4 to 11 December – Not Over Yet

Last week there were positive political developments in Europe (on Brexit and German government) and next week we have 3 major central bank meetings (FED, BOE, ECB). Indeed, 2017 is set to keep investors busy all the way to the end of the year:

• In the US, Trump could pass his tax reforms before January.
• In Chile, there is the second round of the Presidential election next Sunday, which is finely balanced and likely to be market moving given the gulf in investor approval between Pinera (positive) and Guillier (negative).
• In South Africa, a country that has suffered a slow-down in growth and surging unemployment under Jacob Zuma (and last week felt a shockwave of corporate scandal from allegations of irregularities at Steinhoff), ANC elections (16th – 20th) will determine whether Ramaphosa or Dlamini-Zuma will take over leadership. Whilst the former could reinvigorate business sentiment, the latter risks a slide into the economic quagmire.

27 November to 3 December – Setting the Stage

After a mad dash on Friday, the US Senate passed their version of the “Tax Cuts and Jobs Act” by 51 votes to 49. Senator Bob Corker was the only Republican to vote against the bill. Although considered the other two potential dissenters, Flake and McCain also gave their support. A conference committee will now be tasked with eliminating the differences between this Senate bill and that proposed by the House.

The consensus view of Trump’s flagship reform is that it will help stimulate near-term growth and is likely to prompt an upgrade to FED forecasts, therefore raising the potential for rate hikes next year. The market is currently pricing around a 0.4% increase in rates for 2018. However, as we discussed last week, the overall value of the measures is widely debated. Trump has tweeted a letter signed by 137 “economists” strongly endorsing the initiative, but the quality of those lending their support is comical; some have been shown not to exist, others are not economists and almost none are well known. In contrast, a survey by the University of Chicago amongst the IGM Economic Experts Panel, some of the most respected academic economists in the world, showed 100% consensus that the bill will raise US debt-to-GDP substantially and 98% consensus that GDP will not be substantially higher than under the status quo. As Oliver Hart of Harvard commented “many of the changes look like handouts to the rich”.

In any case, a final agreement by the end of the year is possible and could set the stage for an interesting 2018. Whist strong growth momentum will not dissipate in a hurry, the economic backdrop for markets has probably now peaked.

As expected, OPEC and the group of non-OPEC countries led by Russia agreed to extend production cuts for 9 months through to the end of 2018, subject to a 6-month review. Oil prices were largely unchanged.

20 to 26 November: Don’t be a hater

Since the summer, Donald Trump’s tax reform has edged closer to reality. Indeed, next week the bill hits the Senate, where Republicans hope their wafer-thin 2-person majority will be enough to pass a vote of support. Back in November last year, when Trump won election, there was much hope pined on this fiscal re-balance – and in some ways, this is well founded. The US has some of the highest corporate tax rates in the world and aggressive cuts could well engender a revival in investment. However, there is another side to this coin. In order, to be long-run deficit neutral, the plan envisages large income tax hikes. And here lies the rub. These increases are initially offset by a package of temporary tax breaks. This is to say, the Republican’s plan a very 21st century solution; stimulate now and let someone worry about the cheque in the future.

Of course, in the case of the US, with a market near all-time high valuations and after one of the longest periods of economic expansion in history, it’s easy to be a hater. However, for now, economic growth is “picture perfect” with good momentum and low inflation keeping interest rates low and the relative appeal of equities high.

US crude prices hit a 2-year high last week as a leak in South Dakota led to the shutdown of the TransCanada Keystone pipeline. OPEC meet on Thursday when an extension of production cuts could be announced.

13 to 19 November: Are we nearly there yet?

There was not necessarily a clear catalyst for the more elevated volatility seen last week. However, it would be fair to say that weakness in credit over the past month has spilt into broader nervousness. We would continue to highlight strong economic momentum at the global level. However, there is also a sense that the best period for markets is behind us; valuations are generally rich, the monetary impulse is likely to turn negative in 2018 and there is a feeling of investor fatigue.

This week, US markets are closed on Thursday for Thanksgiving.

6 to 12 November: Worst Case Scenario

Last week, developed market bonds and equities fell in unison. These moves were of course small and, in the context of a blockbuster year for equities alongside another positive total return for fixed income, of little isolated significance. Nonetheless, given “risk-free” bond yields in many currencies now trade near the zero lower bound, it is a reminder that, in the next crisis, traditional “balanced” asset allocation may not protect a portfolio.

In particular, we view inflation as the most sizeable tail risk for markets. As a reminder, global inflation has steadily fallen over the past 40 years (see chart 1). In our opinion, this has been driven by more pro-active monetary policy, ageing populations, technology and increasing leverage. The question now is whether the maturing cycle, with unemployment at multi-year lows, could start to stimulate increasing price pressures, therefore forcing higher interest rates and bursting the world’s liquidity filled bubble.

Our take is that, for now, this is unlikely. The forces of secular stagnation are the equal of tightening capacity utilisation and thus this “worst case scenario” will not be realised in the current environment. However, this is not to say we are positive on the longer-term outlook. The developed world continues to live beyond its means, with very low probability of generating sustained and sufficient real growth. Moreover, monetary policy has reached its limit. This is to say, moving beyond quantitative easing (to helicopter money or large negative rates) will challenge faith in fiat currency – and it is this that could unleash the inflation tsunami.

Last week, oil continued its march higher on the basis of uncertainty in Venezuela and unrest in Saudi Arabia (arrests of officials and members of the royal family, as well as the apparent detention of Lebanese PM Saad Hariri in connection with his refusal to confront Hezbollah). US oil inventories however rose, which suggests some ability for US producers to offset any reduction in global supply.

30 October to 5 November: Feeding Frenzy

It was more of the same for global markets last week, as the busiest week of the quarter (if not the year) in terms of news flow reiterated strong economic momentum and unusually low inflation.

This week is somewhat quieter, but Donald Trump’s trip to Asia perhaps provides a “wildcard” for markets. There will also be further corporate earnings releases (with a focus on retail in the US) and amendments proposed to the US tax reform bill later today.

23 to 29 October: Cramming It In

With every data point, the strength and breadth of 2017’s global economic acceleration is confirmed. Truly, a synchronised expansion is in progress with considerable momentum. However, financial markets do not necessarily move in lock step with fundamentals and, of course, nothing lasts forever. Last week there were large divergences at the sector and country level, with global equities falling in aggregate. Indeed, we are in a period with considerable news flow and event risk – and (from a purely tactical standpoint) there are some signs of fatigue.

This coming week, corporate earnings season continues, the Bank of England is expected to raise rates (with the BOJ and FED also holding meetings), Republicans in the US are likely to reveal their tax reform bill, it is rumoured there will be the first arrests linked to Robert Mueller’s Russian vote rigging inquiry (prompting a string of tweets from the POTUS yesterday) and Donald Trump may announce the new chairperson of the FED. Events in Catalonia will also be in focus.

Brent Crude oil traded above USD 60 for the first time in 2 years on Friday.

16 to 22 October: Scanning the Horizon

As the bull market rages on, many investors are “scanning the horizon” for reasons to sell the rally. From a technical perspective, we have already highlighted the (almost never before seen) low levels of realised volatility across asset classes. Also of note, average cash balances have reduced over the last year and (according to the Merrill Lynch fund managers’ survey) are now at 4.7% (the lowest since May 2015). More fundamentally, we continue to bang the drum of a goldilocks global economy with low inflation keeping monetary policy loose.

This week we have an ECB meeting at which we expect a change to the current quantitative easing program. As a reminder, the current commitment is to purchase EUR 60bn per month until December 2017. Given recent messaging from the governing council, we would expect a market friendly outcome that balances a reduction in size of purchases against a longer time horizon. This is likely to be between EUR 20bn-40bn per month for between 6-12 additional months.

9 to 15 October: It’s My Party and Everyone’s Invited

There has been much disbelief at the strength of the global equity rally so far this year. However, as summarised by IMF chief economist Maurice Obstfeld last week, the current global re-acceleration is more broad-based than at any time over the past 10 years. Indeed, the IMF upgraded its growth numbers for 2017 and 2018 to 3.6% and 3.7% respectively. Given also soft inflation, it therefore seems entirely reasonable to us that markets should have performed so well. Nonetheless, we would never have anticipated such low realised volatility (5.5% annualised for the S&P 500 over the last 12 months). This is bound to be contributing complacent positioning and underappreciated risk.

In Africa, South Africa’s appeal court upheld a ruling that 783 counts of corruption and fraud should be reinstated against president Jacob Zuma. The decision highlights the strength of South African institutions which have been uncompromised through Zuma’s tumultuous presidency and makes it more likely that the market friendly candidate (i.e. Cyril Ramaphosa) will emerge from the ANC leadership election in December. A Ramaphosa victory should see business confidence rebound from its historic low, encourage investment, as many South African companies will prioritise domestic over foreign investment. In the past these companies, with strong balance sheets and dominant market positions were investing elsewhere because of South Africa’s poor political environment. A change towards a business-friendly leadership at the ANC will begin the process of unlocking the potential of South Africa, which laid dormant during the past year’s due to its dysfunctional political environment. Global equity portfolio investors have zero to very low weighting to this market, which is characterised by highly profitable, pan-African leaders valued at multi year low valuations.

The Chinese national congress takes place this week (from the 18th).

2 to 8 October: Tour de Force

From the end of the financial crisis until the beginning of this year, the US economy sat at the front of the global growth peloton. Team America were the first, most aggressive and most coordinated in adopting performance enhancing fiscal, regulatory and monetary stimulus and this led to an outperformance of its currency and equity markets. This year, however, global peers have threatened a break-away; performance across European and Emerging economies has improved and US numbers have disappointed given Trump’s inability to consummate reform and gradual FED tightening.

However, there has been jostling for position over the past few weeks:

• At the end of September, FED minutes and speeches reiterated the desire to raise rates in December. This pushed Treasury yields and the USD higher and prompted the largest weekly outflow from emerging markets since the Presidential inauguration (USD 1.8bn from equities and USD 1bn from bonds in the last week of the month).
• There were signs of a US “second wind”, with blowout employment and PMI data sending the USD higher. However, as we cover below, there was a large weather-related distortion and we continue to characterise the US as later cycle.
• Emerging market data releases (for example China’s official NBS PMI rising to its highest level of 2017 and positive surprises from Brazilian vehicle sales) continued to be robust suggesting strong (and in the case of Latin America) improving momentum. This prompted a quick (positive) reversal in equity markets.
• Politics threatened to puncture the outlook in Spain (Catalonian independence) and the UK (Brexit and questionable leadership from Theresa May).

For now, the net result is a continued push higher; the MSCI All Country World equity index hit an all-time high and the VIX volatility index hit an all-time low last week.