"...all the right notes...but not necessarily in the right order” Eric Morecambe
Those old enough to remember the legendary Eric Morecambe will vividly remember the sketch in which Morecambe impersonated a concert pianist to whom the composer Andre Previn (Mr Preview...) accused of playing "all the wrong notes”. Morecambe’s riposte that he was playing "all the right notes, but not necessarily in the right order” is infamous and, at the current juncture, curiously fitting.
Recently we have argued that there are two linked but distinct factors dominating the financial market activity and sentiment. First, the current trade tension between the US and China. Secondly, quite separately from the trade tensions between the US and China, there has been a slowing in the global export dynamic for many months now. It could be argued that the long term desire for China to de-risk and de-lever its economy are driving factors in reigning in growth expectations. This is quite distinct from the trade tensions with the US - and thus are likely to continue even if the trade tensions are resolved. Over recent weeks, markets have, in our view, failed to differentiate these two issues, and in doing so, have generated a set of forecasts that in our view are based on the wrong notes.
"Rational discussion is useful only when there is a significant base of shared assumptions” Noam Chomsky
Our central view remains that there will be a rational compromise between the US and China and ultimately a trade resolution that brings lower, not higher global trade tariffs. However, this is not to say that such a resolution will bring a V shaped recovery in the Chinese, or indeed, global economy.
The dominant theme in financial markets has been a sharp decline in US yields, as a combination of safe haven capital flows into US Treasuries and rising expectations that the Federal Reserve will cut rates as an insurance policy against downside risks. Expectations of US rate cuts now sum around 100bps by the end of next year. This view may be based on the right notes but from our perspective they are clearly in the wrong order.
Stepping back from the current sentiment, flow and even direct pressure from the ‘leader of the free world’, the Fed’s dual mandate is to maintain price stability and full-employment. With current core inflation at 2.0% (core PCE at 1.6%) and unemployment rate at 3.6% (almost 1% below Fed estimate of full employment) it is hard to justify that the Fed is not meeting its objectives. The momentum of the global economy is certainly more negative over recent months, but it is not clear from the data that this is also true of the US economy - an economy that is sufficiently closed as to damp the impact of slowing global trade. We find it hard to justify any rate cuts from the US at the current juncture, let alone four rate cuts over the next 18 months.
"What we hope ever to do with ease, we must learn first to do with diligence” Samuel Johnson
While it appears that the discussion of further accommodation measures (rate cuts, reopening QE, …) at last weeks ECB meeting were skipped over by markets, the emphasis on downside risks and the need for further measures - notably unless the situation improves NOT if they get worse - was grudgingly accepted by markets this week. In fact, Draghi emphasized the burden put on monetary policy by the failure of governments to enact fiscal and structural reform - a point he has made at pretty much every ECB press conference in his near 8 year tenure) and made the case to do even more, at his speech in Sintra yesterday. Against the global backdrop and with the openness of core eurozone economies (and their reliance on Chinese demand), the case for eurozone easing is far greater than that of the US, in our view.
With positioning indicators suggesting that the most crowded trade in financial markets is long Treasuries, the implications of Chair Powell not delivering on the markets super dovish expectations are potentially significant. Furthermore, it is glaringly obvious that the bond markets are following a very different musical score to the equity markets (US equities are near record highs - cheaper funding). Having sold off sharply from the mid 2.50’s at the start of May, 10 year US yields traded below 2.02% yesterday. Technically, a retracement back up to 2.20% or even 2.30% would not damage the longer term dovish trajectory of US rates, BUT in the short term, such a move would be very significant for bonds, equity markets and the USD. To quote President Trump’s comments last night, "lets see what he [Powell] does” this evening.
"I can feel the warning signs running around my mind” Oasis, Half the World Away
Last week we discussed the recent heightening of uncertainty around the US-China trade tensions and increased use of threats from both sides - including further tariffs from the US and limiting the export of rare earth elements from China. We argued that while there had been a marked pickup in geopolitical volatility, financial markets had remained relatively sanguine, but that there were a few warning signs.
Indeed, the warning signs that we noted, namely stronger fixed income markets (lower yields) and weaker oil markets, have extended further, as sentiment has deteriorated. However, amid this deterioration of sentiment and rising uncertainty, equity markets have rallied impressively over the course of this week, as market focus has shifted from the underlying ailment to the cure.
"How ever much I push it down, it’s never enough” The Cure, Never Enough
Over the course of the year markets have become increasingly concerned about the slowdown in the global economy and the pavlovian response from markets in such scenarios is to look to central banks to solve the problem. As not only the dominant player in global markets, but the central bank with the most firepower in the global economy, attention turned to the Fed. Since the depths of the post financial crisis stimulus, the Fed raised its funds rate nine times, and reduced its balance sheet holdings by USD700bn. However, it is also important to note how much the expected (or market implied) path of Fed accommodation has changed over the course of the year.
In December 2018, the Fed was expected to raise the Fed funds rate a further three times (25bps) this year towards an end-2021 target of 3.25% and reduce the balance sheet by a further USD600bn. Now, within the space of six months, the Fed futures market is discounting around three (25bps) cuts - a net stimulus of 150bps (plus the additional impact from the halt to QT - concluding in September). The most recent drop in US yields has indeed brought more dovish rhetoric from the Fed, who in not pushing back against the current market pricing, have been deemed complicit.
Yesterday, market attention turned to the ECB. Despite having announced an extension to the forward guidance (rates to remain at current levels) by a further six months to the end of June 2020, a corresponding extension of reinvestments of maturing QE debt stock, and generous terms on the new targeted loan facility, markets gave a clear indication of their disappointment. Indeed, the vast majority of commentary following the meeting suggested that the ECB had underwhelmed market expectations - even taking into account the comments from President Draghi, that the Governing Council had discussed the possibility of cutting rates and even restarting QE. We have a slightly different perspective.
"Some say the view is crazy” David Bowie, Black Country Rock
There are two linked but distinct factors at play here. First is the deterioration in the current trade tensions between the US and China. If, as many commentators appear to imply, the conflict continues to deteriorate exponentially, then US, European (and pretty much all other countries’) monetary policy will have to become significantly more accommodative. On the other hand, if the two biggest economies in the world were to reach a deal on a fair basis for trade between their respective economies - say at the G-20 Summit in Osaka at the end of this month, then it is far from clear that the US will need to cut rates at all, let alone to the degree being priced by financial markets.
Secondly, quite separately from the trade tensions between the US and China, there has been a slowing in the global export dynamic for many months now. It could be argued that the long term desire for China to de-risk and de-lever its economy are driving factors in reigning in exponential growth expectations. But this is quite distinct from the trade tensions with the US - and thus are likely to continue even if the trade tensions are resolved. For us this means that the USD likely retains its growth and yield premia for some time to come. Further, while our prefered view likely plays out positively for the USD, at current levels it would be less friendly for bonds and for equities even less so.
"Reality is merely an illusion, albeit a persistent one” Albert Einstein
Over recent weeks, we have reiterated our anticipation of a marked pickup in financial market volatility, suggesting that we were just in the B of the Bang. In the subsequent period we have seen a sharp pick up in geopolitical volatility (as the progression of the Sino-US trade talks took a sharp step backwards) and a sharp pickup in domestic political volatility in the UK (as PM May finally ran out of common ground upon which to base her compromise Brexit deal as European elections, and a clear win for the Brexit Party - as well as a sharp uptick in support for the remain biased Liberal Democrats - highlighted the increasing polarisation of the debate). But, as yet, financial markets have remained relatively calm.
However, over the last couple of days, there have been a number of events that may begin to weigh on confidence and stability in risk asset markets. Firstly, the news over the weekend that Chinese (Inner-Mongolia based) Baoshang Bank was taken under the control of financial regulators due to the serious credit risks it poses - the first such action in around twenty years. Initially, while this caused significant liquidity dislocations in NCD (negotiable certificates of deposit) and credit liquidity, there was little contagion.
Roll of the DyCe?
Secondly, and perhaps more far reaching has been the veiled threat of disruption to the supply of rare earths as an extension of the simmering Sino-US trade tensions. The rare-earth elements, of which China is a key global exporter are a group of seventeen chemical elements that are used in everything from high-tech consumer electronics to military equipment. Comments from China State Media yesterday that "China will prioritise domestic rare earth demand but is willing to meet other countries’ ‘reasonable’ demand”. Has caused concern in countries (such as S. Korea) and companies dependent on high-tech exports. Last year the US Geological Survey designated these materials critical to the economy and national defence.
While on the face of things the financial markets remain relatively calm, there are a few warning signs. Firstly, global fixed income markets have been notably stronger over recent sessions as investors seek the safe haven of bonds, driving global yields lower. By extension global yield curves have become increasingly negative from Australia to the US - historically a sign of impending recession. Secondly, having reached (and even exceeded) technical projection targets in April, the backdrop for oil has turned markedly more negative over recent weeks as declining demand forecasts, and weakening market sentiment weighs. Lastly, having outperformed most expectations and asset classes for an extended period, the technical backdrop for equities is less encouraging going forward. The current level around 2785 in S&P (Jun Future) is both the 200d moving average and the neckline of a top formation that could signal a protracted period of weakness in global equity markets. Equity volatility indices are edging higher, but they do not yet reflect the rise in volatility that we expect is in train.
"I started looking and the bubble burst” Coldplay, Warning Sign
Over the next couple of weeks there will be a clear focus on the Conservative Party leadership contest (and by extension the likely direction of the next stage of negotiations / action); there will be a clear focus on the potential intensification of the US / China trade tensions; there will be an intense focus on the evolution of the global economic backdrop (particularly with reference to the global export dynamic) and its implications for US and China and; there will even perhaps be a focus on the evolution of global inflation dynamics (particularly with reference to the imposition of tariffs) and whether that impacts the global monetary policy stance.
However, what there is very little sign of at the current juncture is a bit focus on the rising risks of global financial market volatility. We are increasingly of the view that there should be.
"Whenever you find yourself on the side of the majority, it is time to pause and reflect” Mark Twain
In our last post, we discussed our view that a marked pickup in financial market volatility was imminent - arguing that the dominant cross asset theme throughout global financial markets in 2018 (and arguably prior) has been declining volatility. Since this post - at the end of April - there has been a deterioration in the global geopolitical order with trade talks between the US and China collapsing, tensions rising with Iran and North Korea resuming missile testing. From a macroeconomic standpoint there has been a secondary deterioration in the Chinese economic trajectory after the (targeted) stimulus induced bounce that was obvious in the May data. However, while any of these events on their own could be expected to generate a significant rise in the level of underlying volatility, so far at least the combined impact of a series of significant events has been minimal. Instead of taking the view that markets will revert to contracting volatility, to quote Linford Christie we are more of the opinion that this is simply the B of the Bang.
"Renege, affirm and turn their halcyon beaks” William Shakespeare, King Lear
Just over a week ago, it appeared to all intents and purposes that a US-China trade deal was a ‘done-deal’. However, following some mild rumours of impasse into the NY close on Friday 3rd the subsequent weekend witnessed a notable tweet. President Trump stated that that the trade deal with China was continuing too slowly and threatened higher tariffs as early as Friday. As the week progressed, it became clear that the talks had broken down as China had sought changes to the ‘agreed text’ in IP protection and theft, technology, financial services access and competition policy. This deterioration in Sino-US (and global trade) relations dominated sentiment and flows across all asset classes.
However, market volatility, and thus contagion, was damped in the first instance by China state funds propping up Chinese equities after the hit from US tariffs (and in the second instance the China Statistics Bureau stated that there was relatively big room for macro-policies to support growth immediately after the release of weak April economic data Tuesday morning). Furthermore, just as equities began to turn lower yesterday, headlines were released suggesting the the US would postpone its proposed auto tariffs for six months ahead of the imminent deadline.
Volatility, from a monetary perspective, has also calmed predominantly as a factor of the Fed. After the near dramatic (multi-stage) dovish pivot from the Fed from November through to March, the most recent commentary from the Fed - most notably vice Chair Clarida who has seemingly been the lead protagonist on defining the policy direction - has been more balanced. Indeed, Clarida’s latest speech offered a more comfortable tone "the US economy is in a good place” and gave a vision of near term stability for US rates as the global economic backdrop evolved.
From our perspective global financial markets are still moving towards a necessary regime shift in underlying volatility. We are firmly of the view that the current calm of the Sino-US impasse must by default be a transitory state. Either there is resolution, that is likely a positive for the global export dynamic or deterioration that could have significant implications for global asset prices. Either way, we are of the view that the Chinese economic recovery is more likely to be an L rather than a V (as the most recent data suggests) as the authorities determination to de-lever and de-risk the economy continues.
"Will things ever be the same again?” Europe, The Final Countdown
Elsewhere, there is little or no evidence in volatility markets that the European Parliamentary Elections will cause any disruptions or complications - despite the fact that some polls suggest that up to 200 of the 751 seats could end up being occupied by populist party representatives from across the political spectrum.
And then there is the UK. As the Brexit saga continues without an end in sight it is interesting to note the direction of the debate. Indeed, the European Parliamentary Elections appear to have polarised the discussion even more. On the one side there has seemingly been a movement towards the ‘no-deal’ exit parties such as the new Brexit Party and on the other side a move towards (a more widely dispersed group of) parties such as the Liberal Democrats, Greens and Scottish Nationalists. Both moving away from the compromise deal of the PM and the far from clear position of the Labour Party.
We have stated our view on many occasions that we view the only credible option for the UK as being May’s compromise deal - The Withdrawal Agreement Bill or WAB (the latest form of which we are yet to see) - or no Brexit, as Parliament has made clear its strong will to prevent no-deal by any means possible (irrespective of the constitutional legitimacy or implication). In reality, we still fail to see how no-deal or no-Brexit are anything other than transient states that ultimately end up in a form of compromise agreement - likely not too dissimilar to the WAB. In the meantime. It may be volatile!
"No spring skips its turn” Hal Borland
Over recent months, there has been a notable theme throughout financial markets: Not the uncertainty caused by the global trade dispute between the US and China (and more recently the US and the EU); Not the uncertainty and consternation of the Brexit negotiations; Not the sharp dovish pivot from the US Fed that has seen financial markets price out US rate hikes and price in rate cuts in a short period at the start of the year. The most dominant theme has arguably been that of declining volatility.
In FX terms, volatility over a large swathe of the array of vol surfaces has been at or near historic lows - at least until the start of this week. However, over the last couple of days there has been a notable turnaround. From our perspective this has the potential to mark a significant alteration in the underlying market dynamic. Away from a period of apathy and indifference to a more active global financial market backdrop. Markets look like they are about to get very interesting indeed.
"I want to be what i’ve always wanted to be: dominant” Tiger Woods
Since we last wrote, there has been a notable move lower in the EUR and up in the USD driven by a number of factors. Since the start of the year there has been much focus on the Chinese economy and the impact of its slowdown on the export dynamic and thus the global economy.
In early March, the Chinese authorities embarked on a range of fiscal stimulus measures (targeted tax cuts, credit easing) aimed at providing support to the economy. The significant measures announced at the NPC (National People's Congress) were viewed by markets as a panacea to the woes of the global export dynamic - obviously a Chinese stimulus would boost China’s demand for the inputs to its vast export market, wouldn’t it? Historically this has been the case. However, this time there are a couple of caveats. Firstly, there is a distinct rotation occurring within the Chinese economy, away from the heavy export oriented economic model towards domestic consumption led industries. Secondly, the Chinese authorities have shown a clear desire not only to provide accommodation on a targeted basis, but to limit that stimulus so as to not ‘flood’ the economy with liquidity that is likely to create fragility and or bubbles. At the same time the desire of the China to de-risk and de-lever the economy remains.
These factors are important when viewing the implications of the China stimulus, noty on China, but on the rest of the world. At the start of the month there was a clear rebound in the manufacturing activity in China taking the sector back into expansion. Further, the recent GDP, retail sales and industrial production data all showed significant (if policy induced) rebounds. Historically the market reaction function has been to extrapolate Chinese economic strength into those export oriented economies such as Germany, South Korea and Japan. This time round the market has been disappointed as the China rebound has (at least not yet) driven any noticeable bounce in the global export dynamic. As such the EUR (and notably the Korean Won) has suffered.
"When did the future switch from being a promise to a threat?” Chuck Palahniuk
From a GBP perspective, there has been little progress in the Brexit negotiations. However, it does seem that the threat of European Parliamentary elections, Cooperation with the Labour Party or even a General Election (as rumoured this afternoon) could finally win round enough dissenters to the PM’s withdrawal agreement. If the rumours of its return next week prove true then we will find out. Furthermore, if we are right in our view that the broader financial markets are about to witness a regime shift in the underlying level of volatility, then GBP could become a significant mover in FX.
"I won’t cry for yesterday” Duran Duran, Ordinary World
Much has happened since the last time we wrote. Not just (following on from our last piece) on Brexit, but in the global macroeconomic backdrop. While near term uncertainties over the UK’s future relationship with the EU are significant - particularly for UK business investment - the current decline in the global growth dynamic is potentially both more significant and further reaching.
This week the IMF’s latest World Economic Outlook (WEO), cut its global growth outlook to the lowest level since the financial crisis at 3.3% (from 3.5% in January and 3.7% in late 2018) as "Activity softened amid an increase in trade tensions and tariff hikes between the United States and China, a decline in business confidence, a tightening of financial conditions, and higher policy uncertainty across many economies”. Further, the IMF were clear that risks remain to the downside, citing trade tensions, softness in Europe and a no-deal Brexit”
Wednesday’s agreement between the UK and the EU27 to extend article 50 has reduced the potential for a no-deal Brexit (at the very least until June 1st) and if we are to believe the rhetoric and twitter activity (twitoric?) the Sino-US trade negotiations appear to be reaching the drafting stage of what President Trump has described as the "Granddaddy of all deals”. That leaves the ‘softness in Europe’.
"I hope the tears don’t stain the world that waits outside” Oasis, Where Did It All Go Wrong?
While it may seem like the phrase "delayed not derailed” is a clear reference to the Brexit process, it is actually the new descriptive narrative of choice for the ECB when referring to the convergence of inflation towards target - though at the current juncture it could equally be used to describe the prospect of self sustained growth for the region.
The IMF cut their forecast for 2019 to 1.3% (from 1.6% in January). However, over recent weeks Italian and German institutions have cut their respective growth forecasts to 0.1% (from 1.0% previously) and 0.8% (from 1.9% previously). That puts a lot of pressure on the rest of the bloc to make up for the underperformance of Italy and Germany. Furthermore, with high debt across the eurozone (less so for Germany) and very little room for further monetary stimulus (or come to think of it fiscal stimulus - again ex-Germany), the eurozone economy is acutely vulnerable when downturn strikes.
The eurozone was a key focus Wednesday, as the ECB left rates unchanged as expected. While there was very little change to the statement, there were a couple of notable developments: Firstly, it was clear that the ECB are now openly discussing the implications of its negative rate policy on bank profitability - while stressing that the need for bank consolidation is "very significant”. Secondly, Draghi stressed that there was unanimous agreement from the Governing Council on the use of "all tools available” and even stressed that markets "understood” his commentary - seemingly in relation to lower Euribor and a lower EUR. We continue to believe that the most effective monetary tool that the ECB has at its disposal is a lower currency.
"You can’t always get what you want” Rolling Stones, You Can’t Always Get What You Want
In the UK, Theresa May addressed Parliament earlier today after returning from the EU Summit Brussels in the early hours. Ahead of time there was little expectation that the EU27 would deny the UK an extension to Article 50, as had been formally requested. Essentially, the date of UK departure from the EU has been pushed back to October 31st 2019, although the UK can leave on the first of any month following ratification of the Withdrawal Agreement This was longer then the extension PM May had requested (and it appears President Macron fought for), but shorter than the one year extension President Tusk had proposed. There was also the additional caveat that the UK would have to leave on June 1, if it decided not to participate in the EU Parliament elections in late May.
It was interesting to watch the tone of Parliament at yesterday’s Statement from the PM. Whereas on numerous previous occasions there has been modest support from her own (front) benches and angry attacks from all other angles. Yesterday, the mood was more supportive of her prevention of no-deal and attempts at genuine cross party compromise. The notable critics were the harder line Brexiters who, having voted against the leaving the EU under May’s Withdrawal agreement on three separate occasions now seem furious that the UK has not left yet.
In our last piece we discussed the concept of third time lucky for the PM’s deal. After having been defeated the first time by 230 votes, the second time by 149 votes and most recently a vote on just the Withdrawal Agreement (and therefore not a technically a Meaningful Vote) it lost by 58. We could argue that the PM’s plan - to wear down the ideological objections at either end of the Brexit spectrum towards her compromise deal - is working. While markets appear to have written off the prospect of May’s deal passing, we are still of the view that it could be third time lucky for the Meaningful Vote on her deal - likely at the end of April, after the Easter recess.
Over recent days we have seen some more encouraging data out of China. However, while this is a helpful rebound for equities and risk assets we are far from convinced that this is a sustainable bounce. Indeed we retain the view that the Chinese recovery is more ‘L’ that ‘V’ and that the extrapolated expectations of Chinese growth on the global export dynamic must continue to be corrected - the implications being significant for Germany and beyond. Despite its modest rally over the past couple of days, we expect EUR to continue to remain under pressure.