Market Conditions in Data Overload
Markets often struggle for traction when there is a lack of a clear motivator such as meaningful event risk or an evolving systemically important theme. On the other hand, there are times when a surfeit of important events, indicators and headlines overwhelm the clear speculative picture, leaving us with an abundance of volatility without the benefit of a reliable course. We have dallied with this latter scenario these past weeks, but the constant redirection of our attention will be in special form in the week ahead. There is a near constant run of high-importance events scheduled for release moving through the next five days of active trade. What’s more, many of these various measures will tap into the top level themes that have stood as the undercurrent for economic and financial conditions for months, if not years.
For trade wars, much of the critical development rests in the hands of a few officials who are weighing policy decisions that could significantly alter the course of the global economy. Washington and Beijing continue to negotiate after verbally agreeing to a ‘phase one’ deal back on October 11th but the details and sign off are still vague. The EU meanwhile is weighing whether to retaliate against the United States for the Trump Administration using the WTO ruling of a $7.5 billion ‘allowance’ for tariffs to recoup losses owing to unfair Airbus subsidies with a 25 percent tax on imported European agricultural goods. Meanwhile, data like the US trade balance and Chinese industrial profits figures on Monday will build upon trade-dependent earnings from the likes of AMD, United Steel and Alibaba.
More tracked out for the timing of its updates is the wave of monetary policy updates we are due over a particular 48 hours period. There are a number of supportive updates such as the October US NFPs due Friday, but five central bank decisions between Wednesday and Thursday will make for a far more incisive view of our financial system. In chronological order, we are due the Bank of Canada; Federal Reserve; Brazilian Central Bank; Bank of Japan and Hong Kong Central Bank. Stacking these events so closely together will cater to the relative comparison of the currencies and their assets, but it may also stir further collective discussion of the distortion and costs associated to the extreme easing.
The fundamental theme that will pack the most obvious punch in my view is the run of official (government-derived) GDP updates on tap. The United States is the world’s largest economy, so its Wednesday release will draw particular scrutiny. The Eurozone, French and Italian figures will be similarly important - particularly given the chatter about recession risks and the added pressure of external pressures like Brexit and the US tariffs. Two additional updates that are worthy of reflection for the big picture is the health reports for Mexico and Hong Kong. These are two large economies that stand on the cusp of the developed/emerging market designation with particular exposure to trade wars. This data can potential thaw fears of recession that have hardened over the past year behind data and increasingly complicated diplomatic situations, but the potential definitely skews the opposite direction. If this run of data reinforces the reality of economic struggle, it will serve as another cut to a speculative reach that seems divorced from fundamentals that are traditionally assumed to reflect value. In general, all of the thematic risk represents a greater role of risk rather than relief.
Redressing the Limitations and Costs of Extreme Monetary Policy as Fed Arrives
With the world’s largest central bank and its most dovish both on tap for this week, it is important to consider what is driving these groups to loosen navigate into uncharted dovish waters rather than just go along for the ride by trading relative yield advantages in FX or capitalizing on a familiar speculative equation that suggests more external support buys more lift from favorite capital market benchmarks. There is little denying the years of connection between the amount of accommodation (low interest rates, negative interest rates and quantitative easing programs) and the enthusiasm from the investing masses. This is a relationship forged originally in ‘monetary policy in capital markets’ textbooks, but the connections have grown more than skewed in the latter years of this extended cycle of easing. First and foremost, the overriding intent of monetary policy to foster economic health have been proven to be lacking. It could be argued that the dovish shift after the 2008 Great Financial Crisis / Great Recession stemmed the bleeding. Yet, the exceptional support has only grown over the years and we find ourselves on the cusp of another economic stall. This is a feature of the landscape for most of the major groups, but it is perhaps a lesson that should have been learned earlier through the Bank of Japan’s own experiences. The central bank has failed to return inflation to its target for any period of consistency for decades – not just years. So, though it is not considered one of the most prescient groups for a global overview, there is much to learn here.
Though an inability to reach their principal economic objectives is a significant problem in itself, it may not be the straw that ultimately breaks the camel’s back. That is more likely to be the consequences to come out of the financial market influences from these extraordinary measures. Though it may not be their intent, the central banks’ easing has inflated capital markets substantially. The pressure is not even, but we have seen risky assets hit record highs at various points with different levels of excessive price to value. Few places is the extravagance more evident than with the US equity indices. At record highs, we should consider that the equity market is pricing in perfection for growth, earnings and returns. It is not very controversial to say that is not the case now. Far from it. Stimulus and low rates has not improved circumstances that remarkably rather the lack of significant return and a tepid economic environment has left investors starved for opportunities that can provide substantial growth at a reasonable risk. And so, they accept greater and greater risk to make ‘ends meat’. Propping capital markets higher may seem a net benefit in the absence of genuine growth, but there are serious risks associated to this state. Expectations for more support will grow exponentially with time. Capital distribution outside of the healthy business cycle will encourage funds to underperforming or zombie businesses that will further weaken economies. And, the growing disparity will inevitably lead to a point at which recognition of risks will force an acceleration of deleveraging which will manifest as a financial crisis that more readily turns into an economic crisis.
This troubled state is growing increasingly apparent to investors and business owners, but now the concern seems to be permeating the central banks themselves. Outgoing ECB President Draghi admitted concern late in his tenure, though not as loudly and directly as some of the more hawkish members of his board who will remain with Lagarde at the helm. Some of the Fed officials have stated concern along these lines as well, but the group is not yet as overextended as most of its counterparts. In previous years, the US group’s tightening was viewed as a sign of optimism around the potential of self-generated growth. That perspective may hold as the circumstances change. If the Fed seems forced to loosen the reigns to match the ECB or BOJ, it may not be interpreted as a uniform source of speculative liquidity but rather admission that all economic traction has been lost. It is not wise to cheer negative rates and QE.
A Brexit Solution Seemed So Close
Less than two weeks ago, a breakthrough between the UK and EU teams in their negotiations for a quickly approaching Brexit cutoff date seemed to have changed the dynamic of an impending crisis. With Prime Minister Boris Johnson repeatedly stating the Article 50 extension date of October 31st would be held to ‘one way or the other’, there has been an understandable intensity by all those involved to find a compromise to avoid an economically-painful ‘no deal’ outcome. As such, the concessions found between the UK government and European representatives to form a Withdrawal Agreement Bill seemed the most important hurdle to overcome and sentiment understandably swelled after the developments. Yet, that optimism has significantly deflated this past week. First, it was the previous weekend’s extraordinary Saturday Parliamentary session which delayed the Government’s implementation of the deal which started the decline in ambitious optimism. Tuesday’s ‘second reading’ further delivered PM Johnson a blow when he was outright rejected on pushing forward to meet the short time frame. What was more remarkable to me than the familiar trouble to find an agreement exit from such disconnected parties was the Sterling’s ability to hold onto the gains of the previous weeks – prompting GBPUSD to an incredible 6.5 percent rally in in just a few weeks.
Trading not far from multi-decade lows, it may not seem that difficult for the Cable to hold some of its recent buoyancy even if progress seems to have dangerously stalled. Yet, the real fair value question is to be found in the array of possible outcomes and their market influence. A divorce with no terms is still a serious probability and its economic and financial impact is not likely priced in even after the slide of the past three years. An extension is nevertheless a greater probability than a cliff on Thursday evening. That said, we are inviting more complication and additional cutoff dates while maintaining the same mix of impasses. Prime Minister Johnson, frustrated by the lack of progress, called for a snap election for December 12th this past week. That request will be considered in Parliament Monday. Presently, polls suggest conservatives could gain support but it is not clear if he will be granted his wish. Further a complication is the EU’s allowance for an extension. The PM sent a request for an extension to January 31st according to the Benn Act back on October 19th , and to this point no reply has been given. France is reportedly skeptical of giving the disgruntled country so much additional time without clarity on what they will actually do with it. Uncertainty is having tangible economic impact, and the discount is increasingly permanent even if the next steps are still fluid. So, this week, we will have to find out what Parliament will agree to concerning the election on Monday and the EU will have to grant an extension before the deadline on Thursday night. Mind your UK/Sterling exposure.