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  • 23 Nov 2017 - Martin Shenfield

    The Bank of England and the UK’s Economic Outlook

    The house view remains that both sides of the Brexit argument over-egged their cases and that in the long run provided that there is a ‘Plan B’ as set out in detail in our LSR View of 21st September, the net impact either way on the UK economy would be more muted than is generally touted.

    Moreover, the UK has suffered for the last 20 years from a form of ‘Dutch Disease’ due to a structurally overvalued sterling. One of the positives emanating from Brexit is that this has now been reversed which will be a necessary pre-condition of a much needed rebalancing of the economy away from financial services and London towards manufacturing and the regions.

    My colleague, Michelle Lam, sets out below that although below trend growth will continue awhile as the UK consumer adjusts, real wages will start to stabilise in 2018 and exports and FDI will recover. She also explains the background to the recent Bank of England interest rate hike.

    ‘The economy flirted with below-trend growth over H1, as we previously forecast. Low growth was twinned with strong employment – a repeat of the post-GFC recovery. Britain’s flexible labour market has allowed firms to substitute labour for capital, leaving real wage growth and consumer spending taking the strain of the economy’s adjustment.

    Because that adjustment is continuing, growth in consumer spending and therefore GDP will be slower than it was in the recovery from the GFC, at 0.9% and 1.5%, respectively. We forecast that demand will improve over the course of next year once the current soft patch is over. With import price pressures already starting to moderate, the end of the squeeze on real wages should support household spending in 2018. The Goldilocks state of the global economy, with the US and Europe to the fore, is set to amplify the stimulative effect of a weak pound. Indeed, the UK’s export market share has stopped falling over the past four quarters. Further sterling depreciation against the euro should help as the ECB begins to taper its asset purchases.

    Of course, as Brexit uncertainty lingers, business capex will be sub-optimal even though the conditions for a strong recovery are in place. A transitional agreement, which is looking more likely, would avert the immediate threat of a cliff-edge Brexit but would not end the uncertainty facing firms with a long investment horizon. Not every firm is affected, however. Only 10% of companies surveyed by the BoE reported that Brexit would have a large negative impact on their investment next year. On balance, we expect capex to pick up modestly.

    The risks of under-investment should concern not only the demand side of the economy, but also the supply side. The recovery in business capex after the GFC has been shallower than in the wake of previous recessions. If uncertainty continues to restrain investment, already weak productivity could eventually be undermined further. Potential growth could also be held back if the labour force expands more slowly as a result of the population growing older or if net inward migration falls due to economic strength in Europe or the UK’s exit from the EU.

    This does not mean that policy should not continue to be accommodative. We expect some withdrawal of stimulus, but real interest rates will remain negative.  The timing of the BoE’s recent hawkishness seems odd given that the economy is slowing, but the Bank has succeeded in nudging up the interest rate expectations of a hitherto sceptical market, with the aim of avoiding a jump in short-term borrowing costs later on.

    There is no smoke without fire. As long as real wage growth resumes, which we expect to happen over the course of next year, further tightening will do little to slow the recovery. That’s because household balance sheets have improved, with the debt service ratio back down to pre-crisis lows. Overall, household sensitivity to interest rate changes and potential political upsets points to a gradual normalisation of interest rates.

    Having signalled interest rate rises as early as 2014, the MPC voted by a majority of 7-2 to increase the policy rate by 25bps for the first time in a decade. Given that British consumers are facing the worst real income squeeze since the Great Financial Crisis, some see the move as a mistake and are puzzled by the timing since the BoE’s assessment of the economy has barely changed. But having failed to guide interest rate expectations higher, the BoE clearly felt it was time to translate words into action.

    Moreover, the hike merely reversed the August 2016 rate cut, undertaken on the heels of the EU referendum to mitigate a feared slowdown that has not materialised. It is important to bear in mind that a 25bp increase in borrowing costs will have a fairly limited impact on the economy. Thanks to a decline in household debt and low interest rates, the debt-servicing ratio of UK households has fallen to just 7% from a pre-crisis peak of 11%. With 40% of mortgages on variable rates, down from 60% in 2010, we estimate that a quarter-point rise will knock less than 0.2 percentage points off household disposable income growth next year. An end to the squeeze on real wages should allow households to maintain a decent rate of spending while affording a slight increase in interest payments. Of course, after a decade of near-zero interest rates, households will have to reacquaint themselves with the fact that policy rates do in fact change - in the pre-crisis era, they did so once every four months. But the shock ought not to be great: only one in five of today’s mortgage borrowers have yet to experience a rate rise.  

    What we are interested in, of course, is the future path of interest rates. Here, the Bank endorsed market expectations for only two more 25bp hikes over the next three years. It provided forward guidance that “conditioned on the gently rising path of Bank Rate implied by current market yields, GDP grows modestly over the next few years at a pace just above its reduced rate of potential”. The Bank also expects CPI inflation will remain slightly above 2% at the end of 2020. In other words, the hike is not “one-and-done”, but nor is the BoE in a hurry to jack up rates.

    But if the economy makes a smooth transition to trend growth, as the BoE predicts, the Bank risks falling behind the curve by leaving real policy rates at minus 1% at the end of 2020. Like the BoE, we see limited risks to the economy. We believe growth will nudge up to trend after 2018 Q1 as net trade and capex fill a gap left by flagging consumer spending, leading to a further diminishing of economic slack. Goods exports have enjoyed robust growth, thanks to synchronised global expansion. Capex is not spectacular, but nor is it rolling over. At the moment most firms are making contingency plans that involve only minimal relocations, while awaiting more clarity from the government. Despite the lack of immediate wage pressures, capacity utilisation rates have been above their historical average, and slowing migration and weak productivity will almost certainly push up labour costs.

    Understandably, in the face of Brexit uncertainty, the Bank does not want to back itself into a corner and commit to raising interest rates more quickly than markets have been pricing in. Whether the BoE wants to admit it or not, the pace of tightening will be dictated by political events. Moreover, raising rates too quickly risks hurting business investment and thus further damaging the supply side of the economy. Opinions on the state of the supply side are divided, even within the MPC. But if you take the view that the rate of growth during the pre-crisis period, bolstered by strong consumer spending and rising house prices and debt, was simply not sustainable, then one would see why the BoE is content with slightly lower growth rates. 

    Investors are puzzled by low inflation in the US and the euro area. But if the BoE does indeed stick with its forward guidance and leaves interest rates in negative territory going into the next decade, inflation may well remain above target for longer than the Bank assumes.

  • 22 Nov 2017 - Martin Shenfield

    Saudi Arabia Is Not Driving Oil Markets

    My colleague Marcus Chenevix sets out below why political instability in Saudi Arabia has little significance for oil markets, but rather should concern investors exposed to Saudi assets. Broader Middle East geopolitics may however be a more plausible oil price influence.

    The IEA has recently turned to a more bearish structural view on the oil price based on the conventional US shale output ramp-up market consensus. (It now predicts overall shale production to double over the next decade.)

    However, shorter term robust global demand reflecting the global synchronised economic and trade recovery is driving positive demand surprises and hence pushing the oil price trading range up to US dollars 50/60 and which in turn is supported by the relatively recent move from contango to backwardation.

    Against a constructive demand backdrop, the recent decline in excess global oil & liquid fuel inventories has conferred some more credibility on OPEC’s output cuts, nurturing investor optimism – evident, for example, in the extent of speculative long positioning. The Saudi story does not have direct implications for crude prices at this juncture; it has, however, introduced an uncertainty premium (ie, risk of escalating tensions in the broader M. East) that serves to reinforce the market’s bullish bias in what remains a goldilocks/risk-on investment environment

    'Saudi political risk has suddenly re-emerged. Investors, who mostly prefer not to think about Saudi politics at all, have realised that the oil-rich kingdom is at quite a volatile moment in its history. Both internal strife and regional turmoil could ensue as a result Many commentators have pointed to this volatility as the main explanation for the last two weeks of strength in oil markets – we disagree.

    It is true that the de facto ruler of the kingdom, Crown Prince Muhammad bin Salman (“MBS”) is struggling to maintain political equilibrium as he tries to force through his reform programme. The wave of arrests earlier this month are particularly worrying in that they do not appear to have been planned well in advance (the authorities do not seem to know how many people they were going to arrest when the purge started). This implies that politics was as much of a motive as corruption, and hence that the arrests were most likely a pre-emptive counter to some kind of threat to MBS. This is all very concerning if you hold Saudi or Bahraini debt, and quite a worry if you own certain Saudi equities – but it is not an issue for oil markets.

    The investment risks stemming from political instability in Saudi Arabia do not extend to any serious prospect of a systemic collapse (which would disrupt oil output), but instead have to do with the effects of reform blockages. In other words, latest developments should concern investors exposed to Saudi assets rather than the global oil market. As far as the Saudi investment case is concerned, it is vital that the Kingdom reforms its fiscal system and fixes its structural problems (a glut of cheap labour, a secular deterioration in productivity and a massively bloated state). Failure to reform would mean prolonged low growth and de-rating of debt but it would not pose a threat to oil supply and would not imply a change in oil policy. 

    On that last point, Saudi Arabia has now definitely abandoned attempts to control its oil policy. The last such attempt – which was initiated in late 2014 by the previous oil minister Ali al-Naimi and cost him his job – failed in its goal of driving US shale oil competition out of the market since depressing the oil price low enough (probably around US$40/bbl) for long enough to achieve that aim would also jeopardize the Kingdom’s survival. Saudi Arabia is therefore reduced to being a price taker, sacrificing marginal market share by means of the “OPEC+” output taper in the hope of keeping the oil price out of any such danger zone. In short, MBS, otherwise such an influential figure, has minimal freedom of action on oil policy.

    The geopolitical implications of Saudi Arabian volatility are a more plausible oil price driver. The extraordinary Saudi decision to bring down Lebanon’s coalition government, coupled with an Iranian-supported militia nearly landing a missile on Riyadh airport has considerably raised the geopolitical temperature of the region, but we are still a very long way from a war between Saudi Arabia and Iran. Plotting a path to war between the two states is hard, and relies on the assumption that Saudi Arabia and her allies might sacrifice a decade of economic growth in the Gulf. Furthermore, this summer, when some kind of conflict in the Gulf over the Qatar crisis appeared to be on the cards, oil prices market barely raised an eyebrow.

    Since US shale oil became the price-setting marginal supply source, the oil price has become less sensitive to Middle Eastern political tremors. Actual outages – such as from Iraqi Kurdistan last month – rather than mere worries now tend to be necessary for material price movements. To change that would require a proper shooting war or other such geopolitical earthquake. Sentiment may now be marginally more jumpy about such tail risks given that oil has been coincidentally buoyed by demand on the back of the strong global economy; but this is all about sentiment and volatility.

    For now – i.e. pending the longer-term impact of EV penetration – supply is driving the oil market, not through a fear of shocks coming out of the Middle East, but rather through the chronic over-supply generated by the US shale boom. In its annual World Energy Outlook published yesterday, the IEA – long a sceptical voice on the US shale oil outlook – turned notably more bullish, predicting that shale production is going to double over the course of the next decade. In the long-run, this trend must eclipse concerns over geopolitically imposed supply crunches.'

  • 07 Nov 2017 - Martin Shenfield

    Why China Is Not on a Minsky Brink

    Recent comments by the PBoC Governor Zhou  Xiaochuan have resuscitated the China debt debate but these were as ever non-time specific & more in the nature of a general warning. We note that some of the most prominent foreign China ‘Minsky Moment’ bears (no names no pack drill!) have been & remain longstanding stale bears/’stopped clocks’. This does not mean that China’s rapid accumulation of debt is not a huge risk, not least in terms of the massive misallocation of capital it represents & hence concomitant decline in productivity growth, just that an imminent ‘hard stop’ debt crisis is most unlikely. Bo Zhang our China economist has explored this in more detail below.

    Nothing is going to be linear or smooth in China but we remain in the ’half glass full ‘camp with respect to policymakers’ commitment to ‘Deleveraging‘ as already evidenced by the effective clampdown on shadow banking activities & supply-side capacity cuts in steel, coal & aluminium.

    ‘It is fashionable to ask if China is on the brink of a “Minsky moment” after its surge in debt over the past decade. During this month’s Party Congress, Zhou Xiaochuan, the long-serving governor of the People's Bank of China, cautioned that the country had to fend off risks from excessive optimism that could lead to a Minsky moment. His remark raised eyebrows and gave China bears an opportunity to reaffirm their longheld, long-unrealised thesis of an impending debt crisis.

    Caution over rapidly rising asset prices is sensible. But the triggers for a true Minsky moment appear absent in China today. A debt crisis is neither imminent nor likely, despite the rapid build-up in borrowing. Zhou’s remarks have to be seen in the specific context of a respected official who is about to retire and is keen to protect his legacy. It would be easy to cry wolf after what he said. Much more challenging is to take a stab at the timing of a meltdown – something Zhou and others who speak of a Minsky moment scrupulously avoid. Following are four reasons why we think China is not on the brink of a debt crisis. 

    1. Zhou’s reference to a Minsky moment was part of an answer to a press conference question on systemic financial risks. He was making an assumption, not delivering a statement on the state of the economy. Since he is due to step down in the next six months, his comment may well have been a final appeal directed to the political hierarchy and to his successor to press on with financial reforms he advocates. Remember, Alan Greenspan’s talk of “irrational exuberance” in the US stock market many years before equity prices corrected. Even central bank governors want a place in history - or at least to have been proved right. 
    2. China’s high debt level does not automatically point to an imminent threat. For a debt crisis to occur, a liquidity trigger is needed. People have been forecasting a Japanese debt crisis for two decades, but it has not happened. China’s rising debt ratio reflects, amongst other things, the reluctance of banks to pull the plug on zombie companies. In stark contrast to other emerging economies that have suffered debt crises, China owes little foreign debt and holds more than $3trn in FX reserves. It is virtually impossible for speculators to induce a crisis by shorting the renminbi. According to our estimates, China’s capital outflows have fallen from an average of $150bn per quarter in 2016 to $30bn in the first three quarters of 2017. Foreign reserves have been rising for nine months, and the RMB is up 4.2% against the dollar this year. So we can virtually rule out risk of an externally triggered debt crisis in the short term. 
    3. While Minsky’s analysis is often applied to the onset of the Asian financial crisis and the US subprime crisis, he also believed the threat of a destructive collapse could be averted by a strong government ready and able to step in. In China, this is the case. The Communist Party and the government have the power and the ability to force agreements between creditors and debtors. This is key, given how disagreements between debtors and creditors lead to defaults, triggering financial crises. Most corporate debt in China consists of obligations of SOEs to state-owned banks – in other words, the state has lent to or borrowed from itself. It is highly unlikely that the Party State, which Xi Jinping is set on strengthening, will allow banks to force SOEs to repay debts in a way leading to a plunge in asset prices and fire sales. Instead, it will shift assets among its various balance sheets to preserve stability. The government could still tap a wide range of assets should it run into servicing problems. As long as the overall Communist Party balance sheet does not blow up, there will not be a system-wide financial crisis. 
    4. Chinese debt problems and the risks they pose are not new. Top leaders are fully aware of this. That is why Xi explicitly made financial sector deleveraging a matter of national security. To that end, the PBoC has deliberately allowed market interest rates to creep up since last November. Through new macro-prudential assessment procedures and by keeping a stable bank repo rate to dampen market volatility, the central bank has targeted non-bank financial institutions with excessive leverage. The corporate sector’s debt- to-GDP ratio has declined from 166% at the end of last year to 162% at the end of Q3.

    China's total debt to GDP ratio of 264% is similar to the advanced economies like US and Europe, and below countries like Japan and Spain. We believe the greatest long-term financial risk in China stems from the lack of options for households to diversify their wealth. This raises risks of bubbles, especially in property prices and equities. As we have argued previously, high property prices are a result of market distortions caused by government policies in education and healthcare, lack of urban infrastructure, the gender imbalance and financial liberalization, all of which can only be resolved in the long term. So we do not expect a property bubble crash in the near  future. With tight controls on outflows and limited investment options, the risk of an internal debt crisis will certainly escalate if the rapid accumulation of debt and easy  credit continues at the previous rate to support growth in coming years. But, for the moment, we do not see China facing an imminent risk of the MM in debt.’

  • 06 Nov 2017 - Martin Shenfield

    Fed to Hike in December, March & June

    Our US economist Steve Blitz continues to argue that the Fed is as confused as anyone over the drivers of inflation in general & in particular what the real neutral  rate( ‘the inflation-adjusted level of the federal funds rate consistent with keeping the economy operating on an even keel’) should be. Contrary to the Fed Steve believes it might actually still be below zero given the still sluggish pace of capital spending by businesses & households. Although importantly we now do expect an imminent notable pick-up in domestic capex , irrespective of any Trump tax incentives.

    Indeed the Fed has been waiting for just such a pick-up in the demand for capital that will raise real rates as one of their roadblocks to normalising rates has been the late summer collapse in US TB  10 year real yields which fell 40bps under the weight of Chinese buying at a point when US economic growth was accelerating! Bringing forward QT was done partly in the hope that this would push yields higher again allowing the Fed to hike without coming close to precipitating an inversion of the yield curve.

    The September data imply that finally the upturn in capital expenditure is gathering momentum which should prompt sufficient yield curve steepening for the Fed to raise rates in Dec, March & June-regardless of who the next chair is. Importantly although we are thus much more hawkish than the market we only expect US 10 year TB yields to grind higher to 2.8%( a 50 bps reversal of the QE induced term premium compression),to be followed by further yield curve flattening and not a bear market in US bonds just yet.

    Fed to hike in December – March and June too

    Market participants still don’t respect the Fed’s view of all things economic. They attach a near 90% probability to a 25bp hike at the December 13 FOMC meeting, meaning a 10% chance of a random event that stays the Fed’s hand. As for another 25bp in March 2018, the odds are set at 32%, and there is only a 13% probability of the FOMC going another 25bp next June, which would take the funds rate to 2%. Lowballing the Fed’s trajectory has been the right bet throughout this cycle. The way we see the economy unfolding in the coming year, we believe the Fed gets to a 2% funds rate by June, regardless of who the next Fed chair is.

    Our viewpoint is rooted in earnings and, by extension, wages, as we saw in September, though not in the published BLS average. This measure is weighted by sector employment and so was boosted in last Friday’s employment report for September by a sharp decline in restaurant workers, who make about $13.50/hour against a national average of around $24. Rather, we were struck by the momentum in our own unweighted average and in pay for a number of industries. Wage momentum is rising in most sectors, and this argues strongly for the Fed to raise policy rates in December.

    With profits improving, pay should continue to reaccelerate into yearend and continue into 2018. One caveat is that the forces of globalisation and technology are still holding back the pace of wage gains (in many cases the two forces are one and the same) – notably in industries that are most impacted, including manufacturing and financial services. As a consequence, the pace of pay increases may still broadly disappoint relative to the revival in earnings, based on historic relationships.

    The economy has given off mixed signals this year, reflecting leading and lagging sectoral responses to the inventory cycle in 2015-16 that helped create a small profits recession. Since then, manufacturing has picked up but wages growth slowed in response to weaker earnings. As a result, retail spending growth has pretty much spun in place. Commercial construction, also a lagging indicator, has slowed, and singlefamily housing, strong earlier in the year, has begun to tail off some of late.

    Considering how the global economy continues to expand, as does domestic industry aside from autos, our expectation is that next year the various sectors of the economywill all be growing. At the same time, the cost of carry for non-financial firms (nominal growth in final sales minus the rate on prime commercial paper) remains more than favourable to expansion. 

    Against this backdrop there is little justification to keep holding the federal funds rate below core inflation. In addition, while the equity market is currently not overvalued by our measures (nor is it cheap), as growth continues there is a good chance that inflows, undeterred by higher short rates, could propel share prices into seriously overvalued territory. Confidence in growth, wage hikes and QT should also push up term yields to steepen the yield curve a little and thereby create some runway for the Fed to act. A higher core rate of inflation would also help in this regard by lowering the real funds rate.

    As such, a 2% funds rate next June would be, at worst, about 25bp above core inflation with the core rate trending higher and wage settlements accelerating. This is not a very bold or constrictive level for policy rates. And we haven’t even mentioned the likelihood of some tax cut.

    Capital demand pushing Fed… to higher rates

    The FOMC has been anticipating accumulating signals of improved demand for capital that will raise real rates, albeit slowly. They are focused on the business side, figuring that jobs, income and demographics will eventually raise consumer capital spending (ie, on new homes). September data for durable goods indicate their recovery from the 2015-16 slowdown is accelerating. Last month’s rebound in new home sales, related to the hurricanes that hit Texas and Florida, confirms that average sales are back to their long-term median pace of 600,000 units SAAR and are drifting higher.

    The slump and recovery in new orders for non-defence capital goods ex-aircraft, also evident in other figures such as wholesale sales ex-oil and autos, are what the Fed should keep in mind when figuring out why 2017 data on growth, wages and inflation seem so mixed up (to them). For a good chunk of the economy, 2017 is the first full year of recovery; at the same time, the knock-on impact of the 2015-16 downturn has been slowly rippling through various sectors. From our perspective, positive growth trends in different parts of the economy are starting to get back into sync. This should be increasingly evident in the coming months, lifting wages and eventually inflation in its wake. 

    To be clear, not all corners of the durables industry are recovering. Computers, electronic equipment and appliances have not yet turned up. But new orders for  primary metals, machinery, fabricated metal products and communication equipment are back in their 2011-14 ranges with inventories in line.

    The longer-term picture shows that the level of nominal new orders has effectively been capped since June 2000, even though almost all other nominal indicators of economic activity have reached successive new highs with each cycle. The reason why durable goods orders haven’t kept pace is not immediately apparent, but the point is they have a lot more scope to increase and, in effect, catch up with the rest of the economy. When that begins in earnest, real yields on 10-year maturities should begin to rise and steepen the yield curve.

    On the housing front, there is also reason to believe the peaks for this cycle have yet to be reached. After an extended period of overbuilding and subsequent recession that caused demand to plummet, the recovery in the number of 25- to 34-year-olds with a job, as measured by Y/Y percentage growth has finally gone on long enough to hoist new home sales back to their long-run average of around 600,000 units SAAR. Yet the employment/population ratio for this age group is not quite yet back to its pre-recession high and is still below the 2000 peak. So it is reasonable to presume that Y/Y growth in the number of those employed in this age cohort can be sustained in the 2%-4% range. In addition, the longer they are in work the more their incomes and credit scores rise. If all this comes to pass, and we believe it will, new home sales should slowly trend up towards 800,000 – the top of the cyclical range before mortgage madness took over.

    What the September data imply is that the upturn in capital spending that the Fed has been waiting for (or revival in durable goods, to be more exact) appears to be gathering momentum. With that, the yield curve is set to steepen enough for the Fed to raise policy rates in December, March and June – regardless of who is the next chair. We haven’t weighed in yet on the rest of 2018 because we don’t yet know the extent to which federal tax cuts and spending increases will aid and abet growth in the coming year.

  • 05 Oct 2017 - Martin Shenfield

    Manufacturing Boom - Fed More Hawkish in 2018?

    The ISM survey confirmed our long held optimism for an acceleration in capex to drive the next growth leg as our US Economist Steve Blitz sets out below.

    It also suggests our more hawkish view on eventual Fed rate hikes in 2018 is more likely to play out. 

    Growth momentum in Q3 belongs to manufacturing. We deconstruct the new orders data from the ISM Survey into its NSA net value (% better - % worse) and compare it to prior years. The net is far better than last year and the best of the prior five. 

    Sustained improvement in orders leads to better production and, with a lag of a month or two, employment. The recent strength in manufacturing employment is evident from the BLS showing data through August. We suspect this strength carried into September (data released Friday morning).

    While manufacturing activity accelerated this quarter, private commercial construction has weakened.

    Here we see an echo of the slowdown in the economy in 2015-16. There is a considerable lag from decision to build to construction, and once shovel hits the ground these projects don’t stop, as a general rule.

    Using manufacturing as a guide, there is about a 24 month lag between the ISM Manufacturing production index and construction put-in-place to build manufacturing facilities. While there is nothing absolute about this lead/lag relationship, it is nevertheless reasonable to anticipate improved construction activity in the coming months – which would make the Fed’s anticipated three tightenings in 2018 much more likely than not.

  • 27 Sep 2017 - Martin Shenfield

    Six Bears Out Hunting for Goldilocks

    My colleague Oliver Brennon has re-examined our Goldilocks for longer scenario in a recent note as follows:

    Previously Charles Dumas has outlined why Yellen and Draghi won’t upset global growth. So why are some investors ‘moving closer to the door’? Whilst equities simplistically look richly priced and with the S&P CAPE above 30x  approaching the dotcom bubble level some nervousness is perhaps understandable. But we have argued before why the Shiller CAPE going back over 146 years is irrelevant. If we look instead at the far more pertinent post-Cold War period the CAPE’s mean is around 25 times not the oft quoted average 16.8 times of the longer period. Moreover the much more reliable S&P ‘real value’ index is only slightly above its long term trend and when the market is scaled to corporate net worth valautions are only mid-range. When policy rates start to rise CAPE will naturally fall, but in the context of improving margins and economic growth supporting earnings. Stocks may be in line for a repricing, but not necessarily a bear market triggered by overvaluation.

    Here we look at six other worries and why they may, or may not, be worthy of concern.

    1) The new Fed chair.

    Current Chair Janet Yellen’s term expires on February 3 2018. National Economic Council Director Gary Cohn is probably still just about favourite to succeed her. With Cohn at the Fed and the Treasury headed by Steve Mnuchin, who recently said “having a weaker dollar is somewhat better for us”, economic policy would likely be more political and more expansionary. Good news for stocks short term, but if history rhymes there is also good reason to worry: the last non-economist to lead the Fed was G. William Miller, who had a background in law. In the tumult of the second oil crisis, a 25% fall in the dollar and a sharp rise in inflation, Miller was replaced after 18 months by Paul Volcker, who proceeded to raise the fed funds rate by 10 percentage points.

    Steve Blitz our US economist however has noted that whoever is the next chair, the nature of how the Fed operates means that it may not make much difference to monetary policy or QT. But in contrast the new Chair will  have a crucial role in the evolution of financial regulation, potentially rolling back Dodd-Frank and this is what markets should be more focused on.

    2) North Korea.

    Very hard to calibrate the risk but market worries over North Korea seem to spike and fade away within hours. Quite rightly as far as the US and Europe are concerned, but perhaps not so regionally. As tensions escalate, investors may reassess flows into South Korea – where they are overweight compared to the benchmark – and invest elsewhere in EMs. Although we still favour Korean equities this could increase Korea’s risk premium. We have expressed this prospect through a long INR/KRW position in our Macro Strategy portfolio.

    3) Italian election.

    BTP-Bund spreads have started to widen (another trade we have on) and redenomination risk is in already the price of Italy’s CDS. But the government’s strong handling of migration this summer is a positive for the establishment whilst the anti-establishment parties are now backing away from their anti-euro stance. As we wrote in a recent Macro Strategy, the BTP-Bund spread should widen going into the election, which must be held by May, but an improvement in issuance fundamentals limits the chance of a 2011-style crisis. Italy will remain the key long-term euro area risk: Euro appreciation makes labour costs uncompetitive and its large outstanding debt load may become unsustainable if growth grinds to a halt. But these issues may still take years to come to a head.

    4) US debt ceiling.

    For now the debt ceiling impasse has been resolved but if it should reoccur liquidity in offshore markets will probably dwindle as their available collateral falls through a slowdown in issuance. The reduction in offshore dollar liquidity during last year’s US money market reforms is the template here: basis swaps widened as liquidity conditions tightened. But the Fed will not pursue its own liquidity tightening in a vacuum. We expect quantitative tightening, QT, to begin in October but the Fed can adjust  QT a sit sees fit. Hence this ‘Fed put’ ensures limited market fallout.   

    5) Liquidity tightening.

    The ECB’s taper and the Fed’s QT are set to begin by next year. Bund yields should unwind around 60bp and US Treasury yields around 50bp of QE premium. If both programmes follow our predicted trajectories, overall central bank liquidity will start tightening in mid-2018. However, both banks will proceed carefully. The ECB will take a data-dependent path to reduce asset purchases by €10bn/m at each meeting next year. If financial conditions tighten too far, it can simply delay the next leg. Ditto the Fed, which if necessary can slow the pace at which it raises the cap on debt roll-offs from its balance sheet. However any  spike in the US dollar and a concomitant contraction in offshore US dollar liquidity could be ‘curtains’ for EMs in particular.

    6) China slowdown.

    We expect Chinese growth to slow after the Party Congress in October, led by residential investment. But world trade growth remains resilient and the other locomotives of growth (Germany, the US) are strong. The risk of global contagion is through capital outflows, but since the August 2015 devaluation of the yuan China has tightened capital controls and companies have paid down much of their external debt. By IMF calculations, China’s $3trn of foreign reserves are twice the ‘adequate’ level for a partially-closed capital account and five times ‘adequate’ if it is fully closed. The trade-weighted CNY index is also a release valve for currency management, but this time, with Beijing much better placed to manage capital flows, global contagion should be limited. (cf Why China won’t collapse’).

    Ultimately a revival of inflation is the key economic threat this cycle but that  may not start to emerge until well into next year. The other main threats are political: the new Fed chair, North Korea and Italy’s election. Only one of these (North Korea) has the potential to precipitate an imminent negative global reaction, and even that is unlikely. Goldilocks can sleep easy this year. 

  • 21 Aug 2017 - Martin Shenfield

    Six Reasons for a Stronger Dollar

    My colleague Oliver Brennan sets out the case for a stronger US Dollar into year-end (cf LSR Macro Strategy 16th August)

    Key judgements:

    • A rebound in $/DM is likely into year-end, for at least six reasons:
    • Central banks, valuations, EA C/A, data, positioning, seasonality
    • If we were to bet against the dollar, our money would be on EMs

    The greenback has weakened substantially in 2017, with the dollar index sitting close to a 2½-year low. Most of the dollar’s depreciation has been against DM currencies. The EUR has been the main winner, with year-to-date gains of about 12%, but JPY, GBP, CAD and AUD have all appreciated too, by between 5% and 10%. Emerging market currencies have been less strong than their DM counterparts, but the JP Morgan EM Currency index is nonetheless up 6% ytd (vs 10% for DMs). 

    After five consecutive monthly declines, however, the dollar index is higher so far in August (EM FX has been more resilient). Is this just a pause before the plunge resumes, or is it the start of a rebound? We think that the risk for the USD is skewed to the upside. We see six reasons to expect an upswing going into the end of the year.

    1. Central banks. While there seems to be no risk of imminent tightening by the BoJ, BoE and SNB, both the ECB and BoC are on a policy tightening path: the Fed won’t be unwinding its extraordinary monetary accommodation in a void. Nevertheless, last week’s ECB minutes confirmed unease within the Governing Council over the rapid pace of the euro’s appreciation, with concerns expressed of a possible overshoot. The ECB will tread water to prevent the exchange rate strengthening so much as to undo the progress made in achieving easier financial conditions in the euro area.
    1. Valuations. On a real effective exchange rate basis, JPY and GBP remain well below their respective 10-year averages, while the USD is still more than 5% above it. However, the EUR has corrected much of its former cheapness, and is now only 2-3% below the long-term average. In fact, according to the IMF’s estimated FEER fair value, the EUR REER is currently 3.5% rich. On balance, valuations no longer scream for more USD depreciation.
    1. Euro area C/A. Related to the point above, the euro area’s current account surplus, while still large, has been shrinking for more than a year. To be sure, bond portfolio outflows have also been moderating, suggesting that the downward pressure on the euro we saw between mid-2015 and the beginning of this year has now eased. Nevertheless, a moderation in the C/A surplus should prevent the EUR from appreciating too much as a result of the normalisation of ECB policy, as this should cause yields to rise and portfolio outflows to keep slowing.
    2. US data improving. The US economy has picked up substantially, judging by the recent flow of data. Retail sales were strong, and even the seemingly unimpressive rise in CPI was not so bad once a 13% drop in wireless telephone services is excluded. Consumer sentiment on Friday hit a seven-month high. Importantly, data are beating forecasts more in the US than in the EA, where expectations have caught up with solid macro outcomes.
    3. Positioning. IMM data show that investors hold a record short USD position vs EUR, CAD and MXN as well as a near-record short vs NZD, AUD and CHF. This does not mean a squeeze is imminent, but it increases the chance of a rebound.
    4. Seasonality. Seasonal performance over the past decade shows that the USD tends to rise going into year-end. While the dollar rallied in only five of the past 10 years, the gains when it did so outweighed the losses when it didn’t.

  • 17 Aug 2017 - Martin Shenfield

    The Next Crash

    My colleague Dario Perkins has addressed again market fears of a significant correction or even worse by comparison with the run-up to the GFC (cf LSR Macro Picture ‘The Next Crash’). 

    "The 2008 crisis was so deadly because it was centred on housing and global banking. The financial system is less vulnerable today. While another crash isn’t imminent, elevated asset prices provide the main threat. For the macro economy, this would probably resemble dotcom rather than subprime. But watch out for amplification risks.

    Central banks have allowed a multi-year bull market in asset prices, notably equities. They even encouraged this as part of the ‘transmission mechanism’ from monetary stimulus. While it is debatable whether global stock markets are overvalued, the authorities have been prepared to tolerate the risk of a major correction. While an asset-price crash would hurt investors, it wouldn’t necessarily be a disaster for the macro economy. 

    The subprime crash was deadly because it involved a global housing bubble, excessive levels of household debt and a wildly overleveraged banking sector. Worse, the entire global financial system was dependent on unusual and complex derivatives, which rapidly lost value, became illiquid and triggered a vicious spiral of firesales and forced deleveraging. While it would be foolish to rule out future problems, a repeat of 2008 doesn’t seem imminent. Households are not overleveraged and the global banking system is in a much healthier position, with additional capital/liquidity buffers and lower levels of interbank borrowing. Shadow banking activity, while still significant, contracted sharply after the subprime crisis and hasn’t recovered. With a few notable exceptions (China, the UK, Canada?) global house prices do not seem hugely overvalued. And while global debt levels are higher than in 2008, the public sector is responsible for much of this extra borrowing, either directly (DM) or indirectly (EM).

    This suggests policymakers did learn valuable lessons from the subprime crash. But certain risks remain – particularly from elevated levels of asset prices. For example, rather than lean against the run up in equity prices since 2009 – the classic ‘macro prudential’ intervention – central banks actively encouraged it. It is debatable whether global stock markets are currently overvalued, but while a sudden or significant correction in asset prices is unlikely to trigger another 2008-style financial collapse, it would still be painful for many investors. We identify several forces that could amplify the potential damage, including

    1. The growing reliance on offshore USD financing and the risk of a sudden USD squeeze higher (EMs would be particularly vulnerable)
    2. Limited central bank ammo
    3. High levels of leverage in specific parts of the global economy – particularly those sectors (US corporates) and countries (China) that have taken on more debt since the subprime crisis
    4. Passive investment strategies and algorithmic trading

    While we don’t expect a crash anytime soon, it will be important to monitor these risks."

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