After 9 months characterised by USD weakness, emerging market strength and an outperformance of mega-caps over small caps, last week saw a “role reversal”. In the US, Donald Trump’s tax reform proposal was positively received whilst Janet Yellen confirmed that the market should expect a hike in December. In Europe, politics took centre stage with unrest in Spain and fallout from the German general election.
This week we have monthly PMI numbers.
Financial markets were little changed last week, pausing for breath after the post-summer rally.
The FED meeting passed as expected (with the start of balance sheet normalisation) and economic data confirmed broad-based positive growth momentum.
In Europe, Angela Merkel secured a somewhat bittersweet victory to secure a fourth term as German chancellor, though with a lower than expected vote share and after a strong show of support for the right-wing Alternatives for Germany party. S&P downgraded China’s sovereign credit rating just a month ahead of the National Congress, though this was essentially a formality and largely ignored by markets.
Last week we highlighted the potential for greater monetary policy uncertainty given the FED’s Board of Governors is due to change almost entirely over the next 6 months. Indeed, investors everywhere are walking a “Goldilocks tightrope” – the combination of strong near-term growth but low inflation and confidence about longer-term economic conditions means it is “not too hot” to worry about rising rates and “not too cold” to raise concern about slower earnings.
After a summer rally, global bonds sold-off sharply over the past 10 days on a combination of a hawkish Bank of England, declining risk-aversion and reasonable data. For now, this did not upset the unstable equilibrium, with equity markets rallying alongside falling bond prices. We continue to expect central banks to tighten only gradually. In other words, despite the potential for cross-winds, monetary policy will not be the lever that knocks markets off balance.
Elsewhere, the UN Security Council unanimously voted to adopt a watered-down US resolution to impose new sanctions on North Korea. The resolution includes limits on imports of crude oil, a ban on textile exports (the country’s 2nd largest export worth USD 700m per year) and a ban on new visas for North Korean workers (estimated to cost USD 500m in tax revenue). North Korea’s ambassador to the UN stated, “The forthcoming measures by the Democratic Republic of Korea will make the US suffer the greatest pain it has ever experienced in its history.”
At the beginning of this year, consensus expected a re-acceleration in US growth led by Trump tax reform and fiscal stimulus. As such, many predicted fixed income would deliver a negative return and that the USD would strengthen (hurting emerging markets). Moreover, there was a fear of inflation due to tightening labour markets.
The reality has been quite different. Economic data has consistently disappointed in the US, versus broadly improving elsewhere. Meanwhile, inflation has remained subdued everywhere. As a consequence, the US 10-year has fallen from 2.45% to 2.05% yield (despite 2 rate hikes) and the USD has lost over 10% of its value on a trade weighted basis.
Whilst equity valuations remain full, markets can now be considered to have priced out any acceleration in growth. Indeed, the outlook for monetary policy is as uncertain as it has been at any time over the last 12 months. Last week, Vice Chair Stanley Fischer tendered his resignation from the FOMC (effective mid-October, having been due to leave in 2020). He stated this was for “personal reasons” but it came less than a month after he called efforts to loosen constraints on banks “dangerous and extremely short-sighted”. There were already 3 out of 8 seats on the Board of Governors vacant and it is thought extremely unlikely that Janet Yellen will be reappointed in February (since Donald Trump openly attacked her on the campaign trail). Therefore, we will see a very different FED over the next few years. The exact mix of replacements will be significant for policy. Moreover, investors should reflect as to whether there is increasing evidence that Trump’s fractious leadership is impairing decision-making and, ultimately, growth.
We have talked over the last 2 weeks of a “Goldilocks” economic environment, with broad-based growth but weak inflation. As such, we have speculated that any headwind for markets would be more likely to come from the political sphere than from central bank tightening. Indeed, over the summer, US President Donald Trump and North Korean supreme leader Kim Jong Un have combined to stimulate market sell-offs on a roughly one day per week basis.
Last week, North Korea conducted several exercises in response to US-South Korea military exercises. This culminated on Tuesday in a missile that flew over the Japanese island of Hokkaido (the northernmost of Japan’s main islands). In reply, allied aircraft conducted tests of bunker busting bombs near the North Korean border. Equity markets again sold off briefly, with safe havens rallying (the US 10 year yield touching its lowest level since November 2016 at 2.08% yield), before calm was restored.
Until this point, underlying economic strength has therefore ultimately trumped geo-political squabbling. Over the weekend, however, North Korea appears to have “upped the ante”, claiming to have tested a hydrogen bomb that could be mounted on a ballistic missile. The explosion triggered an earthquake measuring 6.3 on the Richter scale and is estimated to have been 10 times more powerful than anything detonated before. Trump’s first reaction was to tweet “North Korea is a rogue nation which has become a great threat and embarrassment to China, which is trying to help but with little success”. It is expected that the principal retaliation tool will be via further economic sanctions.
Although North Korea might provide the most extreme political tail risk, there are certainly a number of other flashpoints on the market’s radar:
In last week’s edition, we commented on the current environment of abnormally low inflation relative to the breadth and strength of global growth. We argued that this was related to a number of factors including mis-measurement of resource utilisation and overall pessimism about the long-term business environment. As a consequence, we expected monetary policy would remain accommodative for longer than usual and, therefore, that the Goldilocks (not too hot, not too cold) economic backdrop for markets could continue. In this way, we saw the principal risk to markets coming from the political, rather than central banking, sphere.
At the Jackson Hole Economic Symposium, these dynamics appeared to be very much in evidence. Unlike in prior years, where policymakers have used the event to deliver strong signals on future policy, both Janet Yellen and Mario Draghi preferred to “wait and see”, revealing little market sensitive information:
Elsewhere, we continue to hold a positive stance on Brazil as the country emerges from recession, the central bank continues to cut rates and there is an increasing focus on reform rather than political scandal (see below). There is also a “tactical” appeal, given large outflows following the Temer corruption allegations.
Last week, minutes to the ECB and FED July meetings revealed an increasingly agitated discussion about the lack of inflation associated with the current expansion and period of declining unemployment (the failure of the Phillips curve). We’ve highlighted our view many times that monetary policy has failed to properly recognise both declining potential growth in the developed world and its own role in propagating a vicious circle of inefficient asset allocation and increasing leverage.
Considering the Phillips curve specifically, it would be difficult to argue that the link between resource utilisation and inflation has completely broken (as slack reduces, there must be increasing price pressures as demand outweighs supply). However, the nature of this relationship (the slope, position and formulation of the Phillips curve) has never been stable through time and has clearly shifted over the past decade. Currently, we suggest the curve is extremely flat (there are very limited inflationary pressures) because of:
Whilst these trends do not augur well for the long-term, over coming months they could continue to foster a positive environment for risk assets. Global growth is as strong and broad based as it has been since the financial crisis and, if the forces that would usually translate this into inflation and monetary policy tightening are weakened, the “Goldilocks” conditions of the last 12 months could prevail. Moreover, whilst our discussion above focuses on the developed world, emerging market central banks are biased to ease policy.
Of course, this is not to confuse resilience with complacency; our major risks to the outlook are political, particularly in the US.
Early this year (23rd Jan) we suggested “politics is likely to prove an increasingly important determinant of relative performance across asset classes, sectors and regions”. Indeed, as it relates to the US, we later commented (18th April) that “it’s started to look like President Trump will struggle to generate any real change domestically…the US President might switch his attention to geopolitics.”
With respect to the first statement, we have probably not yet been proved accurate; overall global growth momentum has continued to float almost all boats. Nonetheless, there is still notable political risk. For example:
With respect to the second statement, on Tuesday, Trump broke the market from its summer slumber by stating the US would “deploy fire and fury like the world has never seen” if North Korea did not give up its nuclear programme. Two days later, he added that he “may not have been tough enough”. North Korea responded by announcing it was planning to target the waters surrounding the US territory of Guam with 4 missiles by “mid-August”. The US’ top military official (Chairman of the Joint Chiefs of Staff General Joseph. Dunford) is scheduled to meet with the leaders of US Forces Korea and the South Korean President Moon Jae-in later today.
Trump also set his sights on Venezuela, commenting “The people are suffering and they are dying. We have many options for Venezuela including a possible military option if necessary.”
This week, the Czech central bank became the first to raise rates in the EU since Jean-Claude Trichet’s much lambasted hike in the midst of the sovereign debt crisis of 2011. Of course, the US is already 18-months into a rate increase cycle.
However, the pace has been lethargic as low inflation has persisted despite an economy appearing to be at full capacity. As we have highlighted, something appears to have structurally changed with labour markets; the UK, Japan and the US are all near estimates of full employment, but are producing only modest wage growth.
For Europe, the ECB’s job is, as always, complicated. There is a great divide, with German unemployment at the lowest since reunification (3.8%), but Eurozone wide unemployment still high at 9.3%. This reflects double digit jobless rates in southern Europe (for example 21.7% in Greece and 17.1% in Spain) and for youth (18.9%). Meanwhile, across emerging markets declining inflation is allowing central banks to cut rates (India last week and much of Latin America over recent months).
In aggregate, monetary policy remains extremely accommodative from a global perspective.
After sweeping into power on the promise of stimulus, reform and “Making America Great Again”, during his first 190 days in office, one could well judge Donald Trump has tried to do everything but improve the trajectory of the American economy.
First, there has been no progress on tax reform as Trump has repeatedly failed to pass healthcare reforms. Indeed, his leadership has become increasingly fractious – on Friday he accused the 3 Republicans who failed to support his latest amendment (including Senator John McCain) as having “let the American people down”. Following up on Saturday with the threat ““if a new HealthCare Bill is not approved quickly, BAILOUTS for Insurance Companies and BAILOUTS for Members of Congress will end very soon!” Trump is in part referring to government subsidies to insurance companies, which make health cover accessible to poorer Americans. The next such payment is due on the 21st August.
Second, he has often batted from left field, pursuing personal rather than popular agendas on topics such as immigration, the environment and, last week, transgender soldiers. In the latter case, he announced by tweet “please be advised that the United States government will not accept or allow transgender individuals to serve in any capacity in the US military” – a measure taken with apparently no prior notice to the Pentagon and concerning an agency that currently employs more transgender people than any other organisation in the world.
We therefore see Trump as having thus far been “left behind”, with little concrete change as a result of his tenure. The global economy is delivering resilient growth and therefore the US has continued to expand with modest momentum (albeit lagging global peers). However, in stark contrast to the fanfare with which he was greeted (with the potential to address some of the highest corporate tax rates in the world and the lowest levels of government investment for a generation), his unconventional leadership now seems more likely to present a risk of “leading astray” the US economy.
