Appetite for destruction… and procrastination

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Financial markets continue to take into their stride a number of man-made and natural crises and the procrastination of policy-makers in the US, UK and Eurozone.

Global risk appetite remains seemingly well bid despite the still very opaque end-game for rising geopolitical tensions stemming from North Korea and the impact from Hurricanes Harvey and Irma.

In the world of FX, the emerging market carry trade is seemingly enjoying a mini-revival thanks to low yields in developed economies, signs that global GDP growth continues to inch higher and a surge in commodity prices, particularly industrial metals.

Event risk is clearly more acute in September than it was in August but it is not obvious to me that major central banks will deliver the kind of surprises which cause major dislocations in financial markets, including EM currencies.

However, these high-yielding EM currencies’ volatility versus the Dollar remains quite elevated, with perhaps the exception of the Turkish Lira and Indian Rupee.

Chinese policy-makers are seemingly intent, at least for now, on using Renminbi appreciation as a show of strength and I expect further currency gains near-term.

In the UK, the mammoth challenge facing Prime Minister Theresa May is coming into greater focus. Moreover, the Bank of England is unlikely to seriously consider a rate hike before next year, in my view.  With this in mind, I see the risk biased toward bouts of Sterling weakness.

The Euro, which eked out small gains versus the Dollar and Sterling following ECB President Draghi’s Q&A session, is ultimately behaving like a safe-haven currency.

I expect the common currency to benefit, not suffer, from lower interest rates for longer and the associated improvement in economic activity even if future Euro appreciation could be modest rather than spectacular.

 

Financial markets continue to take into their stride a number of man-made and natural crises and the procrastination of policy-makers in the US, UK and Eurozone. Global risk appetite, as measured by global equities and emerging market (EM) asset prices, remains seemingly well bid despite the still very opaque end-game for rising geopolitical tensions stemming from North Korea, Hurricane Harvey which has hit energy infrastructure, oil production, refinery processing and supply chains in Texas and Category-5 Hurricane Irma which is battering the Caribbean and heading towards Florida. The US S&P 500 equity index is only 0.6% away from its early-August record high and the VIX volatility index is back down to 12 having briefly hit 14 on 5th September.

In the world of FX, the EM carry trade is seemingly enjoying a mini-revival while Chinese policy-makers are seemingly intent, at least for now, on using Renminbi appreciation as a show of strength. The Euro is likely benefiting from low interest rates and safe-haven status, unlike the US Dollar – which continues to sink – and Sterling which will struggle to build on recent modest gains, in my view.

 

EM carry trade enjoying mini-revival as global growth and commodity prices push higher

A GDP-weighted basket of high-yielding currencies including the Brazilian Real, Russian Rouble, Turkish Lira, South African Rand and India Rupee has been steady in recent weeks (see Figure 1).

 

Olivier Desbarres Appetite Fig 1

The prospect for the foreseeable future of interest rates remaining low in developed economies, including the US, UK and Eurozone, has renewed the attractiveness of currencies offering high yields. Moreover, signs that global GDP growth continues to inch higher is a net positive for EM economies reliant on global trade. The global manufacturing PMI hit a 75-month high of 53.1 in August, which according to my analysis points to a further rise, albeit modest in global GDP growth in Q3 to around 3.2% (see Figure 2).

 

Olivier Desbarres Appetite Fig 2

Finally, the surge in the price of hydrocarbons and industrial metals in recent month is proving a boon for major commodity exporters such as Brazil, Russia and South Africa (see Figure 3).

 

Olivier Desbarres Appetite Fig 3

 

Event risk is clearly more acute in September than it was in August as central banks resume their policy meetings and parliaments return to work. Even so, it is not obvious to me that major central banks will deliver the kind of surprises which cause major dislocations in financial markets. Yesterday’s European Central Bank (ECB) policy meeting is a point in hand (see below) and I am somewhat sanguine about US Federal Reserve announcements causing a wholesale disruption in EM markets (see We know what you did this summer, 1 September 2017).

However, these high-yielding EM currencies’ volatility versus the Dollar (the main funding currency) remains quite elevated, with perhaps the exception of the Lira and Rupee. Figure 4 shows the magnitude of the largest daily sell-off and rally versus the Dollar in the past month.

 

 

Chinese Renminbi appreciation a show of strength justified by macro data

The robustness of the Chinese economy, which has arguably contributed to both higher commodity prices and supported global GDP growth, provides some justification for the People’s Bank of China’s conscious decision to appreciate the Renminbi. I would also argue that Chinese policy-makers may be keen to use currency appreciation as a visible show of strength given the backdrop of growing concerns over North Korea’s tactics, strategies and ultimate goal(s). In more practical terms, the PBoC may be wary of regional geopolitical tensions re-igniting capital outflows from China and may perceive Renminbi appreciation as a way of short-circuiting such a scenario.

In Nominal Effective Exchange Rate (NEER) terms, the Renminbi has appreciated about 2.2% in the past month to an eight-month high, according to my estimates (see Figure 5). This pace of appreciation is not atypical but history also suggests that it will eventually slow and potentially morph into monthly depreciation – which in level terms implies the CNY NEER eventually stabilising and possibly correcting lower (see Figure 6). Given the North Korean backdrop, the PBoC may opt to delay a little longer than normal this reversal in Renminbi appreciation.

 

Olivier Desbarres Appetite Fig 5 and 6

 

Domestic and external hurdles for British policy-makers likely headwinds to Sterling revival

While the UK’s planned exit from the European Union (EU) on 29th March 2019 may fall short of a self-inflicted disaster, the mammoth challenge facing Prime Minister Theresa May’s government is coming into greater focus. At the same time, the Bank of England (BoE) faced with weak domestic GDP growth, signs that underlying inflation is ultimately modest and Brexit-unrelated uncertainty is unlikely to seriously consider a rate hike before next year, in my view. The hawkish surprise at its June MPC meeting, which led to speculation of a 25bp rate hike in Q3, is an increasingly distant memory (see GBP – Hawkish surprise presents selling opportunity, 15 June 2017).

With this in mind, I see the risk biased toward bouts of Sterling weakness, following a recent rally aided by decent manufacturing growth in July and PMI data for August (see Figure 7). Output rose 0.5% month-on-month – the strongest showing year-to-date – but manufacturing ultimately accounts for less than 10% of the British economy and I would expect markets to refocus on weak real wage growth and retail sales.

 

 

The ruling Conservative Party faces a number of domestic and external hurdles in coming weeks and months. For starters, the government faces the herculean task of getting the Great Repeal Bill – formally the EU (Withdrawal) Bill – approved by parliament. In essence, the bill – which the House of Commons (lower house of parliament) started to debate in a second reading yesterday – seeks to transcribe 12,000 EU laws into the UK statute books ahead of the UK’s formal exit from the EU in 567 days. While not directly related to the government’s ongoing negotiations with the EU, the bill’s passage through both houses of parliament could nevertheless prove at best tricky and at worst derail the government’s goal of a smooth transition once the UK’s membership to the EU ceases.

Theresa May’s Conservative party is handicapped by a wafer-thin parliamentary majority following its poor showing in the 8th June national election. It has only 318 seats in the 650-seat House of Commons and is having to rely on support from its formal coalition partner, the Northern Irish Democratic Unionist Party (DUP) which has 10 seats, to push legislation through (see UK election: Clutching defeat from the jaws of victory, 9 June 2017).

Even with full DUP support, passage of the Great Repeal Bill through its various readings, committee stages and amendments, could be complicated (see UK Parliament for a detailed timeline). A number of Conservative members of parliament (MPs) seek a softer version of Brexit and at the very least are concerned that the government will use “secondary” legislation to fast-track the bill with diminished parliamentary scrutiny. The government may thus be left relying on support from opposition parties, including Labour Party MPs, which have on the whole flip-flopped over their position vis-à-vis Brexit.

Aside from this mainly domestic challenge there is a growing sense that negotiations between the UK and its EU partners are being hampered by major divisions on key topics, including  the so-called “divorce bill” and immigration, and thus going nowhere fast. EU negotiators, who have been openly critical of their counterparts’ lack of preparedness, have repeatedly made clear that reaching an agreement, even if preliminary, on the size of the UK’s financial liabilities towards the EU is a pre-requisite to kick-starting negotiations on the terms and conditions of the UK’s new deal with the EU.

Moreover, a recently leaked British government paper which takes a hard line on immigration post EU-membership has raised the prospect of the EU stalling an agreement on a post-EU transitional set-up – the latter being the government’s preferred route, even if there is little consensus on its length and modalities. While expectations are that the government will soften its stance on immigration, Prime Minister May has so far refused to water down her position. These games of cat-and-mouse are likely to be a key feature of UK-EU negotiations over the next 15 months (UK and EU parliaments would likely have to vote on a new UK-EU deal by end-2018, a few months before the 29th 2019 March D-date).

There has been much debate as to whether the UK or EU benefit from this narrow timeframe and their respective bargaining positions. While both the EU and UK realistically stand to lose out from diminished exports and/or more costly imports should both parties fail to reach a deal, I would argue that the UK economy has the most to lose. The discussion has centred on the share of trade which the UK conducts with the EU and key trading partners such as Germany and conversely the share of trade which the other 27 EU-member states conduct with the UK. For starters, it makes more sense in my view to measure trade as a percentage of GDP as the share of trade in countries’ GDP varies.

 

Trade in goods and services between the UK and the two largest EU economies – Germany and France –is sizeable and in the case of France reasonably balanced (see Figure 8). The UK runs a sizeable trade deficit with Germany but runs smaller deficits with other EU member states or even small surpluses (e.g. with the Republic of Ireland). The bottom line is that if we look at trade between the UK and individual EU member states, both sides would likely lose out from weaker exports and/or higher import prices in the event of no trade-deal being reached. This should in theory incentivise both the UK and the 27 member states to reach a mutually-beneficial deal.

However, this approach ignores the fact that in the event of weaker/more expensive trade, the UK’s losses would be compounded across 27 countries. Figure 9 indeed shows that the UK’s trade with the EU is significantly larger than trade with even its largest trading partners. The UK’s total exports to and imports from the EU, as a percentage of GDP, amount to a whopping 12% and 15% respectively. So to the extent that the UK is negotiating with the EU as a bloc (not individual countries) and the EU has so far shown a great deal of unity, I would argue that the EU is and will remain in a stronger bargaining position all other things being equal. That is not to say that the EU will be unwilling to compromise, merely that it holds the best set of cards and the greatest leverage at least in the sphere of international trade.

 

Euro benefiting from low Eurozone yields for longer and safe-haven status

While British policy-makers’ procrastination is doing Sterling no favours, the European Central Bank’s cautious approach to monetary policy is seemingly doing no real harm to the common currency and I remain bullish the Euro (see No UK rate hikes this year and room for further Euro upside, 28 July 2017). The ECB at its policy meeting yesterday once again kicked down the road an announcement on whether to extend its QE program into 2018 while at the same time shrinking monthly bond purchases from €60bn and its attempt to talk down the Euro was arguably half-hearted. With the next policy meeting on 26th October, the ECB has given itself at least six weeks to prepare markets for an extension of QE combined with lower monthly bond purchases.

This was aligned with my view that the “ECB is ultimately in a pretty comfortable position and can probably afford to do and say little” (see We know what you did this summer, 1 September 2017). The Euro, which eked out small gains versus the Dollar and Sterling following ECB President Draghi’s Q&A session, is behaving like a safe-haven currency (see Figure 7). I expect the common currency to benefit, not suffer, from lower interest rates for longer and ongoing associated improvement in Eurozone economic activity even if future Euro appreciation could be modest rather than spectacular.

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