Market Insights

Euphoria

Well hasn’t this new year just started with an overflow of euphoria? The best start to the year for Global Stock Markets since 2006!

As this chart shows, it was only two years ago that we were lamenting the absolute worst start to the year for stock markets ever. So we’ve gone from worst ever to one of the best ever, in just two short years. Perhaps that’s why it is hard for discretionary investors to shift the sinking feeling from the pit of their stomachs. The question is whether 2016 was the aberration, and bring on the euphoria… or is 2018 just too darn optimistic?

The answer is potentially both. In 2016 there wasn’t any strong fundamental reason to panic but a wobble in China set off a firestorm that engulfed Deutsche Bank CoCos and Oil. Now, in 2018, the global economy is looking a lot stronger but the perma QE central bank taps are being turned off just as politics becomes much more uncertain.

The reason for the over-reaction on both sides? The new nature of volatility. Rather than being linear, it’s a step function. Either we languish in the doldrums of zero vol, or we step up into a giddying spiral of ever-more panic.

We first flagged up in the summer of 2014 “How Volatility Eats Itself“. Central banks were worried. The NY Fed produced a blog post “What can we learn from prior periods of low volatility?” in which they compared the drivers of low vol at that time to those of 2007:

As we noted at the time: ‘This says: Volatility is low because Treasury yields are low and not moving around very much. It’s very different to Lehman, when household confidence was in disarray, credit spreads were high and random news was flying around.’

The authors concluded:

During times of relative market calm, like today, it could be that low financial market volatility is pushing these fundamental drivers lower, rather than the other way around.’

Yes, you got it, this means: stuff not moving around much makes things not move around much. Low vol begat low vol. But then we had a whole host of flash crashes, culminating in the Brexit induced fall in GBP. That crazy start to 2016 was a blow up whose time had come.

So what has happened between then and now which means we have returned to the low vol world? 

The Fed have hiked 5 times, wasn’t that supposed to derail things? Well no, because the ECB took up the QE baton. As the ECB’s Coeure helpfully explained last summer, their asset purchase programme plus a negative deposit rate ended up as turbo-charged global QE. It depreciated the Eurozone’s currency, flooding the world with liquidity, which then found its way into other global bond markets, once again flooding the world with liquidity. Although this process began in 2014-15, it only really started to ramp up in 2016 onwards – see how the blue line runs significantly higher as we cross into 2016:

…and more importantly, it stays in high territory throughout 2016 and 2017. Meanwhile the next leg of the turbo charged QE was kicking into gear: the rise of passive money investments. Look at how money moved from active into passive funds in the first half of each year, and how this picked up speed from 2016:

And so we dropped quickly back into low volatility territory. So, 2016 is the lesson for what will happen when the next blow up comes. But 2018 can get more euphoric before that happens. At some stage, the passive money machine will realise the central bank money machine is stopping. Overnight, the Bank of Japan cut its purchases of >10y bonds by ¥10bn. The ECB is following suit, albeit slowly. If we go back to Coeure’s chart, we can see that it was a year after the APP began when the portfolio shifts really started to motor; and a year after that when the passive money inflows accelerated. So, it’s going to take some time before the market’s accelerator pedal realises the car is out of fuel.

Blondemoney believes political risk will lead to liquidity events, much as we saw in the flash crashes of 2015-16, and that Brexit, with its ticking clock deadline, provides the spark. We won’t escape this year without a wobble of some kind, with the realisation that developed markets have gone the full emerging market.

Until then, it’s like Loreen said:

Euphoria 
Forever, ’till the end of time 
From now on, only you and I 
We’re going up, up, up, up, up, up, up…

 

 

DM becomes EM

Take a little quiz with me, will you? Here is a chart of current account deficits, courtesy of the IMF. The purple line is the European Union; the dark red, with the biggest spike, is EM and developing economies. The EU has been steadily improving; EM countries have deteriorated but are still in surplus. Which country is represented by the blood red line at the bottom of the chart?

Here’s a clue that might help you. The political activity in this country in 2017 has been captured on Twitter by the Southern African correspondent of the FT, Joseph Cotterill. Here’s a flavour of what he covered last year:

This journalist is used to covering politically unstable regimes. Last year in South Africa, President Zuma memorably sacked his Finance Minister Pravin Gordhan, saying he was “very busy trying to fix the country” and poor old Pravin got in the way. We know what happened next – Zuma went on to be ousted as leader of the ruling ANC. Things still aren’t certain however, with Zuma hanging on to his Presidency. Political instability is par for the course.

While we leave the quiz question hanging in the air, how about we consider another country currently prey to the whims of an unstable leader?

In this second country, the leader uses Twitter to taunt his heavily armed and equally unpredictable overseas enemies. He uses it to criticise his biggest trading partners. He uses it to lambast members of his staff that he previously hired, but then fired in a fit of pique.

You all know who this is. And he has just replaced the Chair of the country’s central bank. Due to resignations and retirements, he also now has the power to pack it with his own people.

The market is currently pricing an 80% chance of a rate hike from the Federal Reserve in March. This, despite the central bank losing its central triumvirate of the previous administration, with the departure of Yellen, Fischer, and Dudley.  Sure, Jerome Powell has been on the Fed Board for five years. But that doesn’t mean it’s the same Fed that will be taking decisions this year. That would even have been the case without the Chair suffering under the patronage of a populist. How can we be sure of anything the Fed will do this year?

Let’s take a thought experiment. Let’s say Powell takes some decisions this year that the Supreme Leader doesn’t like. Maybe he causes the stock market to fall. Given that Trump loves tweeting how new record highs in the Dow are clear signs of his call to #MakeAmericaGreatAgain, is he going to take that lying down? Or will a whisper campaign be started that Powell needs to be replaced? It is difficult to do in practice, as Newt Gingrich found out in 2011 when frustrated by then-Fed Chair Bernanke’s ‘irresponsible’ money printing. The Fed Chair can only be ‘removed for cause‘; or Congress would have to amend the Federal Reserve Act. Oh but what if you have the mouthpiece and the chutzpah to issue statements such as these?

How is a Fed Chair going to make sensible and serious decisions for the future path of the US economy when those around his table and his ultimate boss could claim he’s “lost his mind”? Wouldn’t mental incapacity be cause enough to remove someone? Or at least to undermine his decisions to the point where he resigns?

Wouldn’t this scenario suggest a degree of political capture of the allegedly independent central bank? Wouldn’t it suggest a risk premium might have to be factored into that country’s currency and bonds?

In fact, wouldn’t it be just how we would look at an Emerging Market?

This is how political risk can infect asset prices. If you want to look at surprises for the year ahead, don’t think about fractions of a basis point onto inflation. Think about a wholesale reassessment of the stability of the country into which you and others are investing. Think big. Think about how the US Dollar could be undermined as a reserve currency in this brave new world. Isn’t it better to go for, say, the Euro or the Japanese Yen? The European economy is booming, it has a current account surplus, and the central bank is moving away from QE and negative interest rates. Japan is (almost) following suit. Japan even has stable politics, with Abe having called his snap election. The Japanese Yen could be the year’s big winner.

The European political leaders look stable, with France having avoided Le Pen and Germany apparently proceeding as before with Angela. But there are risks in the EU too: the German SPD don’t necessarily want to form a Grand Coalition, as it hurt them so badly in the last election; but if they do, it would leave the populist AfD as the largest opposition party. Macron and most of his MPs in the National Assembly are entirely untested but trying to push through massive reforms. Meanwhile they have to decide on the future of the EU itself. The SPD’s leader has already announced he wants a “United States of Europe” within eight years. The existential crisis in Europe is real.

…which leads us back to our first question.

Here’s a final clue. This country actually has inflation, which has largely been triggered by a pass through from its significantly depreciating currency. We haven’t yet seen a peak in CPI, as shown by this great chart from Rupert Seggins:

The red line is the effective exchange rate, advanced by 2 years. The blue line is core CPI. As you can see, inflation could easily hit 4% in the months ahead, and that’s without any further impetus from a renewed decline in the currency.

So, who is this country? 

  • Large current account deficit
  • Depreciating currency
  • Inflation increasing
  • Central Bank hiking
  • Politically unstable
  • ….and trying to renegotiate a deal with its largest trading partner?

Yes, you’ve got it. The good old United Kingdom of Great Britain and Northern Ireland. 

If we can envisage the USD could lose its reserve currency status, then how about GBP suffering from an EM style currency crisis?

Yes this is the Revolution this year: when Developed Markets become Emerging Markets.

No Surrender! Oh, wait…

And so, an agreement is reached, to move onto talking about an agreement, which might never be agreed. Here’s the lowdown on today’s agreement that the UK has made ‘sufficient progress’ to move onto Phase 2 Trade Talks with the EU:

  • NI/RoI will retain soft border
  • ECJ will have a say over the rights of EU Citizens in the UK for 8 years
  • The UK will continue to pay almost all of its EU liabilities as of 31 Dec 2020 as they come due
  • …But only if there’s a deal at the end of the entire negotiation process

Reaction:

  • Conservative MPs so far falling over themselves to praise Theresa May, including BoGoveJo as are the EU, with Barnier and Juncker keen to explain the agreement was reached through TM’s “personal” hard work
  • Senior Diplomats, such as Christopher Meyer, congratulating PM on getting an agreement done
  • Republic of Ireland PM Varadkar is happy: “We have achieved all that we set out to achieve”
  • DUP leader Foster not so happy, arguing, ‘We cautioned the prime minister about proceeding with this agreement in its present form given the issues which still need to be resolved and the views expressed to us by many of her own party colleagues‘, but happy to have a separate document with Six “clear commitments” from the UK government that NI’s position in the UK would always be safeguarded
  • Remainers unhappy that this finally means Article 50 won’t be revoked, but happy that it might end up looking like a softer Brexit due to soft Irish border
  • Brexiteers unhappy about the soft border and role for the ECJ, as well as TM ‘rolling over’ to meet EU demands, particularly on the ~50bn divorce bill; but grudgingly admit they can’t argue too much against the document as it does still provide room for “No Deal”

With all sides slightly unhappy, this suggests a decent consensus has been forged. On balance, the Brexiteers are less happy, suggesting this is indeed a victory for the “softer” side of Brexit. The RoI/NI spat over the border is just the entire Brexit question in microcosm, and it hasn’t really been resolved. But Leo is happier than Arlene.

This means Brexiteer protests will increase in the next stage, with the clock loudly ticking. Indeed, the document means something has now changed on the “No Deal” front, with paragraph 49 the key:

The highlighted sentence appears to say that if there is No Deal, then the UK (not just Northern Ireland) will maintain ‘full alignment’ with the Single Market and the Customs Union. Now, the second half of the sentence qualifies that it’s full alignment only where those rules “support” the island of Ireland. This is clearly a sop to both the Republic and to NI, that they don’t need to worry, whatever happens. But it may become a noose around the neck of No Deal because it means the SM and CU will exist as a baseline.

As one of Ireland’s political commentators put it it, it’s currently a Schrodinger’s Brexit:

Of course, all of this can be fudged and re-worked. It may lead to a hybrid Customs Union for the UK (like Turkey’s relationship with the EU).

In reality, the only question is this: Can Theresa sell this to the country? 

The spin machine is going into overdrive, with the Conservative Party briefing notes on the deal emphasising how it works for everyone but “nothing is agreed until everything is agreed”:

‘This agreement secures the rights of the three million EU citizens living here and the million British citizens living in the EU, represents a fair settlement of the accounts and maintains the Common Travel Area with Ireland, which has operated since the 1920s, and sets out both sides’ determination to avoid a hard border between Northern Ireland and Ireland, while respecting the integrity of the UK Single Market.

…This is a good deal for citizens, for taxpayers and for all parts of the United Kingdom that will allow us to get on to the vital trade negotiations and get quick agreement to an implementation period in the best interests of people and businesses in the UK and across the continent as we leave EU. While we have reached agreement on the phase one issues, paragraph five of the report makes it clear that ‘nothing is agreed until everything is agreed’.

So we’ve agreed something that works for everyone, but we can always walk away.

A masterclass in spin.

The public will need more than an arcane meta interpretation of a buried paragraph to get upset at today’s document.

Can the Conservative Party now hold the line? In the short term, yes. This staves off the Corbyn threat, and after a trouble-free Budget, there is now a little bit of positive momentum for the government. Even Nigel Farage is left only to say we move onto the ‘next stage of the humiliation’. The Brexiteers will eventually find their killer argument, but it will likely take the next stage of talks to reveal it. All clear on the western front into the end of the year then.

 

 

Elections a-go-go

At the start of the year, the European elections were the big event risk ahead. Fast forward nine months and this weekend’s German election is met with barely a shrug, thanks to the victory of an oedipal ingenue into the Elysee Palace. The threat of Marine Le Pen has receded so much that one of her closest aides has just quit the National Front, and with it, one of the key architects of their Frexit policy. The Eurosceptic knaves have been vanquished. Even a country that has voted to leave, will today see its Prime Minister lay out a policy for its exit that means it won’t exit for 2 years after it’s technically exited. Geddit?

Blondemoney forgives you for EU-fatigue. At some stage, the Brexit shambles negotiations will produce an almighty bout of excitement, but for now it’s just so earth-shatteringly nuanced as to be eminently forgettable. Hand us an instant-result FOMC meeting any day.

At least politics this weekend should provide a binary outcome.

First up it’s the German election. Although no-one really much seems to care about that, with Merkel consistently riding high in the polls, rarely troubled by the opposition’s Martin Schulz. The bookies have her party emerging as the largest at an eye-wateringly certain 1/100. Even as the largest party she likely has to enter a coalition, however, with the following potential scenarios that could emerge:

Given the market is totes not both’d, we might not get much of a reaction to any of those scenarios, but things to watch out for would be:

  • FDP joining a coalition – as they are the most “anti-Euro” of the larger parties
  • AfD gaining any kind of representation – or indeed, if they don’t, despite polling almost twice what they were in the last election, thus suggesting the anti-establishment vote is dying off

Next up it’s the New Zealand election. This had looked to be hanging in the balance with polls showing the charismatic new young (female) leader of the Labour Party driving them into the lead in the polls ahead of the incumbent National party. “Jacindamania” is now ebbing away, however, with the most recent polls giving National a clear lead of 7-10 pts. Again the market doesn’t seem too worried, probably because the New Zealand Dollar is most often used as just a proxy “risk on / yield hunting” currency. But there are potential pitfalls ahead. The Labour Party want to change how the RBNZ works, and introduce a Fed-style dual mandate; while coalition partners could include the anti-immigration party the NZF. Admittedly, the NZF have already been in government, and a new mandate for the RBNZ might not change much in practice.

Either way, we will have a sense of the result by 8am BST Saturday morning when the exit polls come out…
And for Germany, by 6pm BST Sunday evening.

(Although for both, coalition forming could mean the final government isn’t in place for a few weeks yet).

You might wonder why everyone is so relaxed, given how unreliable polls have become recently. Blondemoney would argue that polling accuracy is proportional to the proportionality of the voting system. In other words, if it’s a proportional representation system, then it’s easier for the polls to capture. The more it’s “first past the post”, or an electoral college, then it’s much harder to predict.

Both the German and NZ elections use a fairly proportional system – a mixture of PR and FPTP. For the election geeks amongst you, both countries actually use the relatively unusual ‘Webster/Sainte-Lague‘ method for determining seats from vote share. (And if that’s not your weekend reading sorted, I don’t know what is). So the polls should be decent at predicting the result. (Famous last words??)

Either way, from this point on, Merkel in charge of Germany means she can get on with taking the EU forward. That may be marginally Euro positive. For New Zealand, its currency can get on with being the favourite of those who like to trade EM without being able to invest in EM!

 

 

Will the Fed end the Truman Show?

We have talked before about how the market is sailing with unsurpassed ease towards the inevitable brick wall at the end of the Truman Show. At some stage, we will wake up from the low volatility, lowflation, low rates environment. The tricky part, as ever, is picking the tipping point. So let’s just consider these charts:

1. The last real bout of volatility came at the start of last year, when China was blamed for market turmoil that ended up with a rout about CoCos. Since then, global equities have had a very lovely time thanks, up 40% in almost a straight line (h/t @HayekandKeynes):

2. And as we know volatility has concomitantly collapsed. Here’s another take on that with a look at the 1 month volatility on the Russell 2000, which is in single digits for the first time (h/t @DriehausCapital):

And just a reminder of how mad this is, historically speaking, with @charliebilello flagging up that the last 5 days have been ‘the most peaceful in the history’ of the S&P:

I flagged up before to keep an eye on the AUD, and if it can stay above 0.8000 then that’s a good indicator of euphoria continuing to trend. It’s managing it, but Blondemoney is now concerned about that perennial canary in the coalmine, the South African Rand. That’s fallen almost 5% against the US Dollar in the past two weeks. Now, some of that really is because of issues specific to South Africa (with President Zuma still under a corruption cloud). But we know that when there’s a mad dash for yield, those pesky political issues are pushed aside. The euphoria cannot be all pervasive if the Rand is weakening.

So, it’s over to the Fed. Tonight they have the platform to provide quite a signal of their intentions. It’s Janet’s penultimate FOMC meeting to include a press conference. If her term isn’t renewed, that means it’s her second-to-last chance to make her legacy stick. She was handed the poisoned chalice of removing policy accommodation into a weak and uncertain economy, and she will want to make sure she is considered to have gotten the job done. Equally, she wouldn’t want to leave a trail that could implicate her in whatever the next crisis may be. So, she needs to stick to her guns. They’ve hiked, but not in such a way as to destabilise the markets. Have they done enough to prevent another financial bubble emerging? Or have they done too much, and squeezed out inflation before it got any momentum?

That’s the line she has to walk tonight. USD/JPY overnight straddles are priced around 95 pips, suggesting a big figure move could be on the cards. But with most markets comfortable with no volatility at all, yet a divergence occurring between the high yielders, there is the possibility for a much bigger move. Look out for a higher USD from here.