Politically Incorrect
After a long period in which monetary policy has led markets, the baton has (at least in part) passed back to politicians over the last few months. After the surprise Trump election, yesterday saw the constitutional reform vote in Italy fail. Although expected, the margin of victory and strong turnout underscored a resounding loss for Prime Minister Renzi.
Moving 6,500km east, last week saw the first data release since India’s “demonetisation” (see details below). It is still too early to judge the impact of this measure and opinion is firmly split. On the one side, a number of economists have taken a negative view. They highlight:
– Short-term disruption of removing 86% of paper currency in an economy where 98% of transactions by volume and 68% of transactions by value are in cash.
– Potential ineffective and temporary effect on the black economy of removing relatively low denomination notes (values are roughly USD 7.5 and USD 15 respectively).
– Risk that increased tax revenues are spent inefficiently.
– Monetary tightening as a consequence of a “negative helicopter drop” whereby any notes not deposited with the RBI are cancelled.
– Threat to credibility of government and the currency of such a blunt and sizeable move.
Certainly, we agree demonetisation stands out as bold reform, carrying not insignificant risk. However, we believe much of the criticism fails to take account of the broader context – demonetisation is not occurring in a vacuum:
– Banking penetration has historically been low, but over the last 2 years the government opened 220 million accounts and made some benefits available only through this channel. Although most of these accounts remained otherwise dormant, over the past 3 weeks many have been activated. Therefore, the implementation of demonetisation as a “big bang” has meant that much of the informal sector has had no choice but to go digital. In this way, the process will create permanent change to business practices.
– The starting point is extreme; according to the country’s first release of income tax data for 16 years, only 2.5% of Indian’s filed a tax return and only 1% ultimately made a tax payment. Given such a low tax take, and the evidence of a government focused on transparency and reform, we would argue the multipliers from government spending are likely to be positive.
– Inflation is falling and will fall further, allowing the RBI to cut rates (starting this week). Moreover, it is not clear there will be a large reduction in the money supply. In theory, any notes not deposited with the central bank will ultimately be cancelled, thus reducing the cash in circulation. However, according to Credit Suisse, 56% of notes had been deposited 10 days ago, and some 75% may be exchanged over time. Thus, any reduction will be small. In addition, rather than cancelling the liability, the bank may choose to rebate the gain to the government to be spent on fiscal measures.
And this last point hints towards the principal risk. Such large-scale reform and management of currency walks a tightrope of positive change against faith in government. Just as we have spoken about in the past with respect to “helicopter money”, credibility is all important. If there is any sign of government acting nefariously or in self-interest, the process will unravel. In conclusion, whilst the India story carries risk, we remain extremely positive. History teaches us that to unlock the underlying growth drivers of demographics, urbanisation and structural transformation, requires inclusive and quality institutions and government. The potential for such a combination in India is, in our view, unparalleled.
Last week, OPEC agreed its first price cut in 8 years (amounting to around 1% of global production and prompting a 16%+ rally in the oil price). We remain somewhat sceptical as almost all major oil producers are playing weak hands – they require any and all revenue and are therefore unlikely to stick to production targets. Former Saudi oil minister Ali Al-Naimi summarised it aptly on Friday commenting “Unfortunately, we tend to cheat”.
This week, the RBI in India meets on Wednesday, followed by the ECB on Thursday.
United States
S&P 2,192 -0.97%, 10yr Treasury 2.38% +2.59bps, HY Credit Index 388 -4bps, Vix 14.12 +1.78Vol
Although equities ended their three-week winning streak, the underlying “reflation” trend remained in place: cyclical sectors outperformed and bond yields continued to rise (17-month high on the US 10-year on Thursday at 2.49%).
The move in bonds was supported by most economic data releases including a 9-year high in consumer confidence, the best Chicago PMI since January 2015 and a strong ISM manufacturing. The November employment report was, however, more mixed. Although the unemployment rate fell to 4.6% (lowest since August 2007) and the headline payrolls number was in line with consensus (178k jobs created), average hourly earnings and the labour force participation rate both fell (earnings by 0.1% MOM, participation to 62.7% from 62.8%). Nonetheless, the aggregate numbers reinforced the likelihood of a FED rate hike and markets now price a 93% probability of a 25bps increase on the 14th December. This outcome was supported by Cleveland FED governor Mester saying a hike would be “prudent” and Dallas FED governor Kaplan stating he would “advocate action to remove accommodation”.
Europe
Eurostoxx 3,015 -0.33%, German Bund 0.31% +4.10bps, Xover Credit Index 336 -7bps, EURUSD 1.060 -0.69%
HICP Inflation data for the Eurozone ticked up to 0.6% YOY in November (highest level since April 2014), but “core-inflation” (excluding food, alcohol, tobacco and energy) remained stuck at 0.8%, well below the ECB’s 2% target. This week (Thursday 8th December) there is an ECB meeting at which the governing council is expected to announce a six-month extension to its EUR 80bn asset purchase programme (currently due to end in March 2017). Assuming this occurs, the market reaction will depend on 2 factors:
1. Buying Criteria – The programme contains strict rules over what the ECB can buy. As such, the eligible universe is limited and, without change, national central banks (particularly in Germany, Finland and Portugal) could run out of securities for purchase. If the ECB extends the programme, then it will also change one or more of:
Yield Floor, the bank cannot buy bonds yielding less than the deposit rate at -0.4%. This restricts the universe of eligible securities (approximately 25% of Eurozone bonds trade below -0.4% including all German bonds up to 5-year maturity).
Issue and issuer share, in order to ensure the ECB does not obtain a blocking minority in a debt restructuring, there are ownership limits of 33% at both issue and issuer level. This is because so called “collective-action clauses” mean that a majority (issue level) or 66% (aggregate issuer level) can force a change in terms on all bondholders for all Eurozone bonds issued since 2013. For those bonds issued prior, with no such terms, the ECB could relax their purchase limit.
Duration, the range of eligible bonds is those with a maturity between 2 and 31 years.
Capital Key, sovereign-bond purchases must be split according each country’s share of the total population and GDP of the Eurozone. Any change in this regard would be hugely controversial.
We think changes to the yield floor and issue/issuer share for no-CAC bonds are the most likely alterations
2. Tapering – Not least for technical reasons, the current programme cannot continue indefinitely.
On Sunday, Prime Minister Matteo Renzi offered his resignation after suffering a heavy defeat (59% to 41%), with a high turnout (69%) in the Italian constitutional reform referendum. Attention will now turn to the political fallout and the ability of the country to complete a recapitalisation of its banking system (20% of loans, equating to EUR 360bn, are non-performing vs. an equity base of EUR 225bn). In particular, bankers will need to decide imminently whether the EUR 5bn recapitalisation of Monte Paschi (the poster child for bad banking) can still go ahead.
On a more positive note for European integration, Austria voted against far-right candidate Norbert Hofer in the Presidential election, with Alexander Van der Bellen prevailing by 53.3% vs. 46.7%.
In the UK, economic data showed some signs of the long-awaited “post-Brexit chill”; consumer confidence for November falling sharply alongside a decline in the Manufacturing PMI from 54.2 to 53.4. Elsewhere, “British Influence”, a think-tank, claimed that in order to leave the single market the UK would need to trigger Article 127 (relating to membership of the European Economic Area) in addition to Article 50 (relating to membership of the European Union). This was taken positively since parliament is not likely to agree to an exit from the EEA. In practice, this argument comes down to 2 legal judgements. First, the outcome of the Supreme Court’s hearing on whether Brexit requires parliamentary approval (this week with judgment in January). Second, whether membership of the EEA is considered implied by exit from the EU, or requires a separate ruling. In any case, the mood music in the UK is turning in favour of a “soft-Brexit”. This saw the GBP rally.
Israel left rates on hold for the 21st consecutive month as expected. The country has been in deflation for over 2 years.
Asia Pacific
HSCEI 9,689 -0.09%, Nikkei 1,827.00 -0.19%,10yr JGB 0.04% 0bps, USDJPY 113.900 +0.25%
India continues to adjust to life after demonetisation. The first data points covering assessment periods post the announcement are beginning to trickle through. The November PMI index came in at 52.3, down from October’s 22-month high of 54.4.
FY17-Q2 (three months September 2016) GDP growth accelerated to 7.3% in India, from 7.1% in Q1, though this was below expectations (7.5%). Agricultural output began to pick up following the good monsoon rains, while private consumption growth also accelerated. The market attached little weight to this data point, with demonetisation the only game in town for watchers of India’s economy at present.
China’s official manufacturing PMI printed the highest for two years at 51.7, ahead of expectations of 51.0. The Caixin PMI (unofficial) moderated slightly from a two-year high in October, but remained expansionary. The strong activity was fairly broad across the economy, with manufacturing, retail, logistics and transport all posting good numbers.
Both the official and unofficial PMI data for China have been trending upwards for most of 2016. We attribute this in large part to policy support, both fiscal and monetary. We maintain our view that for 2017 the government will have to rely more heavily on fiscal than monetary stimulus to promote growth. This is due to the implications that relaxed monetary policy has for RMB depreciation and for encouraging capital outflows. Our conviction here has strengthened given the now increased likelihood of more aggressive tightening from the Federal Reserve, following the Presidential election and the inflationary environment that Trump’s fiscal stimulus will likely create. In summary, our view on Chinese economic policy for 2017 is that there will be a segregation of duties between fiscal and monetary policy, which will be made separately responsible for growth and foreign exchange stability respectively. This creates a possible scenario next year of tightening monetary conditions combined with higher fiscal spending, each decreasing the effectiveness of the other.
Donald Trump continues to make a stamp on US foreign policy in Asia, speaking this week with Taiwan President Tsai Ing-Wen. While only a 10-minute congratulatory phone call, this goes against the agreement that all countries wishing to hold diplomatic relations with China must abstain from official contact with Taiwan’s leaders, in recognition of China’s ‘sovereignty’ over the territory.
At this early stage, we read little in to these developments or their implications for US-China relations. Given that it was Ms Tai that made the call to Donald Trump rather than the US-Presiential elect actively seeking contact with Taiwan’s leader, his accepting the call may have been a matter of ignorance rather than a calculated move to antagonise Beijing.
Latin America
MSCI Lat Am 2,248 -2.09%
Brazilian equities (-3.88% IBovespa), fixed income and currency (-2.5%) markets sold off last Thursday, following the announcement that lawmakers tried (but failed) to pass a bill aimed at protecting themselves from corruption probes. Investors were already nervous as approval of fiscal adjustment measures are taking longer than and the political drama continues with some construction companies still plea bargaining with the justice system.
Brazil’s central bank cut the SELIC rate 25bps to 13.75%, as inflation and inflation expectations are coming down gradually. The BCB mentioned global uncertainties (US policies, global interest rates direction…) as a justification for not speeding up the pace of easing to 50bps per meeting.
Brazil 3Q16 GDP came in at -0.8% QoQ (-2.9% YoY). GDP revisions are now to the downside.
Peru annual inflation decreased to 3.35% in November from 4.61% in January. Inflation is closing in on the central bank target of 2% +/-1% and will support a stability of benchmark interest rate (4.25%) over the next meetings.
Africa
MSCI Africa 726
Morocco’s rainy season should help famers put last year’s drought behind them and support the cyclical recovery next year. Last year’s drought was the worst in more than 30 years, but Morocco’s granary (western plains) received up to 70mm of rain this year, which should be enough for a good agricultural season. Although Morocco is modernising its agriculture to be less sensitive to weather conditions, a good rainy season is meaningful for the sector and consumption. Agriculture still has far-reaching direct and indirect implications for the kingdom’s economy.
South Africa kept its investment grade rating at S&P (BBB-), Fitch (BBB-) and Moody’s (Baa2), although Fitch downgraded its outlook to negative. Despite the reprieve, all voice deep concern over political infighting and the impact it is having on SA’s growth and macroeconomic balances. This news also increases the likelihood of P. Gordhan remaining Finance minister. He is the last defence of the investment grade status and last guarantor of fiscal discipline. The ZAR strengthened 1.68% last week as a consequence.
International investors are pouring money into Egypt as they are attracted by high nominal yield (14.75%) and see low downside risk on the currency after the massive 45% devaluation. Foreign investment in treasuries has reached USD500mn as of 20/11/2016. Finance minister A Garhy is targeting a total of USD10-12bn in Fixed income and Equity Portfolio flows, helped by high liquidity in global markets.
Kenya’s private sector borrowing has slowed down to its lowest point in more than a decade, highlighting the reluctance by Kenyan banks to lend under the new regime of capped interest rates. According to the treasury, lending to businesses and homes grew just 4.8% in the year to September, down from 20.6% in a similar period last year. Kenya is facing many imbalances, structural reforms are being postponed, banking regulation is weak and government policies are worsening the situation.
Information taken from Alquity Global Market update 5th December 5, 2016
