17 to 23 July: A World of Difference

Incoming data continues to show global growth has good momentum. Indeed, a number of countries (for example US and Germany) appear to be at full capacity. This should be generating inflation, making it a straightforward job for central banks to raise rates. However, in the new world things are not so easy. First, wage growth is much lower than the historical “Phillips Curve” relationship. Second, commodity prices are subdued – reflecting extensive capacity buildout over the last decade. Third, the extreme liquidity created by unconventional monetary policy has depressed even long-term yields, meaning a change in overnight interest rates could have much larger effects than usual. Last, the developed world is wrestling with lower potential growth than at any other time since the end of the second world war.

In this spirit, last week the ECB struck a dovish tone and the BOJ extended the time horizon for reaching 2% inflation for the 6th time. This week there is an FOMC meeting at which the FED may announce the timing of their balance sheet reduction. More likely, they will stand pat as recent US data (particularly inflation) has been somewhat softer than expected.

10 to 16 July: Splitting Up

The global economy continues to enjoy a growth recovery, with recent data suggesting there has been renewed strength at the beginning of the Northern hemisphere’s summer. However, from a cyclical perspective, there is clear a difference in the maturity of this expansion across different regions:

• North America continues to look late cycle, with interest rates and inflation on an upward trend. Last week, the Bank of Canada raised rates for the first time in 7 years, Mexican inflation touched a near 10 year high and US data continued its tepid trend.
• Conversely, across Emerging Markets inflation is slowing and growth accelerating. Last week, Indian inflation fell to 1.5% and Brazilian inflation touched 3% (both the lowest levels since the 90s). Meanwhile, Chilean inflation also came in lower than expected, Peru cut rates and (this morning) Chinese GDP growth came in better than expected. This suggests the world’s largest economy will post its first year-on-year growth improvement since 2010.

3 to 9 July: Growing Pains

The upturn in global bond yields continued into its second week as central bank meeting minutes and mostly positive data caused investors to reassess the longer-term outlook for interest rates. However, equities were more resilient than a week ago, ending mostly unchanged. Looking in more detail at bond market moves, it’s interesting to note curves steepened, with little action in shorter dated securities. This is to say, the market is not necessarily pricing higher interest rates, but the start of a withdrawal from quantitative easing. In the context of continued economic momentum across most of the globe (UK an obvious exception), this should surely be expected. As former FED Chairman Bill Martin said, the job of a central bank is “to take away the punch bowl just as the party gets going”. Nonetheless, whilst there is certainly room for rates to continue to trend higher (we are still talking about small moves and near all-time low yields), we think it is unlikely we are going to see a “taper tantrum” yet. In 2013, US 10 year yields rose 150bps, as opposed to the last fortnight’s 25bps move, and this all comes in the context of limited inflationary pressures.

Oil experienced a roller coaster, hitting a 1 month high on Monday, before declining around 4% on the week amidst negative headlines; OPEC shipments and US shale production rising. This alludes to our theme of oil producing nations playing weak hands, which restrict their ability to manage the price higher.

26 June to 2 July: Damned if You Do, Damned if You Don’t

Despite continued momentum in global growth over the past 6 months, government bonds have rallied alongside equities. Last week, hawkish soundbites from central bankers prompted a spike in bond yields, a surge in the EUR and GBP and pushed most equites lower.

• In the US, 3 key members of the FED commented on financial market valuations:
  • Chair Janet Yellen “(asset prices are) somewhat rich if you use some traditional metrics like price earnings ratios”.
  • Vice-Chair Stanley Fischer “high-risk appetite has not led to increased leverage across the financial system, but close monitoring is warranted”.
  • San Francisco FED Chief John Williams “the stock market seems to be running pretty much on fumes.”
• In the UK, (not for the first time) Mark Carney appeared to change his tone by stating the current inflation overshot “can only be temporary in nature and limited in scope” and “some removal of monetary stimulus is likely to become necessary”.
• In the Eurozone, Mario Draghi also stressed the state-dependency of policy, saying “as the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instrument”. Moreover, this weekend, Bundesbank President Jens Weidmann commented “at the moment we see that the economic situation is rather positive…if this sustainably passes on to inflation rates then monetary policy needs to be more taut, and it’s not about putting full brakes on monetary policy, but to lift one’s foot off the gas a little”.

It’s important to give some context to last week’s comments and market moves. First, there is surely a case for over-interpretation; policymakers were mostly offering “what-if” analysis, rather than committing to more aggressive tightening. Second, there is still little/no concurrent evidence of a pickup in core inflation. Third, yields remain within their range of the last few months – there has been no breakout move higher.

Overall, we judge that the short-term path for global rates is unlikely to be synchronised. We still believe the US is most likely to tighten further, that Europe (in aggregate) has a lot of remaining spare capacity, which should keep rate hikes on the back foot and removal of QE gradual. Last, we don’t think incoming UK data will be sufficiently resilient to support tightening.

Longer term, we still see monetary policy makers as “damned if they do and damned if they don’t”, unable to manage asset price bubbles and the secular growth slowdown at the same time.

Separately, oil prices have now managed 7 consecutive daily gains, WTI posting an over 8% rise from recent lows after a decline in weekly US crude production.

19 to 25 June: Body Swap

In 2015 and early 2016, the UK was a bright spot for developed world growth. Meanwhile, much of Europe (led by France and Italy) languished in a post-crisis quagmire, hampered by indecision and bureaucracy. This year, the dynamics appear to have reversed.

In the UK, Theresa May’s decision to call a snap general election backfired spectacularly. After a limited and inconsistent campaign, the Conservatives lost their small majority in parliament. In the aftermath, the Prime Minister has not done much better; an agreement with the DUP in Northern Ireland is still outstanding and there is a sense of an overall lack of leadership. Similarly, there is discord at the Bank of England – with a division between the dovish Governor, focused on the weak growth picture, and a more hawkish minority (including the Chief Economist), concerned about recent inflation and low levels of unemployment. After a period “defying gravity”, with resilient consumer spending and exports benefitting from better global growth and a weaker GBP, the UK economy is weakening. On current evidence, we worry about the ability of government to manage Brexit negotiations and think policy uncertainty will create a further drag.

Meanwhile, Europe is enjoying its day in the sun. In France, socialist Francois Hollande (whose politics led to the nickname “Flanby”, a jelly-like caramel custard) was decisively beaten by Emmanuel Macron in the Presidential election, with the latter’s centrist “En Marche” party (formed only 14 months ago) capturing a convincing majority in parliamentary voting. This has resulted in a surge in business sentiment (May composite PMI and INSEE Business climate indicator both at 6-year highs). In addition, the Italian banking system is finally addressing the insolvency and undercapitalisation of many of its participants. Earlier this year Unicredit raised EUR 13bn in capital, this week 2 mid-sized banks from the Veneto region were put into wind down and shortly (there is some doubt about the feasibility of the announced plan) the world’s oldest bank, Monte Paschi, should receive state aid to address its monster book of non-performing loans. Last, the usually dysfunctional ECB mostly appear to be sticking to a single script, keeping policy easy based on low inflation.

Over the longer term, we’re not convinced this “body swap” will continue. In our opinion, the European resurgence is more a case of “every dog has its day”; as Greece has demonstrated, the Euro fundamentally doesn’t work and whilst Italy may enjoy improved confidence in the near-term, underlying growth potential is weak and its fiscal position is far from being addressed.

In commodity markets, oil prices entered a bear market (a decline of over 20%). WTI prices have no fallen over 25% YTD from their high on the 1st January at USD 58.30 and dipped below USD 43 for the first time in 18 months.

12 to 18 June: Hope Springs Eternal

Since the financial crisis, there has been much discussion of “secular stagnation” or a “new normal” for the global economy, with lower growth and inflation. Last year, a commodity rally sparked a brief move higher in headline inflation. However, outside a few special cases mostly related to currency weakness (like the UK), measures of core inflation have struggled to move higher.

Central banks remain resolute that price pressures are just around the corner. With unemployment at multi-decade lows in the US, the FED are using the “Philips Curve” as their anchor (that there is an inverse relationship between the level of unemployment and the rate of inflation) and raising rates ahead of a potential surge in wages.

Markets, however, are more sceptical. Despite 3 rate hikes in 6 months, the US 10-year is 0.5% lower in yield (this week the 10-year hit its lowest yield since the Presidential election at 2.10%). Similarly, whilst the FED is clearly guiding a further rate raise this year as part of an ongoing cycle, futures markets price only a 40% chance of another hike before January and less than 2 hikes over the next 2 years. Commodity markets too are refusing to stick to a bullish regime. Oil prices were again lower last week, extending their longest run of weekly losses since August 2015.

In fact, although the central banking fraternity believe tighter labour markets are going to prompt higher inflation over the coming months, they appear to acknowledge that their current mandates (in US/Europe/Japan/UK encompassing a 2% inflation target) may leave insufficient room to stimulate long-term growth. During the FED’s press conference, Janet Yellen said the question of raising inflation targets was “one of the most important questions facing monetary policy.” In short, although the global economy currently has some decent momentum, the underlying weakness in the developed market story still lurks in the background.

5 to 11 June: Interview with a Vampire

For US markets, a standout feature of the last few years has been the concentration of returns and profitability across a very small number of firms. Indeed, the overall number of listed companies in the US has fallen from 7,300 in the late 90’s to only 3,599 today. Moreover, the share of total profits generated by the top 100 firms has shifted from around 50% in the 70/80/90s to approximately 85%. This dynamic owes much to the technology sector and its “disruption” of traditional business models. As such, the contribution of tech stocks to equity returns has been extremely significant; the NASDAQ has outperformed the S&P 500 every year since 2012, whilst the MSCI AC Asia IT index has delivered almost 2.25x the return of its (already tech heavy) MSCI AC Asia parent over 5 years.

This paradigm has prompted acronyms such as “Fang” – Facebook, Amazon, Netflix, Alphabet (Google) and “Faamg” – Facebook, Apple, Amazon, Microsoft, Alphabet (Google). According to a Goldman Sachs report last week, this latter group explains 37% of the S&P return YTD, a USD 660bn gain (equivalent to the combined GDP of Hong Kong and South Africa). However, there is now concern that the story has got ahead of itself – as GS comment “this outperformance, driven by secular growth and the death of the reflation narrative, has created positioning extremes, factor crowding and difficult to decipher risk narratives.” Indeed, separately Bank of America suggested the sector is the most overweight it has ever been and that “based on EV/Sales, which would not be impacted by accounting differences such as the inconsistent treatment of stock-based compensation… tech trades at its highest relative multiple since the Tech Bubble, and is trading well above average even when excluding the Tech Bubble.”

Of course, the tech rally is certainly not without foundation. However, there is a case that a combination of excess liquidity, few other bright spots across developed markets and strong momentum has caused investors to forget potential cyclicality. Moreover, the global success of US tech firms has perhaps masked the overall picture in US equities. Elsewhere, the oil price continued its struggle, with another week of losses as the Energy Information Agency projected that US domestic oil output will top 10 million barrels a day in 2018.
This week we have a FED meeting, at which we expect a rate rise, as well as Bank of England, Bank of Japan and Swiss National Bank gatherings at which policy is likely to be left on hold. There is also a Eurogroup meeting, which will focus on the Greek bailout review.

29 May to 4 June: Remember Me?

The oil price was under pressure again last week as OPEC’s extension of output cuts (rather than an incremental reduction) and US production hitting the highest level since August 2015 (with a record 20th straight weekly increase in rigs), weighed on sentiment. More generally, the pick-up in inflation, which started in the middle of last year, has abated in recent weeks (the Eurozone experienced deflation on a 1-month basis from April to May). This creates a quandary for central banks – whether to respond to better global growth or keep their foot on the throttle to bring price pressures closer to target.

We expect the ECB this week to sit somewhere in the middle – overall dovish, but with some adjustment to their language. We also have James Comey testifying to Congress regarding Trump’s involvement with Russia and the UK General Election on the same day as the ECB announcement (Thursday). Recent GBP weakness has priced a weakening in support for the Conservatives.

22 to 28 May: Paper Shuffling

After a 9-month odd bull market, some divergence and loss of momentum has prevailed over recent weeks. Over the next month, a number of policy announcements could shape market direction. In particular:

• FED and ECB monetary policy decisions at which the US will likely raise rates and Europe may signal a more hawkish stance on policy.
• UK general elections and the start of Brexit negotiations.
• Italian electoral reform (setting up an Autumn election) and the conclusion of Greek negotiations with the EU to unlock the latest tranche of funding.

15 to 21 May: Politically Incorrect

After a 9-month period in which equity markets have stretched their legs into a “perfect calm” of rebounding global growth, last week saw a mid-week stagger as a 1-2 political punch combo threatened to derail momentum. First, allegations surfaced that President Trump fired FBI Director James Comey to cover up his own and/or his campaign officials’ improper behaviour. Second, reports suggested Brazil’s President Temer might have been complicit in illicit payments to former speaker of the lower house of Congress Eduardo Cunha.

Taking a step back, we continue to believe the global economy has strong momentum and, whilst this political unrest should prompt a pause for thought, we do not see it as a knockout blow. Markets have enjoyed a serene regime in which all indicators flashed green. Going forward it is likely to be less straightforward.

Our bias, would be that US markets might be underappreciating the significance of the investigation into the President, and the severe lack of political capital to make any progress on pre-election promises. Given also the late cycle positioning of the US economy, we remain cautious on US equities. With respect to Brazil, the economy is in a much better place than 18 months ago, with falling inflation opening the door to aggressive interest rate cuts from the central bank. Pending structural reforms are important to avoid a “double dip” recession, and as such the inevitable delay and loss of credibility will have an impact, but the picture is not unequivocally bad. This is to say, it might be rash to “buy-the-dip”, but it is also too early to give up on the secular recovery story.

In commodities markets, oil moved higher on the announcement that Saudi Arabia and Russia had agreed to extend output cuts.