5 to 11 December: Any News is Good News

A cynic might claim that a thirst for yield and return is pushing investors to interpret “any news as good news” over the last few months. Indeed, last week risk assets navigated the failure of the constitutional reform referendum in Italy, and the ECB tapering of bond purchases, with aplomb.

We feel there is a disconnect between pricing/positioning and risk/reward across many markets. Fundamentally, this is explained by a mix of easy monetary policy, extreme leverage and structurally lower trend growth across the developed world. This is a concern in light of significant ongoing political risk (Trump policy implementation, Italian bank recapitalisation, Brexit, French elections). However, in the short-term, the global economy will not be going into recession and, as such, data is likely to be supportive.

This week we have the December FED meeting (which includes a press conference), at which the market expects a 25bps interest rate hike. As Deutsche Bank point out in a note this morning, any tightening should be seen as momentous, given approximately 670 interest rate cuts globally over the last 9 years! Attention will focus on changes to forecasts in the light of the incoming (fiscal stimulus friendly) Trump government. However, given considerable uncertainty about the details of the new President’s policy, the board will perhaps proceed cautiously. There are currently slightly more than 2 hikes priced in for 2017.

Elsewhere, following the recent 1.2mn barrels per day production cut by OPEC members, on Saturday non-OPEC producers agreed an incremental 558,000 barrels a day cut (including Russia at 300,000). Oil markets have responded favourably this morning.

28 November to 5 December: Politically Incorrect

After a long period in which monetary policy has led markets, the baton has (at least in part) passed back to politicians over the last few months. After the surprise Trump election, yesterday saw the constitutional reform vote in Italy fail. Although expected, the margin of victory and strong turnout underscored a resounding loss for Prime Minister Renzi.

Moving 6,500km east, last week saw the first data release since India’s “demonetisation” (see details below). It is still too early to judge the impact of this measure and opinion is firmly split. On the one side, a number of economists have taken a negative view. They highlight:

• Short-term disruption of removing 86% of paper currency in an economy where 98% of transactions by volume and 68% of transactions by value are in cash.
• Potential ineffective and temporary effect on the black economy of removing relatively low denomination notes (values are roughly USD 7.5 and USD 15 respectively).
• Risk that increased tax revenues are spent inefficiently.
• Monetary tightening as a consequence of a “negative helicopter drop” whereby any notes not deposited with the RBI are cancelled.
• Threat to credibility of government and the currency of such a blunt and sizeable move.

Certainly, we agree demonetisation stands out as bold reform, carrying not insignificant risk. However, we believe much of the criticism fails to take account of the broader context – demonetisation is not occurring in a vacuum:

• Banking penetration has historically been low, but over the last 2 years the government opened 220 million accounts and made some benefits available only through this channel. Although most of these accounts remained otherwise dormant, over the past 3 weeks many have been activated. Therefore, the implementation of demonetisation as a “big bang” has meant that much of the informal sector has had no choice but to go digital. In this way, the process will create permanent change to business practices.
• The starting point is extreme; according to the country’s first release of income tax data for 16 years, only 2.5% of Indian’s filed a tax return and only 1% ultimately made a tax payment. Given such a low tax take, and the evidence of a government focused on transparency and reform, we would argue the multipliers from government spending are likely to be positive.
• Inflation is falling and will fall further, allowing the RBI to cut rates (starting this week). Moreover, it is not clear there will be a large reduction in the money supply. In theory, any notes not deposited with the central bank will ultimately be cancelled, thus reducing the cash in circulation. However, according to Credit Suisse, 56% of notes had been deposited 10 days ago, and some 75% may be exchanged over time. Thus, any reduction will be small. In addition, rather than cancelling the liability, the bank may choose to rebate the gain to the government to be spent on fiscal measures.

And this last point hints towards the principal risk. Such large-scale reform and management of currency walks a tightrope of positive change against faith in government. Just as we have spoken about in the past with respect to “helicopter money”, credibility is all important. If there is any sign of government acting nefariously or in self-interest, the process will unravel.

In conclusion, whilst the India story carries risk, we remain extremely positive. History teaches us that to unlock the underlying growth drivers of demographics, urbanisation and structural transformation, requires inclusive and quality institutions and government. The potential for such a combination in India is, in our view, unparalleled.

Last week, OPEC agreed its first price cut in 8 years (amounting to around 1% of global production and prompting a 16%+ rally in the oil price). We remain somewhat sceptical as almost all major oil producers are playing weak hands – they require any and all revenue and are therefore unlikely to stick to production targets. Former Saudi oil minister Ali Al-Naimi summarised it aptly on Friday commenting “Unfortunately, we tend to cheat”.

This week, the RBI in India meets on Wednesday, followed by the ECB on Thursday.

21 to 27 November: General Consensus

Over the past 3 weeks, global markets have decoupled, with price action suggesting strong consensus positioning across the developed world. In particular, investors have quickly priced in that Trump will bring meaningful fiscal stimulus, accelerated growth and higher interest rates (see equities at all-time highs, USD at multi-year highs and bonds at one-year lows). Conversely, Europe is expected to be trapped in a monetary policy “groundhog day” (US-Germany 2yr yield spread touched record 1.81% this week), whilst there remains little confidence on underlying growth and reform (Italy-Germany bond spread widest in 2.5 years, Italian equities 23% lower YTD in EUR terms). As it relates to emerging markets, fund flows have aggressively reversed, but currency and equity markets have mostly held up well.

It may be that markets have got this right; the US will continue to out-perform as Trump delivers, Europe will lag on ineffective policy and emerging markets will “muddle-through”, with domestic growth, cyclical positioning and reform facing off against a stronger dollar head-wind. However, given the degree of political uncertainty (reality vs. perception for Trump and elections across Europe), we think there is a great deal of risk to the market’s central outcome for 2017.

Next week brings a brief respite ahead of the Italian constitutional reform referendum (4th December) and ECB (8th December) and FED (12th December) meetings.

14 to 20 November: Un Cane in Chiesa

After the shock Trump election result, markets have seen some of the largest 2 week moves on record across a variety of assets. In this spirit, last week saw the second largest outflow from bonds since 2002 and a significant reversal of funds from Emerging Markets.

The next major event state-side is the FED meeting in mid-December. However, an interest rate hike is now all but priced in and we therefore see little chance for a major upset unless the market posts a meaningful, prior correction.

Instead, we think events in Italy could be of greater significance. The referendum on the 4th December is expected to fail (although who trusts polls these days!). This would lead to the resignation of Prime Minister Renzi and potential difficulties for the banking sector, which is closing on long needed capital raisings. We remain concerned about Italy over the medium-term given low productivity, high debt, inability to reform and the structural constraints of the Eurozone.

8 to 13 November: Too Many Chiefs and Not Enough Indias

Coming into US election week, the S&P 500 had declined for 9 consecutive days – the longest losing streak in 36 years, for a cumulative loss of around 3%. On Monday however, the day after the FBI concluded there was no criminal wrongdoing in their probe of Democrat candidate Clinton’s emails, the market rallied back 2.2%. Then, in the early hours of Wednesday, when initial results suggested Donald Trump was set to win the Presidential election, S&P futures fell as much as 5%, Asian markets crumbled (Nikkei down 5.36%) and bonds rallied on a flight to safety.

That over the course of the following 3 trading days, we saw a veritable smorgasbord of asset price reversals (including a new all-time high for the Dow Jones Industrial Average, the highest yields on government bonds since January and the most significant rally in copper since 1980) must go down as one of the most significant about turns in market history.

Our appraisal of the seemingly incongruous market moves over the last month is as follows. With hindsight, we think price action pre and during the election (where declines were positively correlated with an increased probability of a Trump victory) were a sign of uncertainty and risk to the status quo, rather than an assessment of the economic consequences. The developed world is suffering from a structural decline in growth (lower productivity, lower labour force participation, ageing demographics). Over the past 35 years, this has prompted a monetary policy dominated response, which has resulted in a bond (and bond-proxy) market bubble, record leverage, falling inflation and high asset prices. Taking President Trump’s promises of a large scale fiscal stimulus at face value, there is now a potential shift in this cycle: government spending could accelerate growth over the medium-term but also, with the impact of import tariffs and a labour market near full employment, promote inflation and interest rate hikes from the FED. That is to say monetary policy could go into reverse – and this is what the market has begun to price with a 37bps increase in yield on the US 10yr and declines in share prices across the high dividend paying utilities, telecoms and consumer staples sectors.

Realistically, the outlook is more complex. First, whilst Trump has the benefit of the first unified government since 2008 (Republican’s control both houses of congress), we need to see to what extent he can and wants to fulfil pre-election promises (recall the headlines of 45% tariffs on Chinese exports, the building of a wall with Mexico, and a drop in corporate tax rates from 35% to 15%). Second, although we think the switch from monetary to fiscal stimulus is intuitively appealing, it is unclear whether it is a sustainable strategy. Certainly the US needs to improve its infrastructure and government investment to GDP is at multi-decade lows (therefore we could anticipate positive multipliers). However, it is unlikely this alone can spur a return to “normalised” growth. Moreover, the risks of unwinding the biggest bull market in history across fixed income are surely not inconsequential. Last, the anti-globalisation, anti-establishment undertones of the Trump victory are slower moving dynamics, but will create volatility.

In summary, we do not change our longer term views. Whatever policy set is pursued, the developed world does not have a sustainable real growth story. Similarly, bonds offer very little reward for enormous risk. Whether by a default/deflation spiral because of policy inaction (most likely in Europe), incremental monetary policy challenging faith in money as a store of value, or indeed the Trump style, deficit funded fiscal approach, the no inflation, no growth, no default paradigm will, at some stage, have to give.

This brings us to what might, in any other week of the year, have been the headline story.

 

India’s government went nuclear in its war on black money, by announcing the withdrawal of bank notes worth 9% of GDP. This forces billions of dollars of undeclared income to be deposited in the banking sector and simultaneously wipes out a chunk of the ill-gotten wealth of India’s tax-evading elite. Long term, this reform will do more for India’s development than almost any other single policy seen in recent times in emerging markets. Short term, frictions during the transition period will challenge established transaction models and disrupt activity for a number of weeks.

Of course we recognise the near term risks to emerging markets from a stronger USD (the JPMorgan EM Currency index fell 3.4 % last week, the worst in 5 years) and anti-trade and immigration rhetoric. However, it’s surely much easier to have conviction on long-term, real domestic growth than on the whims of policymakers.

31 October to 6 November: Playing the Trump Card

Anxiety ahead of the US elections has drip-fed global equities lower over the past 2 weeks. Certainly, it is clear that a Trump victory is seen as market negative – and on this the Mexican Peso and recent polls had suggested the probability of a Republican victory was improving. However, news on Sunday that the FBI will take no action against Democrat candidate Clinton, after a lengthy email probe, has restored market optimism. Assuming no Brexit style surprise, the FED will almost surely raise rates in December, whilst we think a (temporarily) better broader growth picture may support risk assets into the end of the year.

Elsewhere, it looks like Saudi Arabia top ticked the oil price. After hitting a 15-month high on the day of their landmark bond deal, the price of crude has been obliterated, falling 10% last week. This was due not only to perceived difficulties in implementing an OPEC production cut, but also a record build in US oil stocks. As a reminder, Saudi Arabia plan to list up to 5% of the state oil company “Aramco” in 2018 – look out for the oil price surge prior!.

24 to 30 October: Happy Halloween

Most bond and equity markets traded lower last week as the trend of slightly better growth and inflation data/expectations, together with less clarity from central banks, continues. Although the recent bond market sell-off has garnered much attention (US 10 year yield up over 50bps from July lows, German Bund moving from -0.2% to +0.17% yield and October representing the worst month in 3 years), some perspective is needed. Yields are still lower than the beginning of the year and, in most developed market cases, have never been lower outside the last 12 months. Similarly, whilst we expected the underlying pick-up in growth and inflation (and think it will continue over the next 6-9 months), it is nowhere near “escape velocity”.

The US is late cycle, the UK will start to feel the effects of Brexit via lower investment and European remains highly fragile and lacking in joined up thinking. This is not to say the bond market offers value. Ultimately, we remain of the view that (longer-term and outside Europe) central banks will increasingly embrace inflation. Moreover, at this point, efforts to create additional monetary stimulus may challenge the faith in money as a store of value and thus also deliver a less bond market friendly outcome.

17 to 23 October: Super Tankers Passing in the Night

The success of this week’s USD 17bn Saudi Arabian bond market debut reiterated the global hunt for yield. Indeed, it was the 3rd time this year the record was broken for the size of an emerging market issue (previous best was USD 7bn by Qatar in 2009).

Just like super tankers, fund flows and, in turn, economies have considerable momentum and therefore change direction slowly and with difficulty. We think the early warning signs for the bond market ship are flashing – in particular a greater tolerance for inflation and potential changes in policy towards fiscal stimulus and steeper yield curves. Indeed, despite the success of the Saudi deal, the last few months has been characterised by a rebound in bond yields and last week saw the first large redemption from emerging market bond funds since January. On the other side, positive flows towards emerging market equities have started this year but allocations and valuations have only recovered to (approximately) historical averages. Given also the expensiveness of developed market alternatives and the sanguine reaction to the recent USD rally, we think this boat has considerable distance to sail.

10 to 16 October: Easy Peasy Japanesey

At their last meeting, the Bank of Japan made two policy innovations:

1. “Yield Curve Control” whereby the bank will aim to hold the 10yr yield at 0%, inducing a steep curve and allowing base rates to fall further into negative territory (whilst mitigating the tax on banks).
2. Effectively raising the inflation target by saying it was prepared to “over-shoot” the 2% level.

We think these measures may have a greater impact on global markets than initially appreciated. First, the adjustment to QE implementation has heightened concerns that this tool is reaching the end of its useful life. This week’s ECB meeting may reveal Europe’s take. Second, Japan’s move on the inflation target may start the long discussed move towards tolerating a higher level of inflation as a way of managing the interest rate lower bound. Last week Mark Carney (Governor of the Bank of England) also spoke about a willingness to “over-shoot”. So far this month US, German and UK 10-year yields have risen 17,18 and 37bps respectively as investors consider the sustainability of current policy.

3 to 9 October: Yield to Pressure

Government bond yields pushed higher last week as investors were given a plethora of reasons to question the “no growth, no inflation, QE forever” dogma.

First, a Bloomberg article suggested the ECB could announce a tapering of its monthly asset purchases (currently EUR 80bn), following the expiry of the current programme in March 2017. Taken in the context of Japan’s recent decision to start tailoring purchases to manage the shape and level of the yield curve, this rumour solidified concerns that the cost/benefit of central bank asset purchases might be shifting against further stimulus. In particular, the sheer size of quantitative easing has turned government bonds into a policy instrument (rather than an investment asset) and is putting very obvious pressure on bank profitability.

The ECB has quickly denied the report and our base case remains that QE will be extended for at least a further 6 month period (to September 2017).This is not to say we think it is an effective policy. Rather we cannot see the economy sufficiently strong for the ECB to reduce stimulus and believe the fragmented, 19 state currency union will only ever be a follower on policy innovation. With respect to the next steps for developed market monetary easing, we reiterate our belief that we are reaching its upper limits. Ultimately, money is a medium of exchange and going deeper into negative interest rate territory, or embarking on helicopter money, has to challenge credibility. Related, we expect whatever form monetary policy takes going forward, it is likely to be less favourable for bond markets.

Elsewhere, tough talking by cabinet members markedly shifted the market’s pricing of a “hard Brexit” in which the UK’s stance on immigration and political sovereignty will be inconsistent with access to the single market. This resulted in a sharp repricing of GBP (including a Friday flash-crash) and a sell-off in Gilts, as currency depreciation shifted long-term inflation expectations (measured by the 5 year-5-year forward) to as high as 3.62%. Last, on Friday, the US employment report showed enough resilience to support a December rate hike from the FED (probability up to 65%). This saw the US 10 year briefly test June highs in yield. Indeed, this followed a positive tone to global data for the week.