Don't worry about rates

Volatility spiked in December but risk has rebounded in January. The Federal Reserve has found a new settlement with the markets. Rates are on hold and patience is now the key monetary policy virtue. It’s not clear that rates have peaked – most economists still see neutral rates being a little above where we are today – but they have peaked for now. Some might try to blame the Fed for an economic slowdown but the trade and government shutdown issues are more important. So while equities and credit have responded positively to a more dovish Fed, a sustained recovery in markets and an end to downward growth revisions requires a trade deal and an open US government. And over here it requires the purgatory of Brexit uncertainty to come to an end.

Have a little patience

The combination of pressure from President Trump and the US financial markets has resulted in a more dovish Federal Reserve (Fed) stance on interest rates. The Fed Funds rate was increased to 2.5% in December and it now looks as though it will remain at that level for some considerable time. Who knows whether this is close to neutral or not, the fact is that the Fed recognised that if it had continued to project a tightening cycle of a quarter of a point every 3-6 months, the volatility that raged in equity markets in December could have continued into 2019 with damaging consequences for the economic outlook. I suspect that many Fed officials are more sanguine about the prospects for economic growth in 2019 than that implied by the sharp fall in stock prices and widening of credit spreads towards the end of last year. Yet at the same time they have become more sensitive to the potential signal that markets are sending – flat yield curve, increased equity and credit risk premiums – and to the political environment. By that I mean the very public criticisms of the Fed by the President. It would be very damaging to the Fed to become embroiled in a spat with the executive, especially as it is likely to become evident that the deterioration in the economic outlook is much more to do with policies emanating from the White House rather than the level of interest rates. Every post-war US recession has been signalled by much higher real short-term interest rates than those that prevail today. So while there is a lot to criticise the Fed for, most importantly its lack of a clear philosophical policy framework in the post-post-crisis era, I suspect that the Fed comes out of this period looking better than the President. Most recessions are either caused by a shock or by the Fed but I am not convinced that the Fed has done enough to cause a recession yet.

Trade shock

However, there is a set of potential shocks that is generating downgrades to the growth outlook globally. Trade protectionism is one of them. The US has already increased tariffs. Theoretically that increases import prices to US consumers, generating a shift in demand away from imports to domestic production. As the US is operating at close to full employment, this may create some additional inflationary demand for domestic resources and some pass-through to final prices as purchases of intermediate goods face higher costs. For the exporting countries, there should be a drop in external demand and some deflationary tendencies. Reduced production then has knock-on effects through the supply chain. In reality, it is complicated but recent evidence fits the narrative. Business surveys have fallen sharply. The US ISM manufacturing index dropped by 4 points in December to 54.1 – the largest monthly fall since 2008. European and Asian surveys have been weak too. Chinese data has continued to soften and its inflation numbers for December, reported this week, were well below expectations. The Chinese economy is being impacted by the trade situation – which could still get worse – and by domestic de-leveraging. The impact of this is seen in Apple Incs. recent lowering of guidance on revenues and by the significant decline in German exports to China. On a smaller scale, a no-deal Brexit would mean higher import costs for the UK and UK exporters would face increased tariffs on their goods – there is no way trade deals with third parties can be put together quickly enough to counteract the loss of the EU’s existing third party trade relationships. While protectionism appeals to some pressure groups (I note support for President Trump’s steel tariffs from the leader of one of the biggest steel industry labour unions this week) and fits the current mood of populism, there is a reason that most economists think protectionism is a bad idea. It creates an inefficient allocation of global resources.

Oil shock

So trade is one shock that raises growth risks. For the US there are two more. One is the decline in oil prices and the impact that has on the US energy sector. The Dallas Fed’s December business survey showed a sharp decline in readings across most categories with the index tracking overall business activity dropping from 17.6 to -5.1 led by sharp falls in the corporate outlook. This may have been a short-term shock. Oil prices have bounced with Brent crude spot at $60.7 per barrel at the time of writing. The recent low was nearly $10 lower and as recently as September the price was above $85 per barrel. Such a rapid decline in prices will have impact on revenue projections at oil producers. How confident can we be that the bounce is sustainable? Again, the White House has been quite vocal in wanting lower oil prices and I doubt that the market goes back to the above $70 range that it was in for most of 2018. We may have seen the lows for the time being but I suspect the oil industry is going to have to deal with average prices that are lower than they have been for a while.

Political shock

The other shock to the US is the ongoing political impasse that is keeping the US government partially closed. The longer this goes on the more it impacts the economic outlook through the disruptions to payments and Federal employee wages. Moreover, much data is not being published. I suspect that we will get the usual winter weather effects on economic activity as well which could all add up to a very uncertain picture about the true state of the US economy as the beginning of this year. It may be enough to re-ignite the risk off price action in markets, especially if the Democrat leadership continues to refuse to provide funding for the border wall and if President Trump refuses to sign-off on re-opening the government. I’m sure on the point of trade and the border, President Trump’s view is “short-term pain for long-term gain” but markets aren’t likely to share that sentiment.

Pain trade

Of course there is an optimistic scenario. A trade deal with China could be agreed. The two sides in Washington could come together. With the Fed on hold for a couple of quarters this would be enough to send equities back up and put a floor under the GDP revisions. If the Chinese authorities can ease policy somewhat more as well the picture could change markedly. The pain trade then is that Treasury yields and rate expectations will rise again. Much of this will need to happen for the Fed to be able to go against the President and the markets and start tightening again, which is why we now don’t expect another move on rates until June at the earliest. The data has to bounce back (especially the confidence indicators), the “shocks” have to diminish, China has to stabilise and market volatility needs to move lower and stay lower.

Higher yields

Despite all the volatility in the market since the end of last year, fixed income is panning out as we expected at our December strategy review. The most beat-up sector from 2018 is leading the way in terms of total returns. Early days of course but emerging market debt is putting in a good performance, helped by the pause in the US interest rate cycle, the stability of the dollar and the fact that many investors redeemed their emerging market debt exposure last year. The inclusion of some middle eastern issuers in key indices since the beginning of the year has also helped and our view is that both the macro and the credit outlook for emerging markets is reasonably solid. Saudi Arabia came with a huge bond issue this week and it was very well received, helped by the rise in oil prices. The JP Morgan Emerging Bond Global Diversified index is up 1.82% so far in January following the near 5% decline in 2018. We were also positive on high yield markets and they are also performing well after a torrid December. The US high yield market has delivered a whopping 3.2% return so far with the average spread on the index coming down from 544bps on January 3rd to 452bps at the time of writing. In yield terms that is a move from 8.1% to 7.2% in just over a week. Of course, the risk for investors is to now chase the market when the near term fundamental outlook, for all the reasons cited above, is far from certain. Yet these are attractive yield levels when the Fed is on hold. At 7.1%, investing in a representative high yield portfolio would deliver a positive return over a year as long as the yield stayed below 8.875%. The carry is attractive in emerging market and high yield bonds and even for UK and European investors the rise in yields and the softening of US rates has improved the prospective hedged returns from USD denominated higher yielding assets.

Brexit

We are no closer to knowing what the UK’s future relationship with the rest of Europe will be. Despite that, and the increasingly fraught domestic political situation, it is still not clear how to trade UK financial assets. Sterling has remained stable against the dollar for some time now ($1.25-$1.30 since early November), gilt yields and credit spreads have not done anything remarkably different to other major bond markets and the UK equity market (at least the FTSE-100) has done better than most, including the S&P500. The problem investors have in trying to call UK markets is that there are layers of uncertainty. First is the politics. At this stage the potential scenarios include an extension of Article 50, a no-deal exit, an exit based on PM May’s Withdrawal Agreement, a second referendum and another general election. The second layer of uncertainty is what are the potential economic implications of any or all of those political scenarios and the third is the policy responses that would come in the wake of the expected economic shock. Unlike what would be the case for most other members of the EU leaving, there is no redenomination risk in sterling assets and the risk of domestic capital flight is much less than if the UK was a member of the euro. The no-deal scenario is most likely the worst case for the economy thus trading that depends on what happens with monetary and fiscal policy. One would like to think that the growth shock would be more important for the monetary policy committee than the inflation shock, so that rates would be cut and quantitative easing potentially re-started. That would be good for gilts. But, what if there was a big fiscal response to cushion the growth shock. The supply of gilts would increase. The previous episode of QE tells us that still would suggest lower yields. On the credit side it really would depend on the funding environment and the earnings profile for UK issuers. While I am in no doubt a no-deal Brexit would be bad for the economy, a lower sterling, lower rates and a fiscal boost might mean that is not a permanent state of events. So it is difficult to have any conviction on market moves attached to any particular Brexit scenario. Except my gut feeling is that a political shock, such as the failure to get a deal or there being a change of government after a general election, would likely see sterling move below the $1.20 level. That would be close to my working life-time lows and would be a massive buy.

Football

I don’t want to jinx things but, Ole Gunnar Solskjaer! Five wins in a row, lots of goals and certainly a happier Manchester United since the last time I wrote this note. United are not going to win the league but if things keep going as they are, a top four position in clearly possible. A big test this weekend with the away match to Spurs. When Jose left there was a lot of talk about Pochettino being the long-term target replacement. Yet up stepped the baby-faced assassin, a United legend. Long may it last with Ole at the wheel.

Have a great weekend.

Chris

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