Tag Archives: Olivier Desbarres

Emerging markets – What will sour sweet spot?

Emerging market (EM) asset prices have performed well since the UK referendum on 23rd June. The overall driver is the perceived view that the risk-reward of investing in EM has improved, both due to better relative returns and more limited risks.

Major developed central banks’ willingness to keep monetary policy loose to put a floor under economic growth is central to this improved risk-reward trade-off for EM assets.

Near-zero rates in most developed markets have put in high-relief high-carry currencies such as the BRL and ZAR which are also benefiting from high global metals prices.

On the risk side of the equation, slowing rather than collapsing global growth and higher commodity prices have attenuated concerns about EM economies’ ability to prosper.

Moreover, stable and still significant EM central bank FX reserves have dulled fears about their ability to defend their currencies in the event of an endogenous or external shock.

At the same time, acute economic, political and geo-political risks in developed economies has led markets to revisit the perceived notion that emerging countries’ economies and political set-ups are inherently less stable and more risky.

Put differently, developed market economies remain just about strong enough to drive EM growth but are sufficiently weak and susceptible to endogenous shocks to highlight the attractiveness of EM assets. The question is what, if anything, is likely to destabilise this fine balance.

The two events which have seriously rattled EM assets, including currencies, in the past year had their epicentres in the world’s two largest economies: the PBoC’s renminbi “devaluation” in August and subsequent government tinkering with Chinese equity markets and the US Fed’s first hike in a decade on 16th December.

An EM crisis is still more likely to have its birthplace in the US or China than Europe for example, in my view, with EM asset prices in the past 18 months relatively resilient to made-in-Europe stresses.

US GDP growth remains unspectacular, with the manufacturing sector weighed down by a strong dollar, while China’s economy is still dependent on loose credit policy and vulnerable because of banks’ growing non-performing loans.

While both the Fed and Chinese policy-makers have seemingly learnt lessons from prior misjudgements, in both countries the risk of policy mistakes remains very much alive. Moreover, the US presidential elections scheduled for 8th November present a significant event-risk to emerging markets and their currencies.
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Bank of England rate cut – Seven years in the making

For the past few years, the Bank of England’s MPC meetings have been pretty straightforward affairs, with the policy rate firmly on hold at its record low of 0.5%.

But the referendum result has dramatically changed the British political landscape and amplified the uncertainty over the near and long-term outlook for the UK economy.

A 25bp rate cut today is perhaps not quite the foregone conclusion which markets are almost fully pricing in. The BoE could today make valid arguments both to support a 25bp rate cut and no change.

On balance, however, I think the BoE has more compelling reasons to cut its policy rate 25bp today than to leave it on hold.

First, BoE Governor Carney has made clear that a rate cut was potentially on the cards, making it harder for him to backtrack.

Second, the British economy was showing clear signs of weakness even before the referendum.

Third, there are signs that economic and political uncertainty post referendum are already having a negative impact on consumption, investment and confidence.

Finally, the BoE may be the only game in town for now as there is limited room for domestic fiscal policy and global monetary policy reflation.

But cutting the policy rate to 25bp or even zero is clearly no panacea to the challenges which the UK faces in coming weeks, months and perhaps even years and there are valid counter-arguments as to why the BoE may leave its policy rate on hold today.

These include that the BoE should save its (limited) bullets and wait for more hard data, a BoE rate cut would set in motion self-fulfilling prophecy, the BoE should balance post-referendum chaos with a steady policy rate, the global equity market rebound has removed the sense of urgency and a rate cut could trigger uncontrolled Sterling depreciation.

Regardless of today’s decision, the BoE’s accompanying minutes will likely try to capture this new paradigm.

A rate cut today would still leave the BoE the option of cutting rates again at its 4th  August meeting but negative interest rate policy and/or quantitative easing are still likely to be measures of last resort. Read more

Post Referendum Circular Reference

It has been a fortnight since the UK electorate voted to leave the EU and the British political and financial landscape has already changed dramatically. But what we don’t know or can only tentatively forecast still dwarfs what we know.

The referendum result simply reflected a popular preference for the UK to leave an international organisation, nothing less, nothing more. There is no precedent for UK and EU leaders to rely on and Article 50 is at best only a very skinny rule book.

For all intents and purposes UK and EU leaders are flying blind. It’s not even obvious who is at the controls, let alone who will lead negotiations on behalf of the EU and in particular the UK following seismic changes in political personnel.

The next steps are thus anything but straightforward and the UK government and EU are currently caught in a prisoner’s dilemma, with none of the key players seemingly willing to make the first move.

The referendum result is not legally-binding, only advisory, and therefore the Lower House of Parliament will likely have to vote on whether to trigger Article 50. But the British government has so far provided only a vague wishlist and simply doesn’t know what the EU may or may not agree to.

Parliament will not want to kick start an almost irreversible process whereby the UK has announced a divorce but doesn’t know the terms and conditions of this divorce, let alone what its new relationship will look like. Unsurprisingly, the British government is playing for time.

But EU leaders have suggested that discussions about the UK’s exit from the EU and future trade agreements were conditional on the UK government first triggering Article 50. And that takes us back to square one.

When this deadlock is broken will depend on many variables, including the length of the stalemate itself, who is in charge at the point of making a decision and the ability and willingness of negotiating parties with different vested interests to compromise.

I would argue that the longer this stalemate lasts, the greater the likely damage to the UK and EU economies and the greater the odds that Article 50 is not triggered in the first place or that a mutually satisfactory deal is eventually reached. Early British general elections cannot be discounted, nor can a second referendum in a more extreme scenario.

Assuming that the current circular reference paralysing EU and UK leaders is unbroken near-term, the associated uncertainty will likely continue to weigh on the UK economy, sterling and global risk appetite. Whether this morphs into a deeper and more widespread crisis may boil down to how patient global financial markets are willing to be. Read more

Brexit: More questions than answers

The UK, the world and financial markets have now had five days to digest the British electorate’s vote to leave the EU and its impact on UK and global asset prices.

So far Sterling and Japanese and European equity markets have borne the brunt of the initial shock, while the FTSE is down only 3.3% since Thursday and most major and emerging market currencies have been reasonably well behaved (see Figure 1).

But there are still far many more questions than answers and the situation remains extremely fluid.

For starters there is no precedent for a country leaving the EU and thus no clear-cut rulebook to rely on. The government has limited institutional capacity to start negotiations with the UK’s 27 EU partners until Article 50 of the Lisbon Treaty is triggered and no timeline has been provided for when this will happen (assuming it is triggered at all).

Perhaps unsurprisingly given the mammoth task ahead, the Leave campaign leaders have been very short on specifics regarding the mechanics and timing of the UK’s exit from the EU, the likely shape of future trade treaties and national policies such as immigration. Prime Minister Cameron’s de-facto resignation and wholesale changes in personnel in the opposition Labour Party are adding to the head-scratching.

Moreover, it is not one country seeking to leave the EU, but a union of four countries – England, Wales, Scotland and Northern Ireland – which further complicates matters as both Scotland and Northern Ireland seem intent on remaining part of the EU and potentially breaking free from the UK.

At this point in time, all we can do is take stock of what we know (or at least we think we know) and what we don’t know (but can tentatively try to forecast).

I would conclude, as I did in Europe – the Final Countdown (21 June 2016), that the many layers of political, legal, economic and financial uncertainty are likely to keep UK investment, consumption and employment, as well as Sterling on the back-foot for months to come. Financial market volatility is also likely to remain elevated in coming weeks.

In this context the US Federal Reserve is likely to keep rates on hold in coming months and the European Central Bank can probably afford to do little for the time being. The Bank of England is likely to seriously contemplate cutting its policy rate while the Bank of Japan will be under renewed pressure to curb soaring Yen strength.

Of course, British policy-makers and business associations have come out and said the right things in order to limit the carnage and contagion. But they have far more limited room to reflate the economy and fade gyrations in financial markets than they did during the 2008-2009 great financial crisis. They are not in control at this juncture and it is not obvious who is.

 

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UK referendum: Blame the weather, not Brussels

The outcome of today’s crucial UK referendum on EU membership will partly depend on how many of the 46.5 million registered voters cast their postal votes and turn up today at voting booths which opened at 07.00 (UK time) and will close at 22:00.

Opinions polls have concluded that a lower voter turnout today would favour the Leave vote while a higher turnout would favour the Remain vote. 

But intentions to vote are not the same as actually ticking the ballot box. Bad weather is more likely to keep people at home and turnout low, favouring the Leave vote while dry weather would in theory encourage people to vote, in turn favouring the Remain camp.

There have so far today been scattered showers across the UK and the Met Office has issued an amber weather warning for the East of England, London and South-East England, with predictions of thundery showers throughout the day.

However, the Financial Times is reporting that in many parts of London there are long queues at several polling stations and the Met Office is forecasting largely dry and cloudy weather elsewhere in the UK.

It is somewhat ironic that the unpredictable British weather, a favourite topic of conversation, could potentially change the British economic landscape for years to come.

The consensus expectation is that if the UK votes to remain in the EU, sterling, UK equities and to an extent the euro and global equities will rally sharply. But this rally could start to fade after a few days, as markets refocus on global data and events and the British turn their attention to the all-important matter of the Euro 2016 championships and perennial question of whether Andy Murray can win a second Wimbledon title.  

But acute uncertainty and market volatility would likely persist for weeks and potentially months should the leave camp win today’s referendum, particularly if it wins by only a very narrow margin and/or turnout is low. Read more

Europe: The Final Countdown

On Thursday 23rd June, the British electorate will hold arguably the most important vote in a generation, with the result of the UK referendum on EU membership due to be announced on Friday.

The latest opinion polls have the remain camp slightly ahead and bookmakers attribute a 75% probability of the UK voting to stay in the EU. But caution is warranted as opinion polls have swung back and forth in recent weeks. Turnout, and therefore the weather, may be a critical factor with a high turnout likely to favour the leave vote.

I am nevertheless sticking to my long-held view that the British electorate will vote for continuity and for the UK remain in the EU.

The popular assumption is that after the referendum UK markets and global risk appetite will move in clear directions. This belief is likely to be tested, particularly if the British electorate votes in favour of brexit as the government is not legally bound to the referendum result.

Specifically, the consensus expectation – which I share to a degree – is that if the UK votes to remain in the EU, sterling, UK equities and to an extent the euro and global equities will rally sharply. But this rally could start to fade after a few days, with “business-as-usual” resuming.

Conversely, the over-riding view is that sterling and global risk appetite will weaken, potentially very sharply, in the days following a vote for the UK to leave the EU.

Importantly I see six potential sources of uncertainty and a number of possible scenarios (see Figure 6), particularly if the leave camp wins by only a very narrow margin and/or turnout is low.  Market volatility could thus persist for weeks and potentially months, keeping sterling and UK equities on the back foot:

  1. Prime Minister Cameron’s future;
  2. The risk of the British government ignoring the referendum result;
  3. The risk of the British parliament ignoring the referendum vote, the government re-negotiating a deal on the UK’s membership to the EU and holding another referendum;
  4. The risk of a second Scottish independence referendum;
  5. The risk of a protracted UK exit from the EU leaving the door open to a decision reversal; and
  6. The re-negotiation of new trade treaties.

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It’s oh so quiet…for now

Frequent u-turns in the Fed’s policy stance, central banks’ lack of monetary policy credibility, currency wars and gyrations in macro data are being blamed for financial market volatility and record lows in government bond yields. The forthcoming EU referendum has also buffeted UK financial markets.

But on the whole, financial markets and macro data have since 1 April showed a far greater degree of stability than in preceding quarters.

US interest rate, equity and currency markets have weathered the gyrations in the Fed’s policy stance and the ebbs and flows in US data. German and Japanese government bond yields have fallen but ultimately been less volatile than in Q1. The World Equity Index has also been constrained in a reasonably narrow range, thanks at least in part to signs that global GDP growth stabilised in Q1.

This relative stability has not been confined to the dollar. So far, Q2 2016 has been the least volatile quarter since January 2015 – as defined by the low-high range using daily data – for most major nominal effective exchange rates (NEERs). These include developed and EM currencies, as well as commodity and non-commodity currencies. Among G7 currencies, the euro NEER has been particularly stable in a 2.1% range.

The picture is also one of relative calm in emerging markets, with the pick-up in foreign capital inflows in April and June and in commodity prices since March helping to stabilise EM currencies without central banks having to draw on still significant FX reserves.

Commodity prices, including crude oil, have risen sharply so far in Q2 but their volatility has remained in line with historical standards, particularly in recent weeks. This has contributed to greater stability in commodity currencies, with the exception of the Australian dollar.

If anything, this lack of directionality has forced financial market players to be light-footed and adopt short-term tactical strategies. The question now is whether this relative calm is here to stay or whether it augurs more violent corrections as was the case earlier this year.

The UK referendum on EU accession has the potential to be far more destabilising to financial markets than the BoJ’s policy meeting on 16 June and in particular the Fed’s meeting the day before. While UK markets would likely feel the brunt of a decision to leave the EU, the euro would also likely weaken and global equity markets conceivably sell off.

The Fed’s policy meeting on 27th July could also prove disruptive at a time of potentially reduced summer-liquidity. Read more

Fed on the ropes but not down

The US Federal Reserve and markets have been engaged in a bruising duel for the past six months. Round 6 should have been an easy one for the Fed given reasonably well behaved equity and FX markets, surging energy prices and signs that global GDP growth was stabilising.

But softer US employment data for May have put the Fed on the ropes, with markets having now all but priced out a hike next week and only pricing in a 24% probability of a hike on 27th July.

The Fed is not down, however, thanks to decent earnings, income and spending, a pick-up in most inflation measures in April and a robust housing market, which all point to a rebound in GDP growth in Q2.

In the labour market, an increasingly high percentage of those who want a job are finding one and the steady share of full-time employees points to decent hourly earnings growth in months ahead. There is still slack but arguably less than in December when the Fed hiked.

The Fed will be hoping that the next data set, particularly for the labour market, manufacturing and inflation, will go its way so that it can finally deliver a second-hike in a decade at its July meeting.

This is still my core scenario, although if labour data for June disappoint the Fed may well turn to its 21st September meeting as its next possible trigger point.

A July or September hike would leave the Fed with another few rounds to hike its policy rate by another 25bps, in line with Fed members’ current average forecast of two hikes in 2016. The Fed will want to show markets that it will not be swayed by soft data punches or temporary market developments and is still in control, but without flooring markets. Read more

Chinese PMI very sensitive to underlying economic activity

The Federal Reserve has 23 more days worth of data and market developments to analyse before its policy meeting.

China’s official and (unofficial) Caixin manufacturing data for May will be released tomorrow and Friday before the usual deluge of monthly economic indicators. Markets tend to give weight to the early release of PMI data in the world’s second largest economy and the question is whether this is justified.

Looking at data for the past decade, there was a good correlation up till about 2012 between China’s official manufacturing PMI and exports, imports, industrial output, retail sales and GDP, with the added advantage of the PMI leading by a couple of months. However, since then these correlations on the surface appear to have broken down, even if we use the sub-components of headline PMI.

The main issue is seemingly one of calibration. Since 2012, the official manufacturing PMI has only fallen marginally in a narrow 49.0-51.7 range while monthly economic indicators have weakened considerably. If we shorten the time scale, the PMI’s correlations with monthly data again look reasonable.

Markets need to take into account this increased sensitivity of the PMI data, as small moves may ultimately be associated with significant changes in underlying economic activity.

Even so, the official manufacturing PMI has seemingly over-estimated China’s economic strength in recent months. An alternative view point is that monthly economic indicators are about to rebound quite sharply.

The unofficial Caxin manufacturing PMI data – which have been more volatile than the official measure – and the official non-manufacturing PMI have even over longer time-frames been somewhat better correlated with monthly economic indicators. They too point to a rebound in economic activity in coming months.

Please see Appendix for complete set of correlation charts.

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Sticking to forecasts: Fed summer hike, Dollar hat-trick still on the cards, Modestly weaker EM currencies, UK to stay in EU and Sterling to appreciate

The Federal Reserve’s minutes of its 27th April policy meeting released last week set the tone for a possible June or July rate hike. On balance, recent US and global data are unlikely to have fundamentally changed the Federal Reserve’s view that a summer hike may be appropriate.

This is in line with my long-held forecast that the Federal Reserve would likely hike once or twice this year, with the first hike in June. I recently updated my forecast to a July hike as it gives the Fed more time to assess US and global data and the result of the UK referendum on 23rd June. The risk is that the very threat of a hike derails financial markets sufficiently for the Federal Reserve to postpone its second-hike-in-a-decade to later this year. Read more

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