Market fatigue in the face of catastrophic success
The relative stability in the Dollar, S&P 500 and US yields is broadly in line with my view that analysts and markets had got ahead of themselves with respect to the path of the US economy and financial markets.
Moreover, Chinese policy makers’ willingness and ability to use central bank FX reserves to support the Renminbi tallies with my expectation that “near-term, the PBoC may continue to see some value in a broadly stable Renminbi.”
Currency, equity and bond markets may also be suffering from “political-fatigue”, with Donald Trump’s “policy-by-tweets” exhibiting diminishing returns.
Expectations that Trump will have to deliver a more cohesive set of policy priorities will likely rise exponentially after his inauguration as President today. If he is unwilling or unable, markets’ good-will may flounder and the Dollar and US equities may correct lower.
In the UK, Theresa May’s speech was an important milestone in the UK’s already tortuous path towards a world outside the EU. But there are still many legal, political and economic hurdles the government must clear, including a number of parliamentary votes.
Given the uncertain path which British executive and legislative bodies will take to reach a difficult-to-predict outcome at a still unidentifiable point in the future, fluctuations in Sterling will likely remain common-place.
I see the risk tilted towards Sterling weakness due to the British government’s acute challenge of negotiating favourable trade deals with EU and non-EU countries and the UK economy’s reliance on faltering household consumption growth.
FX, bond and equity markets stuck in ranges despite (or because of) political noise
Markets have in recent weeks had to contend with an increasingly loud backdrop of political noise. Key macro data have been put in the shade by the ongoing saga of US President-elect Trump’s historical relationship with Russia (and potential implications for the United States’ future relationship with the world’s twelfth largest economy), Team Trump’s increasingly frequent posturing about China and British Prime Minister Theresa May’s much-awaited speech on her plans for the UK post-EU.
And yet currency, equity and bond markets have on the whole remained in reasonably narrow ranges.
- The US Dollar Nominal Effective Exchange Rate (NEER) – the dollar measured against a weighted basket of the currencies of the United States’ main trading partners – is still broadly in the middle of a two-month range (see Figure 1).
- The Renminbi NEER has traded in an even narrower range, confounding the seemingly well-entrenched (and now ageing) view that the Renminbi has nowhere to go but down (see Figure 2).
- Sterling has had a roller-coaster week but is ultimately back to recent levels versus both the dollar and euro.
- 2-year US yields have been trading in a 15bp range of 1.15-1.29% since mid-December and market pricing of Fed rate hikes in 2017 has been hovering just over 50bp since early January.
- 10-year US yields have ticked up to the high-end of a 2.32-2.50% range in place since late-December but are still 10bp lower than in mid-December.
- The S&P 500 is flat-lining around 2,270, having spent the past two months in a 2,250-2,280 range (bar a brief bout of weakness very late in 2016).
Stability in US financial markets and Renminbi broadly in line with my expectations
The relative stability in the Dollar, S&P 500 and US yields is broadly in line with the view I expressed in Hawkish pendulum may have swung too far (21 December) that analysts and markets may have got ahead of themselves with respect to the path of the US economy and financial markets. Moreover, Chinese policy makers’ willingness and ability to use central bank FX reserves to support the Renminbi tallies with my expectation that “near-term, the PBoC may continue to see some value in a broadly stable Renminbi” (see Chinese Renminbi – Squaring the circle, 6 January 2017).
Markets may also be showing the first signs of political fatigue and of being hungry for tangible and detailed policies. Trump’s admittedly novel “policy-by-tweets” has diminishing returns, with each new 140-word pronouncement having somewhat less impact than the previous one. The compounded effect is that the world-at-large is struggling to differentiate between noise, posturing and clichés on the one hand and actual policy stances on the other.
Expectations that Trump and his team will have to deliver a more cohesive set of policy priorities will likely rise exponentially after his formal inauguration as President today (which commences at noon Washington-time). In particular, clarity will be sought as to Trump’s proposed tax cuts, infrastructure spending (of which we have heard little recently) and geopolitical ambitions. While Trump and his team have upped their verbal attacks on China’s trade and currency policies in recent days, he has arguably blown and cold when it comes to Russia.
Traditional approaches to interpreting Trump’s musings on the relationship between the US and the world’s super powers will likely continue to fall short. Trump will in a few hours time be officially declared the 45th President of the United States, but at heart he is a businessman who thrives on getting a good deal, regardless of who is sitting at the negotiation table (that is how he made his money). He has no friends or enemies, at least not in the traditional sense – only people he wants to beat in the art of deal. Nevertheless, if Trump and his team fail to provide a more detailed roadmap for the US economy, markets’ good-will may flounder and the Dollar and US equities may correct lower.
UK’s tortuous exit from EU and economy’s vulnerabilities to leave Sterling under pressure
In the UK, Theresa May’s 17th January speech was an important milestone in the UK’s already tortuous path towards a world outside the EU, clarifying the Prime Minister’s so-far ambiguous stance vis-à-vis the UK’s planed exit from the European Union. However, markets are seemingly well aware that negotiations with the EU will likely be long and complex and that there are still many legal, political and economic hurdles which the government must clear if it is to deliver successful new trading arrangements with both the EU and non-EU trading partners. In this context the UK economy’s outlook remains cloudy at best.
Given the uncertain path which British executive and legislative bodies will take to reach a difficult-to-predict outcome at a still unidentifiable point in the future, fluctuations in Sterling such as those recorded this week are likely to be common-place with the risk of higher implied Sterling volatility, in my view.
Moreover, Sterling is likely to remain under pressure due to British government’s acute challenge of negotiating favourable trade deals with EU and non-EU countries and the UK economy’s reliance on faltering household consumption growth. I acknowledge, however, that forecasting Sterling’s path remains fraught with difficulty over both the near and long-term (see The A-Team has a plan, the British government has a nebulous plan, 13 December 2016).
Assuming that the Supreme Court on 24th January upholds the High Court’s ruling that the government does not have the prerogative to trigger Article 50 of the Lisbon Treaty, the next critical step will be for government to present to both houses of Parliament a draft law which allows it to trigger Article 50 by end-March. The vote on this draft law, particularly in the 650-seat lower house of parliament (House of Commons), will be first litmus test since the 23rd June referendum of parliament’s level of support for Brexit, particularly amongst the 329 MPs of the ruling Conservative Party.
If Parliament indeed votes (by a simple majority) in favour of granting the government the right to trigger Article 50, British Parliament will then have to vote at least three more times before a final deal with the EU becomes law (based on Article 50 of the Lisbon Treaty and cabinet members’ statements – see Figure 3). The European Parliament will have to vote on the terms and conditions of the UK’s exit from the EU (as will the European Council) and likely vote on the terms and conditions of the UK’s new relationship with the EU-27 member states. During that time the British government will be engaged with both the EU and other trading partners in probably the most complex set of negotiations that any European country has engaged in since the Maastricht Treaty established the EU in 1993.
British government facing uphill task of securing favourable agreement with EU
The ability to negotiate a favourable trade deal is conditioned by a number of factors, including the strength of the initial bargaining position as well as the institutional capacity to negotiate and implement this deal. The British government will find it incredibly challenging to secure advantageous new deals with EU and non-EU trading partners within the ambitious time-frame which it has set out, in my view (see Sterling singing to (leaked) tune ahead of Theresa May speech, 16 January 2017).
Trade with the EU
In aggregate, the EU has seemingly far more leverage over the UK than vice-versa assuming these 27 EU member states are willing and able to negotiate as one trading block. The EU is by far the UK’s largest trading partner. About 45% of the UK’s exports of goods and services are destined to the other 27 EU member states and about 53% of its imports of goods and services come from the EU (using 2014 data). In comparison, only about 9% of the EU-27 exports of goods and services are destined for the UK. Similarly, only 9% of the EU-27 imports of goods and services come from the UK (see Figure 4).
If the UK exits the Single Market and tariffs are applied to goods and services traded between the UK and EU, the cost of these goods and services will rise (all other things being equal). This loss of price-competitiveness could result in fewer goods and services being traded between the UK and the EU and/or traded at higher cost, which could in turn have a negative economic impact on both the UK and EU. However, while a small percentage change in these flows and their costs would likely have a modest absolute impact on the EU as a whole, it could have a large absolute impact on the UK.
From the perspective of institutional capacity and the ability and scope to negotiate complex trading deals, the EU-27 member states also have the upper hand. The British government, by its own admission, has a very modest number of staff working in EU institutions. In comparison, the EU-27 has a vast civil service based predominantly in Brussels and Luxembourg which over the past 20 years has been geared towards bringing new countries into the EU and negotiating international trade deals. Moreover, the British government will be tied up in the gargantuan task of reviewing the 50,000 pages of EU laws which it needs repeal, amend or retain.
A House of Commons Foreign Affairs Committee report in June 2013 concluded that:
“The Government is correct to have identified both the importance of UK personnel on the staff of the EU institutions as a channel for UK influence in the EU, and the fact that the UK faces a serious problem with respect to its declining representation among EU staff. We commend the Government for launching an effort to increase the UK staff presence in the EU institutions. However, the Government’s efforts are not so far reversing the decline in the UK presence. In relation to its share of the EU’s population (12.5%), the UK is significantly under-represented among the staff of the major EU institutions (Council, Commission and Parliament)” […].The UK staff presence at middle-ranking and more junior and entry levels in the Commission is insufficient to compensate for the exit of senior UK officials. Even if UK representation at entry levels were to start to pick up, the Government must therefore reckon […] with declining UK representation at the most senior levels there in the medium term. [my emphasis].
To put it in perspective:
- The Council of the EU, which together with the European Parliament is the main decision-making body of the EU, has 3,500 members of staff in its General Secretariat, of which fewer than 4% are UK nationals. By comparison, France (which has a similar population as the UK) accounts for 7% of the members of staff.
- The European Parliament, which will have to vote on the terms and conditions of the UK’s exit from the EU, has approximately 6,000 members of staff, of which fewer than 6% are UK nationals. France accounts for nearly 9% of members of staff.
- The European Commission has 30,000 members of staff, of which only 1,023 (3.5%) are UK nationals – fewer than Romania (1,280). France has three times as many members of staff as the UK (3,079).
Trade with non-EU partners – Priority and size matter
The British government argues that it could compensate for any loss in trade with the EU by boosting trade with non-EU countries, pointing to President-elect Trump’s desire to strike a “quick and fair deal” with the UK (as reported in the UK Times) and its desire of starting unofficial negotiations with New Zealand. But the UK faces a number of hurdles in its aim to secure advantageous trade deals with non-EU member states.
First, it cannot officially start negotiations with these countries until it has formerly left the EU, as Theresa May has publicly acknowledged. So while the British government can and has started unofficial discussions with non-EU countries, it will have to wait a further two years before it can formally sign any new deal with these countries.
Second, while the British government may able to quickly secure new trading deals with some of its smaller non-EU partners, larger and more complex deals with its main trading partners – such as the United States – may be far harder to nail down. Given what we know about Trump, it would be naïve to assume that he will simply roll over just to please his British counterparts. For starters, the US economy is seven times as big as UK’s. Moreover, while the UK may be eager to sign new deals quickly, Trump arguably has bigger priorities to deal with and trading deals to negotiate (or repudiate), including NAFTA. That puts Donald Trump, not Theresa May, in the driving seat. It is noteworthy that Trump has so far met Nigel Farage (former UKIP leader) and Michael Gove (former cabinet member) but not Theresa May. This suggests to me that Trump may be in no rush to sign a deal with the UK and will decide the UK’s position in the queue.
Third, it is not obvious to what extent the UK can materially boost its exports, particularly of goods. If it was so easy for the UK to boost trade with non-EU countries, why has the UK not already done so? Germany, Europe’s exporting powerhouse, exports (on a per capita basis) 50% more goods to India than the UK does, despite the UK’s historical ties to India. It is a similar picture for exports to other large non-EU countries such as China (see Figure 5).
From the demand side, Asian markets present great potential for UK trade. But the time-zone, legal, regulatory, currency, and political risks are difficult to manage for all but the largest multinationals. African and Latin American markets remain small in comparison and are likely to remain so. The largest Latin American export destination for UK goods is Brazil, which comes in at 27th place in the UK’s top 50 export destinations, accounting for less than 1% of the UK’s total exports of goods (see Figure 8).
From the supply side, Sterling’s 18% depreciation (in NEER terms) since mid-November 2015 has greatly boosted UK’s exports competitiveness which should in turn lead to a narrowing of the UK’s trade deficit. However, the trade deficit has actually widened in the past 12 months (see Figure 6) and continues to be a significant drag on UK GDP growth (see Figure 7). One argument is that the trade deficit will narrow in the long-term even if it deteriorates near-term due to the time it takes time to substitute imported goods for domestically produced ones and boost production and exporting capacity (the J-curve effect).
Only time will tell whether this applies to the UK but history is littered with examples of countries which were unable to translate a more competitive currency into a material improvement in their trade balances. Ultimately, UK imports may not decrease much and/or exports not increase much if domestic companies are unable to supply goods and services which can compete on every metric (not just price) and/or are unable to boost output and export capacity because of labour or technology constraints for example.
Finally, any increase in UK trade with non-EU partners may be insufficient to compensate for any loss of trade with the EU. Looking at the list of the top 50 UK exports destinations, seven of the UK’s top 10 export destinations are EU member states (see Figure 8). India for example is only in 17th place. While UK exports of goods to the EU amounted to £134bn (in 2015), UK exports to India amounted to £4.1bn. If UK exports of goods to the EU fell by just 1%, UK exports to India would have to increase by a third to make up for the loss. New Zealand just makes it in the UK’s top 50 export destinations, in 45th place, with UK exports of £600mn in 2015 – less than half of the UK’s exports of goods to Portugal.
UK economy running on one engine and signs that engine under pressure
As the British government embarks on this arduous and complex path, the UK economy remains vulnerable due to its large current account deficit, the reliance on household consumption growth (see Figure 7) and potential downside to fixed investment growth – a theme I have elaborated on in recent research notes.
Specifically, I argued in Sterling singing to (leaked) tune ahead of Theresa May speech (16 January 2017) that “The concern is that Sterling’s collapse post-referendum will start feeding through more forcefully to imported inflation and consumer prices, which in turn will dent already modest real wage growth and ultimately household consumption – the UK’s main engine of growth.” UK data for November-December seemingly support to this concern (which Chancellor Hammond also shares):
- CPI-inflation jumped to 1.6% year-on-year in December from 1.2% yoy in November;
- Real weekly earnings rose only 0.1% month-on-month in November, with year-on-year growth slowing to 1.8% from 2.0% in October; and
- Retail sales collapsed 1.9% mom in December – the largest monthly fall in four and half years.
Nominal wage growth is struggling to keep up with inflation (resulting in slower real wage growth) which runs counter to the increasingly publicised view that the 4.8% unemployment rate points to a very tight UK labour market. Put differently, I believe that there is still slack in the labour market – with the number of those unemployed, working part-time or inactive but wanting a job still high by historical standards (see Figure 9) – which is in turn curbing workers’ ability to negotiate wages which outstrip inflation. If this is indeed the case and real wage growth remains tepid, let alone slows further, Figure 10 suggests that UK GDP growth will remain modest or even slow slightly.
Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.
 I appreciate that it is difficult to gage what share of those who say they want a job are truly able and willing to work. In the same way, it is conceivable that some part-time workers are unable or unwilling to become full-time workers while some of the unemployed may not have the skills-set which matches demand. So adding all three groups together (unemployed, part-time workers and inactives who want to work) may not give a totally accurate picture of the potentially available pool of workers. However, the overall trend is of informational value in my view.