terminal rate. However, we disagreed, suggesting that the economic summary (consumer spending and business investment are "expanding briskly”) and the explicit suggestion that that there would be little "aggregate impact” from trade tariff escalation imply that the bar for the Fed to pause is high.
With the domestic situation strong (and likely sustainable for several quarters at the very least) and the impact of a trade spat played down, the popular arguments for a Fed pause come from emerging market stresses as a function of higher US rates and or a correction in US equity markets. The former was played down by Powell at the September press conference - "we understand the Fed effects on the world” - and the latter was addressed last night in a speech by San Francisco Fed governor Daly, who stated her view that a correction in the stock market is "not necessarily a worrisome thing”. Stock market, or EM wobbles, may have caused a Fed pause under the guidance of Janet Yellen. Under Powell, we continue to view the risks to US rates as up, not down.
Furthermore, with growth at above 4%, almost double the potential growth rate, and with record low unemployment, rising oil prices, and the continued positive implications of the pro-cyclical fiscal stimulus, our view remains, that the biggest risk for the remainder of the year is an acceleration in inflation. If this view is correct, then US rates and the USD can rise significantly further.
This evening will provide an important reference point for US monetary policy. Last week, the IMF published their world Economic Outlook (WEO) update, in which a key point was that the period of synchronous economic growth, or global growth convergence, was anomalous, and that divergence is likely in the near future. Further, the ECB minutes from the September policy meeting painted a less rosy picture than that at the time of the statement / press conference. The minutes highlighted a less optimistic view on both growth and inflation, where growth risks are likely biased to the downside (not balanced, as the statement suggested) and that domestic inflationary pressures are likely to move higher "gradually” (not "relatively vigorously”, as Draghi stated in the press conference). Fed minutes this evening that offer no deviation from the strong growth, continued rate hikes mantra likely reinforce the IMF ‘divergent growth’ forecast, and highlight the prospect of US, and USD, outperformance.
"And still I’m here, to try and figure it out” Figure It Out, Royal Blood
"Bad news is a headline, gradual improvement is not” Bill Gates
In what was a quiet start to the week, there was little in terms of market price action - broadly flat global equities, bonds and the USD - and despite the near certainty of market expectation for a 25bp hike from the Fed, there was relatively little expectation of anything else from a policy perspective. In part, this had come from the Fed’s now engrained ‘gradual’ normalisation mantra and in part from the fact that there had been two prominent calls for the Fed statement / inference (following the ‘done deal’ 25bp hike): one for an indication of an acceleration of the pace of monetary tightening; the other for a removal of the term ‘accommodative’ in the statement, indicative of the increasing proximity to the neutral level of interest rates - and by extension, the end of the tightening cycle. We are significantly more sympathetic to the former.
Ultimately, the Fed raised rates by 25bps to a new target range of 2.00% - 2.25% and removed their reference to "accommodative” policy. At the same time, the statement highlighted the acknowledgement of further strength in the labour market and economic activity (the forecast for economic growth in 2018 was raised from 2.8% to 3.1%), yet continued signs of ‘at target’ but nonetheless contained inflation and inflation expectations.
The Summary of Economic Projections from the Fed also gave us revisions to the ‘dots’ (member expectations for future rate moves) that highlighted greater consensus around a 25bp hike in December, and another three similar hikes in 2019, essentially giving a median estimate of the terminal level of US rates at 3.375%.
At the press conference, Powell reinserted the "rates are accommodative” narrative, suggesting that its omission in the statement does not signal a change in the rate path, simply that this factor of the forward guidance lexicon has run its course. That said, I would imagine that the question "Are rates still accommodative?” now simply becomes a regular feature of the press conference Q&A.
From our perspective, there were some key inferences from the press conference and Q&A. Firstly, in his refreshingly straightforward, frank style, Powell was clear to point out the underlying strength of US economic activity and the Fed’s resultant favourable outlook. This is enhanced by the fact that consumer spending and business investment are "expanding briskly”. Secondly, Powell played down any negative prophecies from the current, escalating trade tensions / spat / war with China stating that "its hard to see much aggregate impact from tariffs”. Lastly, in the three months since the last Fed rate rise, there has been a period of acute stress in emerging markets, stress that may have caused previous Fed governors to waiver on their commitment to normalisation. Powell’s message in this regard was very clear, "we understand the Fed effects on the world”, highlighting his view of the importance of communication and transparency - not accommodation - implying the bar for the Fed to pause is high.
Our view remains, with growth at above 4%, almost double the potential growth rate, and with record low unemployment, rising oil prices, and the continued positive implications of the pro-cyclical fiscal stimulus, that the biggest risk for the remainder of the year is an acceleration in inflation. Ultimately, against the current backdrop we maintain our view that unless we see a sharp moderation in US growth, or a deceleration in US inflation, USD outperformance likely remains dominant. After all, despite the current growth and interest rate premium the "dollar has only partly recovered its decline of 2017”: Jerome Powell
"The problem with socialism is that eventually you run out of other people’s money” Margaret Thatcher
In his closing speech yesterday, Jeremy Corbyn, the leader of the UK opposition party promised higher wages, higher spending, the nationalisation of major industries (with cheaper services and higher wages for the workers), forced corporate equity carve outs for workers (undefined), boosting child care, aged care, adding 10,000 police officers and embarking on the biggest homebuilding programme ever. Spending plans well beyond the means of any realistic taxation plans.
Perhaps, Mr Corbyn should look at the impact on Italian borrowing costs from the suggestions (light by Corbyn’s standards) of the Italian coalition government, where 2 year borrowing costs went from around negative 0.30% (as a function of the negative ECB rate and QE programmes) to above 2.80%. After much backtracking and pledging to delay spending programmes (and respect the maastricht criteria of the EU) those costs moderated to around 0.75%. This morning, the debate has intensified once again as we approach the Budget announcement. Watch this space.
Next Blog on the 17th October.
"Unlike presidential administrations, problems rarely have terminal dates” Dwight D. Eisenhower
Over recent, sessions we have seen a significant rebound in risk appetite, equities and emerging markets and, despite the rally in US yields, a weaker USD. Regular readers will be well aware that this move is counter to our near term expectations. We have maintained the view that USD strength should result from a continued gradual path of monetary normalisation from the Fed - as continued growth momentum and significantly negative real yields leave the Fed already behind the curve. In the emerging market space, the combination of a managed China slowdown / deleveraging and intensifying Sino-US trade spat has had significant negative implications for a large number of economies. Those that have high external (USD) debt will also likely suffer the negative spiral of higher servicing costs, weaker investment and thus a weaker currency. In the G10 space, outperformance has likely been dominated by stable or widening growth and interest rate differentials.
From an idiosyncratic perspective, there have been two significant events that have exacerbated, if not driven, the case for a weaker USD over recent weeks. The first was likely the larger than expected rate rise from the Central Bank of Turkey (CBRT), which, despite intense pressure from President Erdogan to lower inflation, reasserted their independence and raised rates 625bps to 24.00%, in defense of the TRY. The rate rise calmed nerves and reduced fears of a further disorderly collapse of the TRY - halting, even reversing, the negative contagion across broader EM.
The second significant point was more subtle, but perhaps further reaching. At the ECB meeting last week, Mario Draghi noted that "domestic cost pressures [including wages] are strengthening and broadening”, projecting "significantly stronger core inflation” - despite current measures remaining generally muted. By extension, this positive (if still second order) progression of eurozone inflation - and thus rate expectations - contributes to the proposition that we may be entering a period of a more synchronous monetary and economic progression. The USD had likely benefited in large part from the very opposite for much of this year.
(Inflation) "Born in the USA” Bruce Springsteen
This theme is further accentuated by the concept that the US is approaching its terminal level of rates. This is where we diverge from current ebb of market participants towards a weaker USD. We are of the view that the Fed will continue to raise rates on a ‘gradual’ basis (broadly once per quarter) well beyond the current expectations of the market (approximately three and a half more 25bp rate rises). We also retain the view that the most significant risk for Q4 is likely higher (US-led) inflation. If this is to materialise, then the current debate about the proximity of terminal rates, r*, and even likely curve inversion will dissipate and the second order derivatives of the relative directions of monetary policy between the US and the rest of the world likely turn sharply back in favour of the USD.
In short, we are inclined to see the recent weakness of the USD as a pullback, not a change of direction.