26 September to 2 October: Back to the Future

In a throwback to the GFC, global markets closely tracked the Deutsche Bank share price last week. Long considered to be under-capitalised, DB navigated the post-crisis period “Italian style”, failing to properly address its balance sheet and protected by its national champion status. However, this year the share price has unravelled after the IMF judged the bank “the most important net contributor to systemic risks” and its US unit was one of only two to fail FED stress tests. The latest moves were prompted by a 16th September fine by US authorities for mis-selling mortgage securities amounting to USD 14bn. Given a price-to-book ratio of 0.25, this led to client’s questioning the bank’s solvency (some funds withdrew “excess cash and positions held at the lender”) and the share price hitting a 33-year low of EUR 9.90. However, reports that a USD 5.4bn settlement with the Department of Justice is close, saw a Friday recovery – by the end of US trading the company’s ADRs were 14% higher on the day.

Rumours of a reduced Deutsche fine are yet to be confirmed, but it is very unlikely that the bank will have to pay anything close to the original number. This is both because it is not in the interests of the regulator to create a systemic bank failure and because the fine appears outsize relative to peers. In terms of broader solvency, the current valuation makes it difficult to raise equity and for clients to have faith in the institution. Moreover, the question of political support is complex. However, the current central bank toolkit is far evolved from 2008, with a vast range of liquidity “escape-valves”.

In a second blast from the past, OPEC agreed on Wednesday to cut production at a meeting in Algiers. Whilst the ultimate price impact will depend on final agreements (likely at the 30th November meeting), as well as the participation of non-OPEC members, the group indicated it will reduce production to 32.5 million barrels per day (the first cut since 2008 and a reduction of around 2.2%).

The OPEC agreement has helped support the oil price, but remains lacking in detail (such as individual member commitments). Oil producers are playing weak hands, for example Saudi Arabia has seen a 12% budget surplus in 2012 slip to a 16% deficit, and Iran, Iraq, Libya and Nigeria are all seeking to increase production. Last week, the number of rigs drilling for oil in the US increased for the 13th week in 14 and on Sunday Russian oil output posted a new all-time high, up 4% in September vs. August.

This week should have a greater data focus with Global PMIs and US employment data.

19 to 25 September: Shot in the Arm

Bonds and equities again moved together last week – this time pushing higher, with yield curves flattening. Given the FED will now not raise rates until at least December, any central bank action over the next 11 weeks will be further easing (possibly including BOJ and BOE rate cuts). We think the market could therefore benefit from a tail wind until the US election on the 8th November. More precisely, we believe there is a bias towards continued yield compression and emerging markets inflows.

Longer term, the picture is much more uncertain. Wednesday’s FED meeting revealed major divisions amongst the committee, whilst the changes to BOJ strategy (announced the same day) highlighted our long running theme of monetary policy losing credibility. Further innovation risks losing faith in currency and creating a “stagflation” type environment.

12 to 18 September: Stall for Time

The last few weeks have seen a reversal in bond yields, with a bounce from all-time lows and steepening yield curves.

On the one hand, these moves could be viewed as a constructive step, with investors anticipating a more buoyant recovery. Alternatively, as we have argued, they could relate to the next potential iterations for monetary policy (helicopter money, higher inflation targets, expanded experimentation with negative rates) having the potential to generate proper inflation; going much further beyond the zero lower bound could challenge the faith in money as a store of value. More likely we think the bond market sell-off implies a scaling back of expectations for policy easing in the short-term.

Although most central banks outside the US remain biased to add stimulus, there is a lack of conviction and policymakers have no clear idea where to go next. As such, many central banks are stuck in wait and see mode. This week sees FED and BOJ meetings where any move may challenge this hypothesis.

5 to 11 September: Rocking the Boat

Our view remains that monetary policy has reached a critical point – the current toolkit is almost exhausted, with little obvious benefit from “unconventional” measures. As such, policymakers will soon need to give up (unlikely) or innovate further. The important point is that monetary stimulus does have limits; at some stage permanent increases in the money supply, or aggressively negative rates, will cause a loss of faith and for the real economy to abandon the currency.

This perhaps explains the current trend towards fiscal measures – this week in the UK, Chancellor Philip Hammond reaffirmed that he no longer sought to achieve a budget surplus by 2019, setting the stage for fiscal stimulus later this year.

Similar spending packages are likely in the US (whoever wins the election) and have already started in China and Japan. However, whilst fiscal spending might provide a short-term boon, it cannot address the long-term structural growth problems of the developed world.

29 August to 4 September: Wide Open

After a typical summer lull, investors return this week to a wide open outlook:

• The oil price continues to swing wildly (falling 6.5% last week after an equally violent rally).
• Most central banks are likely to ease, but with the current toolkit exhausted, there is little clarity on next steps.
• The FED is biased to tighten, but the second hike of the cycle remains elusive.

The hunt for yield and growth currently favours emerging markets – and EM equity funds saw their 9th consecutive week of inflows last week (the longest stretch in 4 years).

22 to 28 August: Careful What You Wish For

Whilst we think the near term prospects for the global economy (coming 6 months), could be somewhat better than expected as recent confidence shocks subside, we believe the developed world has a structural growth problem. Moreover, we think current policy is inadequate to address these challenges and we will therefore see policy innovation. Certainly this is expected to involve a return to fiscal stimulus but, as highlighted by Jackson Hole, it is also likely to see central banks get serious about sparking inflation. For example, Janet Yellen spoke of higher inflation targets and nominal GDP targeting, while Marvin Goodfriend proposed ideas to increase the ability to enforce negative rates such as abolishing paper currency. Considering also the market focus on helicopter money, if central banks do evolve, then their actions may no longer be so bond market friendly.

15 to 21 August: Broken Record

This week excerpts from hedge fund manager Paul Singer’s Q2 letter to investors were quoted across the media. He describes the fixed income market as “broken” and that “the biggest bond bubble in world history,” will lead to a breakdown which will “likely to be surprising, sudden, intense, and large.” Thus in reference to sub-zero yield debt, investors should “hold such instruments at your own risk; danger of serious injury or death to your capital!”

8 to 14 August: Low Life

As the Bank of England re-started QE, the global hunt for yield continued last week. Not only did UK Gilts hit new records (10yr at 0.50%) but the FT reports the value of negative-yielding bonds rose to USD 13.4trn up USD 300bn on the week.

Actually, whilst it is perhaps the record low “risk-free” government bond yields which have caught the headlines in recent months, there is evidence of general spread compression. Peripheral European bonds have legged tighter and you can now own 10yr Spanish Government debt below 1% yield (0.93%). Moreover, US high yield spreads are at 10 month lows and net fund flows to emerging market debt are at 6 week highs, amounting to USD 18bn YTD.

1 to 7 August: Running Out Of Options

The performance of both Japanese (-15%) and European Bank (-28%) shares so far this year is, in our view, testament to the problems facing policymakers. Negative base rates, unprecedented QE and targeted measures to tackle perceived credit market frictions (corporate bond and equity market purchases and bank financing programmes) have all failed to spark a full recovery. As such, we think the current monetary policy set has reached its limits. In the last quarter, this has prompted record flows into emerging market bonds (in the hunt for yield) and renewed talk of fiscal stimulus and the potential for helicopter money.

We think these dynamics are concerning. Neither the ECB or BOJ are in a position to innovate policy effectively. Europe is restricted by bureaucracy – getting 18 countries to agree to pre-emptive and progressive policy is impossible and therefore the single currency zone will also be a follower. Japan, instead, is hamstrung by ineptitude. Indeed, the only major central bank with the ability to make considered policy advances is the FED – but they are, for now, out of the picture.

25 to 31 July: The Boy Who Cried Wolf

Given the FED’s inability to follow through with planned rate hikes over the last 12 months, last week’s more hawkish statement failed to change market expectations for little further policy action this year. Similarly, the prospect of new staff projections at the BOJ ahead of the September meeting, leaves investors still biased to expect more stimulus in Japan. This week the Bank of England steps up to the policy plate.