Fixed income outlook 2nd half 2019 (video)

So far 2019 has been unpredictable. We’re yet to see Brexit come to a conclusion, new EU and ECB leaders have been announced and are poised to take on their roles, and Trump (and his Tweeting) remain an enigma. With all this in mind, Adrian Hull, Iain Buckle and Sandra Holdsworth give us their thoughts on what lies ahead for markets in the second half of 2019.

If a picture paints a thousand words

At times, an image is better than 1,000 words ….

Source: US Bureau of Labor Statistics.

For the first time in 18 years, the number of job openings (JOLTS – blue line) in the U.S.A. has surpassed the number of unemployed people in the labour force (orange line)

The Federal Reserve is delivering on its objectives. The economy is in full employment and inflation, as measured by the annual change in the price index for personal consumption expenditures (PCE), is at target. Financial conditions remain accommodative and the Federal Reserve believe that the Federal Funds Rate still remains 0.75-1% below the neutral rate. In an environment where financial imbalances are building, it is hard to imagine that some volatility in financial markets will derail the gradual rate hiking process.

The reaction function of the Central banks has now changed. Deflation is not a concern and emergency policies are no longer required.

Sovereigns and corporates that have not dealt with their structural challenges while liquidity was ample will have to pay the price. Buying the higher yielding asset (not only applicable to Fixed Income assets) in the hope that Central Banks will bail you out will no longer be a suitable approach.

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Thought of the day – the next funding crisis

The world of scrolling news is a strange one. Headlines stream all day with the really important ones, as designated by a robot somewhere, coming up in RED, but occasionally one of the yellow ones catching your eye and provoking a moment’s thought.

Today has been one of those days. Whilst sipping my afternoon cup of tea (I am from Yorkshire after all), I noticed the headline:

U.S. Debt Load Seen Worse Than Italy’s by 2023, IMF Predicts

Really? I thought. Surely not. It is well known that Italy has a public sector debt problem; it was involved in a small funding crisis not so long ago. But the US?

Intrigued, I read the story behind the headline. And true enough, the International Monetary Fund has produced forecasts for the G7 group of countries suggesting that, if correct, the US government debt to GDP ratio will be as high as Italy’s in 2023 at around 117% of GDP.

Some further thought on the two countries… One has a large current account deficit (US), the other a current account surplus (Italy). One has a heavily indebted private sector and a low savings rate (US) and the other a high savings rate and low level of indebtedness (Italy). Which country is most likely to suffer the next funding crisis?

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A fiscal deficit to make your eyes water

Last week the Congressional Budget Office (CBO) updated its deficit estimate, in order to incorporate the recent tax reform and spending agreements.

The fiscal outlook for the US is simply eye watering. The CBO projects the deficit to increase from 3.5% in 2017 to 4.9% for fiscal year 2021. However the forecast is based on overly optimistic growth assumptions. We are of the view that US growth for this year will be healthy and above potential, but 3.3%, as the CBO is forecasting, appears too high. The Bloomberg consensus is 2.8%, while I personally think that 2.5% is more reasonable. Using more realistic growth assumptions, the fiscal deficit for 2019 to 2021 will range between 5 to 5.5%.

Having a large fiscal deficit is not without precedent. Only going back to 2009 the deficit was 10%. But what is certainly unprecedented is this degree of (unnecessary) fiscal stimulus at this point in the economic cycle.

We can debate all day long about the correct level of the NAIRU (the non-accelerating inflation rate of unemployment) – which is 4.6% according to the Fed, versus 4.1% unemployment. But what cannot be put into question is that the economy is close to full employment, that business and consumer confidence indicators are close to all-time highs, that investments are increasing and that the current level of debt is historically elevated as a proportion of GDP. In other words, fiscal loosening is not something that the US requires at this moment in time!

The chart below shows the unemployment rate (rhs, inverted) versus the deficit (lhs) over time. At the current level of unemployment you would expect the US to run a fiscal surplus. In contrast, as the projections show, it will run an even larger deficit.

Chart 1: US fiscal deficit deteriorating

Source: Bloomberg as at 15 April 2018. Projections forecast to December 2020

Aside from the economic rationale (or lack of) of these policies, a large deficit will have implications for the funding requirements in the US. Going back to the CBO estimate, the US Treasury will require an additional $1.7 trillion of funding between 2018 and 2025. To put this number into context, China, the largest holder of US Treasuries, owns $1.3 trillion of them.

It is also important to remember that further financing needs will also be required as the Federal Reserve reduces its balance sheet further. At the current pace, Jeffries estimates that this will add an additional $750bn between FY 2018 and 2021. So overall the US government will have to find a home for an additional $2.5 trillion of Treasuries over the coming years.

There is much debate about the impact that this will have on Treasury yields. Personally I have no concern for the US being able to fund this amount of debt – but I do not think it will be done at current levels. Once the visible hand of the central banks (ECB and BoJ) is lifted, the clearing price will be higher. So far, it has only been the T-Bill market that has been showing signs of indigestion, but eventually longer tenors will have to reward investors with a greater premium (term and inflation) for the lack of frugality of the US government.

One final thought: Mr D. Trump frequently complains about current account deficits with China (among other economies). What he fails to appreciate is that a large proportion of the reserves accumulated have been invested in Treasuries, greatly reducing the cost of the US debt. Reserve diversification (over the last few quarters flows are returning to the euro area) and a greater relevance of the renminbi as a reserve currency might also represent a further challenge for the US government.

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Italian Election Results

As expected the Italian election produced an inconclusive result. None of the political parties obtained an absolute majority and we are likely to face a long period of uncertainty. In 2013 it took two months to form a government.

A positive…

  • The Five Star Movement did not obtain an absolute majority. The probability of this happening was always very remote.

The negatives…

  • The Five Star Movement was the most voted party with 32% of the votes. They performed better than expected.
  • The Lega party (former Northern League) gained 17% of the votes. Importantly they obtained more support than Forza Italia (Berlusconi’s party).
  • The populist parties obtained more than 50% of the votes and are likely to be present in the government.
  • The centrist parties lost ground to the populist ones. The Democratic Party result was particularly weak; Renzi is likely to resign.

Within the likely scenarios, today’s result is towards the most negative outcome. From here the greatest risk is that Five Star forms a coalition government with Lega. This is very unlikely but not impossible. The most likely outcome is a long period of uncertainty (constant headlines – probably unhelpful ones) leading to a government with Five Star or Lega the main actors and maybe protagonists.

The European Central Bank and the Bank of Italy are still buying BTPs (Italian bonds) on a daily basis, which is likely to provide some support in the market. In April there is a large amount of maturities that will require reinvestment, so the technical environment is benign for European bonds. Aside from this and given the relatively muted reaction, the ECB will likely be unfazed with this result. Ultimately the result reflects the will of the Italian people.

Fundamentally the situation is likely to deteriorate in Italy. Political risk will remain elevated in the coming months. Economically looser fiscal policy (with an already elevated debt to GDP level) and a more confrontational stance versus Europe are likely to put off some investors (such as Japanese investors). This should result in higher BTP yields and wider spreads versus core and semi-core markets.

In conclusion, the electoral result is not positive for Italian assets. Uncertainty will require a larger credit premium. As active managers this is something we will aim to profit from: this morning we have reduced our Italian risk and in unconstrained portfolios have sold Italy versus Spain on the expectation it will underperform in the near term.

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The Italian Election – numbers you should know

There will be a lot written about the General Election in Italy on 4 March 2018.
We thought we’d add a few numbers…

Silvio Berlusconi tops the charts of time spent as Prime Minister since World War II. Elected four times and is the current leader of Forza Italia and the Centre Right coalition. He is 3rd in the list of time served as Prime Minister since the formation of Italy in 1861. Only Mussolini and Giolitti have served for longer. Is he going to try and make it up to 2nd place?

The number of houses that make up the Italian legislature: Chamber of Deputies and the Senate. Both are up for election in this year’s General Election.

The number of major parties or coalitions contending to form a government: the Centre Right coalition, the Centre Left coalition and Five Star Movement.

The number of general elections that have been held since Italy adopted the euro. This is the 5th.

The number of political parties that make up both the Centre Right coalition and Centre Left coalition.

The number of Prime Ministers since Italy adopted the euro (Berlusconi served twice)

The number of parties contesting the 2018 General Election.

The number of elections since World War II.

The age of Luigi Di Maio, Prime Minister Candidate for the Five Star Movement (M5S), who entered the Chamber of Deputies in 2013.

The number of governments since World War II

The age of Matteo Renzi, leader of the Democratic Party (PD) and the Centre Left coalition, former Prime Minister, resigned in December 2016 following the loss of referendum regarding electoral reform.

The age of Silvio Berlusconi, leader of Forza Italia and Centre Right coalition, more life experience than Renzi and Maio put together and that is just taking his age into account! Amongst many controversies he was convicted for tax fraud in 2013. As a result of this conviction he has been banned from public office until 2019. It remains unclear who would be Prime Minister therefore in the event of a Centre Right victory.

The predicted majority for the Centre Right coalition in the Chamber of Deputies based on opinion polls taken 10-11 January 2018.

The current basis point spread that Italian debt trades over German bunds.

The highest level of spread that Italian debt traded at, in the run up to the French election.

The number of seats in the Senate up for election.

The number of seats in the Chamber of Deputies up for election.

The size of Italian government debt as at November 2017 (euros) = 132% of GDP as measured at the end of 2016.

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Make sure to challenge the core…

January is a time for getting back to normality – better eating, early rises and often, going back to the gym. While those gym-goers are challenging their core strength, we are challenging our core macro views as we head into the New Year.

2017 was the most positive environment for the global economy since the 07-08 financial crisis. Growth was above potential, but was also balanced and synchronised across developed and emerging markets. Importantly for financial markets, the strong growth was accompanied by a healthy but modest level of inflation.

Forward looking indicators remain encouraging and global real growth looks like it will maintain the current 3.5% to 3.7% pace. Growth is also now less reliant on household consumption as investments are increasing.

This is a relatively benign view so we are asking ourselves – what challenges this base case? We consider the following downside risks and potential upside surprises in 2018.

Downside risk! China:
In recent years China has been the master of recalibrating monetary and fiscal policies. But its task is becoming more challenging as authorities try to shift from an investment-driven economy to a consumer-led one, impose controls on the housing market, whilst achieving a level of economic growth that is more sustainable in its composition. Total debt has reached alarming levels (financial imbalances are a primary concern for the authorities) and geopolitics (including tensions with the US) are increasing.

The central case is a lower but still healthy level of growth: the risk is that the recalibration of policy does not produce the desired effect and growth drops below 6%.

Downside risk! Protectionism:
Protectionist policies became an obsession for the market in late 2016. These fears seem to have dissipated despite little progress in the NAFTA negotiations and ever more prevalent tensions between China and the US.

The need to avoid a conflict with North Korea makes a trade war unlikely. Nevertheless Mr D. Trump is arguably the most unpredictable US president in history; trade is an area where he has a degree of flexibility and where he could express his frustration. A disruption of global trade or the proliferation of protectionist policies represent a meaningful downside risk to growth, especially for open economies like China, Europe, Japan and some of the emerging market economies.

Upside surprise? Investment:
The improvement on the composition of growth and the noticeable pick-up in global capital goods orders and capital expenditure is encouraging. Looking beyond the very short term, investment is an essential ingredient to improve productivity. Debt-funded consumption simply brings future demand into the present and increases the debt burden of future generations. Investment increases potential GDP. This is particularly relevant in those economies that face challenging demographic dynamics.

Upside surprise? Europe:
Despite the recent strength, I see more room for positive surprises in Europe. Unlike the US, the economic cycle in Europe is very young. The deleveraging process has just concluded. A positive credit impulse will support activity as consumers and businesses (where confidence is at multi-year highs) increase their credit demand.

These dynamics are among those we will be keeping a close eye on into 2018.

The King (well, Queen) is dead, long live the King!

Janet Yellen is set to be replaced by Jerome Powell as Chair of the US Federal Reserve. Whilst markets have speculated what the new kid on the block will deliver, the outcome is evolution, not revolution. Powell was not the preferred candidate of those who thought that interest rates should be materially higher; rather Powell is born in the image of Yellen, who gently allowed short rates to edge higher over her four-year term.

But just as significant is the change down the Federal Open Market Committee’s (FOMC) pecking order. The FOMC’s vice chair Stanley Fischer is gone, as will be William Dudley – the New York Fed rates ‘hawk’ who announced early retirement for mid-2018. There are further rotations to the rates-setting committee in 2018, which will see the dovish Neel Kashkari exit to be replaced by the more hawkish John Williams.

So what does this all mean? A change in members creates further uncertainty as people’s pronouncements tend to differ when they are ‘in the job’ i.e. on the FOMC. But more importantly, markets will be keen to see what ‘mettle’ Powell brings to his new role. Markets will want to understand what the FOMC looks like and testing its mettle is likely to be on the agenda. Expect to see an increase in volatility, especially in the front-end of the $ market. However, this is most likely at a disappointing rate compared to the choppier days of Greenspan and Volcker.

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No Hope for hay fever

Last week Yuriko Koike, the leader of Japan’s ‘Party of Hope’ and the main opposition to Japanese Prime Minister Shinzo Abe, unveiled her “12 zeroes” manifesto. The promise of ‘zero’ hay fever caught my attention: a welcome claim for the 25 million sufferers in Japan, but astonishing that politicians can claim to defy Mother Nature! If we made such a pledge in our marketing materials I suspect the regulator would have something to say about it…

What has also caught my attention of late is the impressive level of activity in Japan. Second-quarter real GDP was 2.5%, which is meaningfully above the assumed potential of 0.5 to 0.75%. Even more encouraging was the composition of growth, with private consumption and investment activity strong. The Tankan survey – a quarterly survey of business confidence – points towards a continuation of this trend into the second half of the year, as shown in Chart 1.

Source: Bloomberg

This pick-up in business activity is not unique to Japan. The rotation towards investment has been highlighted by central banks, in particular by the Bank of England in its August inflation report and its governor Mark Carney, who recently pointed out the increase in capital goods orders in advanced economies (Chart 2). I believe that this development is one of the most encouraging macroeconomic events that we have seen in a while.

Source: Macrobond. Capital goods are tangible assets such as buildings, machinery, equipment, vehicles and tools that a company uses to produce goods or services.

Global corporate profitability and elevated business confidence point to a changing dynamic in business investment, but only time will tell if this is the beginning of a trend. If so, we should expect higher productivity, healthier potential growth and less depressed neutral terminal rates – all of which will have an impact on monetary policy.

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Cure us of this lunacy!

In a remote north-west corner of Scotland there is an island in the middle of a loch called St Maree. On it are the remains of a chapel and a holy tree, believed to be around 1,300 years old. Legend had it that if you rowed around the island twice, submerged yourself in the water and made an offering to the tree, you would cure yourself from lunacy. Many people made this offering over the years, and the tree was filled with hammered-in coins.

Even in today’s more enlightened world, we see versions of this money tree – be it a political party making unfunded promises, or offering money to cure a problem that money can’t solve.

Regarding the latter, central banks globally have offered money to institutions to cure the problem of low or no inflation. They may not directly give the money away (although you could argue that the ECB’s Long-Term Refinancing Operation does just that), but central banks have been buying bonds that institutions hold, both sovereigns and corporates. Through different channels this money was meant to stimulate lending, boost growth and, importantly, lift inflation.

Years on, global GDP looks fine, but inflation has not taken off, while at the same time we have significant side effects – not least inflated asset prices in bond markets.

The ECB is set to continue its QE programme into 2018; yet inflation has not returned to target and is unlikely to over the bank’s three-year horizon. Which leads me to the popular quote: “the definition of insanity is doing the same thing over and over again expecting a different result”.

On the island of St Maree there were too many offerings to the tree – eventually it died of copper poisoning. Is this what we can expect from the central bank money tree?

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Prepare to be Prepared

The Bank of England (BoE) today made a not-so-subtle attempt at getting the market ready for an imminent interest rate rise. In the minutes of today’s 7-2 vote it was noted that “a majority of MPC members judge that…. some withdrawal of monetary stimulus is likely to be appropriate over the coming months….”. From previous statements the BoE Chief Economist Andy Haldane has made, the rate rise would be more about removing stimulus added in the wake of the Brexit vote rather than the start of a hiking cycle.

That is the communication tightrope they will have to walk going into the November Quarterly Inflation Report. Do they go down the “one and done” Haldane view? Or do they have the confidence in the economy (and more to the point that wages will finally rise) that means a full-blown rate hiking cycle in the coming months? Of course “coming months” could include February 2018, but either way it is the most explicit the Bank can get in paving the way for a decision.

What should be certain is that we will all be pouring over the MPC members’ speeches in the run up to November. Given that this could be the first increase for 10 years, the Bank will want the market to be fully prepared.

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Positive on the periphery

The European Central Bank’s (ECB) Governing Council decided yesterday to keep monetary policy unchanged in the euro area but signalled strongly that, all being well, policy would be ‘recalibrated’ at the October meeting. So we will all have to wait until later in the year to see the results of this meeting and whether the pace and makeup of purchases (currently spread across three programmes, the PSPP, CBPP, and the ABSPP) will change. 

Mr Draghi did rule out any change to the amount of each bond it can buy (issuer limits) and also ruled out any change to potential sequencing of its removal of accommodation – in other words, the projected path of reducing asset purchases first and then moving interest rates remains unchanged. This outcome is unlikely to come as much of a surprise to financial markets as few had been expecting any clarity at this stage in the year.

The ECB also announced its latest staff forecasts for the Eurozone economy in 2017, 2018 and 2019. Economic growth has been revised up in 2017, reflecting the current positive environment, but forecast were left unchanged for 2018 and 2019. Inflation however was revised slightly lower for 2018 and 2019, reflecting for the first time some pass-through from the strength of the euro. The revisions made were quite small so while there was some note of euro volatility in the accompanying statement, it signalled that (at this stage) the ECB is not too concerned over the external value of the euro.

We continue to expect tapering to start in 2018, and think that some change in the composition of asset purchases is likely given the ‘shortage’ of German government debt. In our view this will add to the relative attractions of peripheral European debt, already performing well as the outlook for the Eurozone economy continues to improve. As long as there is no political hiccup, the better economic outlook will continue to benefit credit ratings across the region, with most countries in the periphery likely to retain a stable or positive outlook.

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Inflation, remember that?

Both German and Spanish CPI was released today for August. They can be added to the expanding list of countries in the European area where inflation is coming in higher than expected. Germany reported 1.8% year-on-year, with Spain at 2.0%.

To put these figures into context:

  • The average inflation in Germany over the last 5 years was 1.2%, and 0.6% in Spain.
  • The average inflation in Germany since the euro was formed was 1.5%, and 2.2% in Spain.
  • The average inflation in Germany since Bloomberg records began (in 1997) was 1.4%, and 2.2% in Spain.
  • The inflation rate in Germany when the ECB started quantitative easing (QE) was 0.2%, and -0.8% in Spain.
  • The inflation rate in Germany when the ECB expanded QE (in June 2016 post the Brexit vote) was 0.1%, and -0.9% in Spain.
  • The inflation rate in Germany when the ECB announced the extension but reduced amount of QE (the first taper) was 0.5%, and 0.0% in Spain.

France and Italy release their figures tomorrow, so it will be prudent to keep an eye out for that. With regard to inflation, these countries remain the laggards with France at 0.8% year-on-year and Italy at 1.2%. After the figures today, I would expect these to come out higher than forecast – with the obvious implications for ECB policy.

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100 days to fall out of love – a French romance

The hundred-day mark is an important checkpoint for every presidency. Mr Macron, France’s youngest leader since Napoleon, moved in the Elysée palace after an inspiring campaign which carried substantial political credit. The first days of his tenure went like a dream but clouds have rapidly started gathering around “Jupiter” (Macron has been nicknamed after the king of Roman gods, which is, one might think, more flattering than “Flamby” or “Sarko”).

So what went wrong? The first sign of trouble came with “les affaires” judiciaries which pushed four of Macron’s ministers to resign under questionable circumstances. The Minister of Justice, Mr Bayrou, who was supposed to fight political sleaze has been ironically forced to resign (alongside Sylvie Goulard) under allegations of wrongful use of European parliament assistants. Richard Ferrand resigned under allegations of nepotism, whilst the Minister for Labour Muriel Pénicaud has been weakened by an ethics probe. Then came the crisis with the army over some budget cuts which resulted in the resignation of the general-in-chief Pierre de Villiers, unprecedented in modern times with the last occurrence way back in 1958. The lack of experience of Mr Macron’s party (La République en Marche) in the parliament also cast shadows on the president’s capacity to profoundly reform the country. The icing on the cake has without a doubt been on the social front. The looming reform of the labour market, using rulings in the parliament rather than a vote and a planned housing aid cut triggered the president’s approval ratings to plummet sharply.

After a hundred days only one third of French people (36%) say they are satisfied with the President’s actions compared to François Hollande’s 46% approval ratings in 2012. This is the lowest score by a French president after the first 100 days. To put this into context, this is even worse than Donald Trump’s ratings who is embroiled in the threat of thermonuclear war with North Korea! (amongst many other concerns). The outlook is also worse as only 23% of respondents believe that the country is moving in the right direction compared to 45% in August 2007, three months after Nicolas Sarkozy’s election.

On the bright side, during the state of grace, Mr Macron delivered on some of his most iconic promises. He tore up the old partisan divisions by forming a progressive government and renewing the National Assembly in an unprecedented fashion. He reaffirmed his political priorities through government spokesman Christophe Castaner who wants to “restore the confidence of the people in our democratic institutions, renew our social model, reform our education system, bolster the ecological transition and return to the European promise.” The French president’s first three months were also marked by international issues with visits to France by US President Donald Trump and his Russian counterpart Vladimir Putin. Mr Macron put France back on the map for the rest of the world, by showing an ambitious and progressive political agenda domestically and internationally.

Mr Macron’s next obstacle will be the planned autumn social movements and already represents a tremendous challenge to his authority. It will be fascinating to see how firmly the President will deal with the street reaction as it could already be a cornerstone of his five years tenure.

Since the election, nuances around French politics have not really impacted OAT yields which have instead mostly been driven by Japanese and ECB flows. Pre-election, Nippon investors were amongst those that became net sellers as the Le Pen/Mélanchon risk intensified, pushing the 10 years OAT-Bund spread to widen from 30bps to 80bps. Post-election, they have started buying again and the spread has progressively re-tightened to 30bps. In June, Draghi’s speech at Sintra triggered a sell-off which benefited OAT’s versus Bunds while ECB QE purchases have been increasing towards France (and Italy). At this level, I would be neutral OAT-Bund spreads as they cannot get much tighter and in a risk off event Bunds would outperform.

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Greece-ing the wheels of recovery

Greece returned to the international bond markets last week with its first issuance since 2014, which at the time was its only issuance since the European Sovereign Crisis when the vast bulk of its debt was ‘restructured’. This return to the market is another small step in the long road back to financial health. Around half of the issuance was bought in exchange for existing debt but some new investors subscribed to the deal, some at least likely to be from outside Greece.

In a small way this should help the Greek banking system by injecting funds from outside Greece into the country, and allowing the amount borrowed under the Emergency Liquidity Assistance (ELA) programme to continue to reduce – something that is probably necessary before the 2015 capital controls are removed. Since 2015, many changes have occurred in Greece and it may surprise some that the outlook is looking much more favourable. Economic growth has turned positive, helped by firm Eurozone economic performance. Unemployment levels, although very high, have been falling since 2014. The fiscal position also looks better, with Greece recording a primary surplus in 2016.

The outstanding level of total government debt is still enormously high and is almost universally agreed as being unstainable in the long term. That said, in view of these more recent positive developments, Greece has been upgraded by rating agencies Standard & Poor’s and Moody’s over the last 12 months. Still rated at a worrisome B- at best, but at least going in the right direction. For this reason Greece offered a credit premium of near 5% over German debt in its recent issuance. This compares with the 1.3% spread that Portugal offers, the next ‘worst’ of the major countries that are active in the debt markets.

The credit trends are not isolated in Greece. Two of the other former ‘PIIGS’ countries, Ireland and Spain, have also seen upgrades in their credit ratings in recent years, and while Portugal’s rating has remained stable, Fitch has upgraded its outlook to Positive. Only Italy has seen a downgrade recently – but even there the outlook looks, for the short term, reasonably sanguine. The revival in economic growth and the long-awaited action regarding the banking system should mean stability for the foreseeable future. The good news can continue.

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UK employment is not the full story

The dilemma for the Bank of England (BoE) intensifies in light of this morning’s May employment figures. UK unemployment has fallen further to 4.5%, versus the BoE forecast at 4.7%. To find a similarly low level you have to go back to the mid-70s, as shown in Chart 1. Moreover, the current level of unemployment is below where the BoE sees the natural level (the level of unemployment below which inflation should rise), all at a time when monetary policy is at emergency levels and inflation is well above the target.

Chart 1: UK unemployment

Source: Bloomberg as at 11 July 2017

And unlike in the US where the participation rate has been coming down, in the UK it has been increasing. Over the last three months the economy has created an impressive 175,000 jobs, taking the overall employment figure to 32m people, 324,000 higher than last year. The employment rate is 74.9%, the highest since comparable records began in 1971.

But employment is not the full story.

Real disposable income for UK consumers continues to be challenged by elevated headline inflation and low earnings. Leaving aside employment, the macroeconomic data has been surprising to the downside (Chart 2). The weak Q1 GDP at 0.2% will likely be followed by only a marginally better Q2 at 0.3%, and below what the BoE was expecting in its inflation report.

Chart 2: UK Economic Surprise Index
Source: Bloomberg as at 11 July 2017

On balance, the BoE has gained back some optionality. The market is now listening to its rhetoric and reacting to the macroeconomic data. In a speech on 20 June, MPC member Haldane complained about market complacency – but the market is no longer pricing the first rate hike in 2020 (a full hike is now priced for May 2018) so expectations appear to be much more reasonable.

I do believe that a removal of some of the emergency measures adopted in August 2016 is becoming more likely. But in the near term I don’t expect this to be a rate hike as the conditions set by the central bank are unlikely to be met. The economy remains weak and I am not hopeful that investment and exports will be strong enough to compensate for the weakness in consumption, while the chances of a smooth negotiation of Brexit are very slim. Instead, the BoE will leave the door open to a rate hike, but focus its efforts on the unwind of macro prudential measures, such as the countercyclical buffer and Term Funding Scheme.

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Monetary policy: Soft or hard approach – not just a political dilemma

As the anniversary approaches of the Brexit referendum it is not just political life that has been buffeted by the referendum’s fallout. Yesterday, Bank of England MPC member Andy Haldane said he would most likely be voting for higher rates later this year. This was a day after his boss, Mark Carney, indicated that rates shouldn’t go up. This is the central banker’s equivalent of the different approaches to Brexit voiced by Philip Hammond and Theresa May.

Wind back to the policy response after last year’s referendum. BoE action was fast and furious as rates were cut by 25bps and a further round of gilt and corporate quantitative easing was announced. For some this response was an outcome of the pessimistic expectations for the economy from the ‘Project Fear’ playbook and was ahead of events. However, the solid growth of the last year is starting to lose energy. Weak-currency-induced inflation and continued high debt levels are playing havoc to consumers’ real spending power. Wage inflation is failing to keep pace with inflation, keeping pressure on both consumers and politicians.

So what is the difference between Haldane and Carney? To be fair, Haldane refers to “partial withdrawal of the additional” policy measures from last summer – i.e. rates can go back to where they were prior to last year’s vote, back to 0.5%. But the current environment of decreasing consumer spending power and the uncertainty over the Brexit negotiations are not a great backdrop for rate rises – Carney’s point. Furthermore, the election has thrown a “dust cloud of uncertainty”, to borrow from Haldane. The politics of austerity are in the spotlight too, with dwindling Tory enthusiasm for it along with the fallout from the Grenfell Tower tragedy. Despite likely looser fiscal policy it also feels more likely that a soft rather than hard approach to monetary policy is on the cards.

“How’s that reflation stuff working out for ya?”

In the pantheon of American leaders, Sarah Palin does not obviously spring to mind.  Nonetheless she did have a good barb at then President Obama in the early stages of his administration when the economy wasn’t going so well when she asked a tea party convention in Nashville (aren’t you sorry you missed that?): “How’s that hopey, changey thing working out for ya?”

From a government bond market perspective, reflation is everywhere but in the price.

A few charts illustrate the buoyant state of economic confidence.

Source: JP Morgan as at 30 April 2017

Global business confidence is not only high, it is coordinated with all of the major developed markets performing well.

This is mirrored in consumer confidence with a particularly marked rise in emerging markets – note the equity performance of luxury goods manufacturers such as Richemont and LVMH for a cross-check on this.

Source: JP Morgan as at 30 April 2017

In this world, one would expect higher government bond yields, steeper yield curves and higher breakeven rates of inflation.  Now admittedly if we take mid-2016 as a starting point all of these conditions are fulfilled.  However, recent government bond price action suggests at least a pause in the “reflation stuff”.

The Federal Reserve started the current rate rise cycle on December 16, 2015.  On that day the 10yr US bond yield traded at 2.29%.  There have been two further increases in rates since then and more are expected.  The current 10yr US bond yield is 2.29% (spooky, no?)

A flattening of the yield curve tends to be a late cycle phenomenon.  The gap between the yield on US 2yr notes and US 10yr bonds is around 102bps.   This spread is close to the flattest it has been since the financial crisis.  Government bonds are anticipatory assets, they provide signals of expectations for future economic activity.

The breakeven rate of inflation is the gap between the yield on an inflation-protected bond and a nominal bond.  The spread provides an indication of the balance between inflation and deflation fears.  In early 2016 deflation fears dominated and this spread fell to around 1.12%.  This spread did react in mid-2016 in anticipation of a stronger global upswing.  However, this spread peaked just below 2.10% at the beginning of 2017 and the level is now 1.84% – not a massive endorsement of “reflation stuff”.

History Repeating – divergent economic data

History has a habit of repeating itself.  We often hear “it’s different this time” only to find that events at least rhyme if not repeat the past.  A good example is US GDP data: Q1 GDP data has been weaker than expected in the US in each of the last few years and it proved to be so again this year. The latest GDP report showed only 0.7% growth on an annualised basis – which was below the consensus forecast of 1%, even after downward revisions to those expectations in recent weeks.  This was the latest in a series of data “misses” in the US so far this year.

Interestingly these disappointments have occurred as economic data elsewhere has remained robust.  The chart below shows the difference between the economic surprises in the US compared to Europe (how many data releases come in either above or below the “official” consensus).

Source: Bloomberg as at 2 May 2017

So what’s going on?  Is the US now lagging Europe?  The answer is “not necessarily” – it has a lot to do with the level of expectations. The optimism that followed the US election pushed both consumer and business confidence surveys to multi-period highs and left expectations overblown.  The inevitable normalisation in this “soft data”, along with some misses on the hard data side, has driven the surprise indices lower.

In Europe the opposite is true – expectations have been so depressed for so long that the recent uptick in data (from a low base) has been enough to beat the consensus.  This feels like the start of the European economy entering into a new phase where investors will need to be focussed more on upside rather than downside risks.

For the US, it’s not all doom and gloom.  The Fed commented last night that they see the weaker data in Q1 as “transitory” with their growth forecasts still in place.  With expectations having been pared back in recent weeks, maybe the scene is set for the US economy to now surprise on the upside.

Challenging consumption in the US

We should not totally dismiss the weakness in Q1 GDP in the US. Private consumption disappointed – no question about it – while inventories detracted 1% over the quarter. But there were also reasons to celebrate. We saw a healthy increase in investments – and since an improvement in productivity requires capital investments, this is the main route to higher potential growth and a higher neutral rate of interest.

Furthermore, in contrast to the hard data, the soft data has not dipped materially and still points towards 2-2.5% growth, a level of growth that will continue eroding the limited amount of slack that exists in some areas of the economy. More globally, GDP growth ex-US is around 3.5%, a level of activity very much towards the upper-end of the range since the global financial crisis.

Arguably, the most relevant piece of data that we got on Friday (28 April) was the Employment Cost Index, which increased by 0.8% in the quarter (a level not seen since 2007) versus market expectations of 0.6%. This data, along with hiring relative to job openings from the JOLT report (the ratio continued moving lower) and the hiring difficulties across several districts highlighted in the latest Beige Book, point towards a full employment market – and one that could finally see pricing pressures (i.e. wage inflation).

We are likely to continue to see unemployment coming down (currently at 4.5% versus the 4.7% long-run level according to the Fed). The three-month average nonfarm payroll is still above 170k, a number that should naturally come down towards 50-100k as the Fed has been signalling for a while. Some might say this will be countered by a meaningful increase in the participation rate. But I think this is unlikely. The structural reasons that brought it down are not going away – after all, the baby boomers are not getting any younger.

Putting all the above together – healthy employment, better compensation along with elevated confidence – challenges the validity of the weak private consumption figures in last Friday’s Q1 US GDP release.

To reinvest or not to reinvest

Last night the US Federal Reserve debated its $4.5 trillion balance sheet. This discussion has started to gain momentum with the change of politics on Capitol Hill at the end of 2016, and with one of the Fed governors William Dudley already indicating that 2018 may start to see a reduction of the Fed’s balance sheet.

Despite the end of Quantitative Easing being in sight QE “continues” here in the UK as well as in the US through the reinvestment of maturing bonds which has the effect of maintaining a static nominal balance sheet. That doesn’t hit the headlines as this is regarded as the small print and quietly forgotten – but it is material and going forward is up for grabs.

So for example, in 2018 the Bank of England will continue QE to the tune of £18bn as it reinvests maturing bonds. Policymakers to date have chosen to reinvest redeeming bonds in order to keep their nominal balance sheets constant – in the UK’s case £435bn of Gilts and in the US a total of $4.5 trillion.  For the UK there is no plan or policy to reduce the amount of bonds held by the Bank Of England, but the Federal Reserve has pushed it up its agenda.

Previously, US Federal Reserve Chair Janet Yellen had suggested it was a secondary consideration, but with rates anticipated to be up another 0.5% by year-end, it seems like reducing the Fed’s balance sheet will become part of the policy mix. We see this as being a material part of likely policy and market debates over the coming months. Previously the bond markets had anticipated that the Federal Reserve would start reducing its balance sheet when short rates (Fed funds) were around 2%. It is likely that as short rates are pushed up we will also see the cessation of reinvestments. Being a reversal of QE is implicitly monetary tightening and may well help elongate the gentle rate cycle we currently see. It may also be part of the Fed’s desire to provide a natural counter balance to a more expansionary fiscal policy from the Trump administration. Either way this suggests the Fed continues to believe the US economy is gaining strength.

Pointing to healthy levels of economic growth

The March survey PMIs (Purchasing Managers’ Index) continue to point towards healthy levels of economic growth. Encouragingly, the pick-up in activity is very broad-based across developed and emerging market economies.

In GDP terms the current level is associated with a global real GDP above 4% (global nominal GDP above 6%). This level of output compares positively versus recent years.

Below we provide a summary of the Global Manufacturing PMIs.

Source: Bloomberg as at 9 February 2017

In the latest dataset, over 75% of the countries’ PMI indices were above 52, showing a good level of expansion, while just three economies were below 50, a level associated with a contractionary environment. This compares to a year ago when the proportion of countries above 52 was less than 50%.

In the coming months we will find out if this is simply a cyclical improvement or we are finally moving towards a structurally healthier level of global activity.

But for now the story is very encouraging.

French politics – where the mud sticks

In France, the National Front is stronger than ever. The rejection of the elites, the international military tensions (Chinese sea, NATO troops in Romania and in Poland) and the effect of globalisation could lead Marine Le Pen to an important score in the looming French presidential elections.

French politics look awful with a peak of mediocrity into the coming elections with all the “affaires” surrounding the candidates. It created some space for some fresh, out of the box, faces like Emmanuel Macron or Benoît Hamon but also reinforced Marine Le Pen (mud only sticks to moderate candidates).

In a tail risk scenario where Marine Le pen gets elected, OATs could widen 20-25%, using 2011-12 as a template to price Eurozone breakup and redomination risks. On the other hand, if the populist candidate does not win, France would outperform the periphery and the focus would move onto tapering.

For now Spanish sovereign debt is not affected compared to OATs, investors seem to only be focusing on French risks and show a disbelief for the dismantlement of the Eurozone. The fact is that even if Marine Le Pen gets elected, she would have a hard time in the parliament election of June and she would not be able to rule as she wishes.

In a positive election outcome, France would need deep structural reform in order to heal and become once again the co-motor of the Eurozone.

Reforms are much needed but they are challenging to implement given the sociological context of the country. One way would be to do a big package of reform simultaneously in order to diversify the pain that they would engender. As the class struggle culture is really important in France pedagogy would be necessary.

On the latest polls (15/03/17), Marine Le Pen remains ahead of the vote for the first round of the presidential election, with 26.5%, followed by Emmanuel Macron (25.5%) and François Fillon (18.5%).  In the second round, Emmanuel Macron is predicted to beat Marine Le Pen, with 61.5% against 38.5%. The socialist Benoît Hamon declined by 0.5 points, to 13.5%, while Jean-Luc Mélenchon is stable, at 11.5%. 72% of the French people wants to keep the euro as the national currency.

Very low government bond yields seem much more likely than higher yields

We don’t share the common view that government bond yields are heading materially higher. Indeed, very low government bond yields seem much more likely than higher yields.

Data from the National Bureau for Economic Research says that the current 90-month economic expansion from the trough of June 2009 is the third longest since they began measuring such things in 1854. But just because it has been a long cycle, does not mean it must end. And it is worth investigating what actions central banks may have to take to respond to any future downturn.

The US Federal Reserve is still raising rates, but I doubt it will be able to raise Fed funds above 2% without provoking a significant slowdown in the economy (the current rate is 0.75%). So any future easing will have very few interest rate ‘bullets’ to fire and even more ‘unconventional’ monetary easing would be likely. In this context the risk of negative US rates seems higher than the prospect of ‘normalisation’.

That is why we don’t share the common view that government bond yields are increasing significantly. The current 10-year US treasury yield is 2.4%. If the current business cycle runs for another three years it will be the longest expansion ever. The market pricing of the 10-year US treasury yield in three years’ time is around 3%. Unless business cycles have been abolished (and we don’t believe they have) the US will at some point experience an economic downturn. At this point the conventional tools available are likely to be much less than has typically been required in the past.

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What’s wrong with the bond market?

The last few months have seen some dramatic changes. Lots of attention has been paid to the Trump team line up; much political capital spent on Britain’s Brexit Bill being pushed through the UK Parliament. Given these events along with upcoming European elections, you would expect the bond market to be experiencing unprecedented volatility. But you would be wrong. Since mid-November the 10-Year US Treasury has traded in a range of 30 basis points – eerily similar to the UK’s 10-year Gilt as well as Germany and Switzerland’s benchmark issues. Likewise, the ‘term structure’ of yield curves for 30-year bonds compared to five or 10-year bonds for all these major markets are not dramatically different.

Also cross market valuations are not distinctly different over the last three months. European markets (Germany, UK and Switzerland) have become a little more expensive compared to US treasuries.

So what are the bond markets telling us? They are reminding us that they are forward looking and efficient. With 10-year US treasuries priced at 2.45% and 10-year Gilts at 1.3% all the action was in the previous three months. That action was driven by Brexit and Trump – with neither event anticipated by markets.

Thus, bond markets rapidly assessed a material change in outlook; Gilts almost trebled in yield from mid-August to November with a logical and unemotional assessment of higher inflation and further political challenges for the UK. Likewise, for the US, expectations of Trump shaking the political tree in Washington were rapidly priced in the days after his election. For Europe a similar story, Bunds were unchanged over this period but political stress signals are starting to be priced into the valuation of French and Italian bonds.

So what are the bond markets missing? Not much bar the politics – witness the underperformance in French bonds. Expect volatility if populism really does become a European phenomenon; Wilders in The Netherlands and Le Pen in France are still regarded as unlikely winners by markets but swathes of people voting for them can readily change that.

But the central case is that Europe rattles on with the European Central Bank in the driving seat. Slightly higher inflation and moderate growth across the EU, Switzerland and US are what the bond markets are currently expecting. However, a political shock from Europe has the capacity to shake the bond market from its current complacency.

A million miles apart

The scores were in today for Europe’s 2016 GDP. A mildly disappointing 0.4% growth in last quarter took the full year’s growth in 2016 to 1.7%. Not bad but short of the achievements in the US and UK where growth measured more than 2% for 2016.

Digging deeper and an odd fact occurs – at the bottom of the European growth pile for Q4 2016 – Greece and Finland. Growth contracted by 0.4% in Greece and 0.5% in Finland. Whilst both economies contracted, all eyes are on Greece, again. Deterioration in Finland’s finances are not the stuff of market volatility. Fundamentally there is trust in Finland to honour its liabilities. This is encapsulated by Finland’s 10 year bond yield of 55bps – a mere 20bps higher than Germany’s – impressive for a country with one fifteenth of the population.

Whilst Greek debt to GDP has barely increased from c. 175% over the last 5 years we are about to enter the fourth round of negotiations over Greece’s debt burden since 2010. For Finland that debt has increased by over 50% over the same time period to 63%, but ranking number 50 in the world’s most indebted countries (measured by debt/GDP) it isn’t the stuff of default nightmares. However, for the IMF, the EU and ECB (the “troika”) Greece’s position continues to be systemically problematic.

Finland is rated AA+ and Greece is CCC (technically having not defaulted in 2011). Greek 10 year debt at 7.3% yield is 6.75% more than Finland. The ECB currently supports Finland’s debt through its QE purchase programme, keeping Finnish yields low. The ECB judges it has already used its QE pro-rata firepower for Greek debt back in 2011 with previous programmes of Greek support.

There are two age-old debt market facts. Number 1) Borrowers who are committed to repaying can access funds at the cheapest terms. Finland. Those who aren’t committed, struggle. Greece. Number 2) If your debt is big enough it’s the lenders problem not yours i.e. the EU which owns around two thirds of Greek debt. 2017 represents another stab for the EU in an attempt to deal with Greece’s debt and a recalcitrant Greek government.  There may only 1,500 miles between Athens and Helsinki but they are still a million miles apart.

We are coming to the last seconds of Central Bankers’ 15 mins of fame

The Bank of England has kept its policy rate unchanged at 0.25% and has voted to keep the stock of purchases unchanged by 9-0. This was expected by the market.

The important conundrum for the BoE is if the economy continues to be more resilient than the Banks’ own forecasts, what is its reaction function to above-target inflation?

Within the Quarterly Inflation Report it did indeed improve its outlook for UK GDP. 2017 predictions moved from 1.4% to 2%, coming from both an improvement in household consumption and business investment. At the same time it also moved down its unemployment rate forecast for 2017 from 5.4% to 5%. But it kept its inflation forecast broadly unchanged.

The Bank has managed this by changing its view on how much slack there is still left in the labour market. It does not think wages are picking up fast enough for the level of unemployment that we are at. So it has lowered where it thinks the equilibrium rate of unemployment is – moving this down from 5% to 4.5%.

This gives the Bank of England plenty of room this year to keep interest rates the same even if inflation goes above the target. What will most likely call this into question is if wage growth were to surprise to the upside.

A very interesting throw-away comment from Mr Carney in the press conference: “we are coming to the last seconds of Central Bankers 15 minutes of fame”.

Removing the cover of low inflation

Eurozone CPI has picked up quite dramatically in recent months from 0.5% in October 2016 and just 3 months later to a very respectable 1.8%. Ok, most of this is base effects of energy and food inflation coming through, but the average CPI rate in the Eurozone has only been 1.7% since 2001. At the ECB meeting in December, Draghi managed to extend the current monetary easing QE policy until the end of 2017 when we coming off the back of very low prints. In other words, he had the cover of very low inflation prints to toughen the stance that more monetary stimulus was warranted.

While the 1.8% rate we saw for January is not exactly anything to worry about and the programme will most likely continue in its pre-announced version, Draghi will no doubt play down the inflation prints, stating this is base effects rather than self-sustaining over the medium term. However the disconcerting voices over the QE policy will become louder and I can easily imagine a scenario in the summer months where the “taper” word is being openly discussed.