Money Matters February 7, 2017

This week’s market moves, policy announcements, and political news flow provided a very good summary of the current outlook. Coincidently economic data is unequivocally positive, but investors and central banks are tentative because of a plethora of political risks:

  • Trump on immigration, trade, fiscal stimulus (and more)
  • Brexit
  • French Elections
  • Greece (again)
  • Italy snap elections

Of course, valuations and liquidity don’t help either; the “inflation and growth scare” has already prompted a sharp repricing, with limited asymmetry in return across most assets. The exception is perhaps select emerging markets.
S&P 2,297 +0.12%, 10yr Treasury 2.44% -1.95bps, HY Credit Index 322 -18bps, Vix 11.39 +0.39Vol

Although it was only a 0.6% fall, Monday was the biggest drop in the S&P 500 since the 8th November Presidential election. It came after considerable backlash against Donald Trump’s (2) executive orders on immigration, which ban entry from seven Muslim countries, including by legal residents and visa holders. Indeed, the debate continued this weekend as the President’s administration failed in an appeal against a court order to suspend some of the new measures. 

In the related area of trade policy, the new government is yet to announce any formal measures (other than withdrawal from the TPP). However, speaking in a series of press appearances, Peter Navarro (Economics Professor at the University of California at Irvine and Head of Trump’s National Trade Council) gave an indication of the areas for concern. In particular, Mr Navarro picked on the 4 countries with which the US has the largest trade deficit: China, Germany, Japan and Mexico.

  • “You look at what China’s doing; you look at what Japan has done over the years. They play the money market, they play the devaluation market and we sit there like a bunch of dummies.’’
  • Germany “Continues to exploit other countries in the EU as well as the US with an ‘implicit Deutsche Mark’ that is grossly undervalued.”

The latter was acknowledged by German finance minister Wolfgang Schäuble, “The euro exchange rate is, strictly speaking, too low for the German economy’s competitive position,…, when ECB chief Mario Draghi embarked on the expansive monetary policy, I told him he would drive up Germany’s export surplus . . . I promised then not to publicly criticise this course. But then I don’t want to be criticised for the consequences of this policy.”

On Friday, Trump issued his 8th executive order to direct a review of the “Dodd-Frank Act”, which was designed to tighten regulation of the financial industry. President of the Director of the National Economic Council, Gary Cohn (ex-President of Goldman Sachs) called this “a table-setter for a bunch of stuff that is coming”. Shares in the sector rallied 2% post the announcement, helping bring markets back to flat for the week.

At the February FED meeting, policy was left unchanged and the statement was mildly more dovish than expected; the only meaningful addition was that “measures of consumer and business sentiment have improved of late”. Therefore the committee refrained from an “internalisation” (to use their own words) of Trump’s policies or to signal an impending rate hike.

In terms of data, the labour market report was very much in “goldilocks” territory with non-farm payrolls ahead of consensus, but unemployment ticking higher due to an increase in the participation rate. Average hourly earnings rose at 2.5% YOY, down slightly from last month’s cycle high of 2.9%. Corporate earnings also continued the positive trend (Apple up 6% for the week), with blended EPS currently up 7.1% for Q4 (best quarter since 2014) after approximately half of companies have reported.
Eurostoxx 3,268 +0.02%, German Bund 0.40% -5.00bps, Xover Credit Index 293 -0bps, EURUSD 1.075 -0.79%
Eurozone GDP for Q4 2016 confirmed encouraging economic momentum at 2% annualised growth, whilst “final “ PMIs were in line or better than the “flash” estimates.
In France, the conservative candidate for the upcoming Presidential elections, Francois Fillon, has seen his lead in the polls disappear on the back of allegations that he paid his wife more than EUR 800,000 for a fictitious job as a parliamentary aide. This has left independent candidate Emmanuel Macron as a marginal favourite to face off against far-right Marine Le Pen in the second round (who has promised to remove France from the Euro). Whether it is Fillon, Macron or socialist Hamon who make round two is unclear, but it is still seen as very likely one of these conservative candidates wins over the National Front’s Le Pen. Sovereign risk was, however, in broader focus last week with peripheral bond spreads all widening.
The Bank of England left policy unchanged, managing to strike a balanced tone, which contributed to Gilts rallying. On the hawkish side, they upgraded growth forecasts and acknowledged that members had moved “a little closer” to the limits of their tolerance for inflation. More dovishly, they brought down their assessment of full employment to 4.5% from 5%, which allowed inflation forecasts to be little changed.
The UK government cleared the first hurdle towards invoking Article 50 by passing the second reading of the “European Union (Notification of Withdrawal) Bill” through Commons on Wednesday, with a vote of 498 versus 114. The approval process should be concluded late this week.
In a week of general dollar weakness, the Turkish Lira staged a rally last week, erasing half of its losses for the year as the IMF called on the country’s central bank to raise interest rates. Russia left rates unchanged at 10%, noting ongoing inflation concerns.
HSCEI 9,840 -1.23%, Nikkei 1,897.00 -0.52%, 10yr JGB 0.11% +0bps, USDJPY 112.640 -2.10%
At the BOJ meeting, monetary policy and CPI inflation forecasts were left unchanged, whilst the real GDP growth projection was upgraded. Price action in the JPY and JGBs, was volatile as the central bank was forced to intervene on Friday after bond market buying disappointed, forcing the 10 year yield up to 0.15%. In particular, the BOJ said it would buy “unlimited” quantities of 10 year bonds at 0.10% yield as part of the “yield curve control” policy. This week Prime Minister Shinzo Abe will meet Donald Trump for an extended summit.

This week’s Japanese experience highlights the weak execution of monetary policy in Japan. Yield Curve control is more about dealing with the difficulties of policy implementation (a scarcity of bonds) then a step forward in stimulus.
The People’s Bank of China continues to adjust monetary conditions, indicating a clear focus on macro-prudential factors rather than inflation. On Friday the central bank raised the interest rate on open market operations by 10bps, as well as increasing the standing lending facility (SLF) rates by 10bps-35bps depending on the maturity.

The PBOC has used reverse-repo open market operations as a central policy tool for managing banking sector liquidity, and has not increased the interest rate on reverse-repos since 2014.
The SLF is a form of collateralised lending from the central bank to the banking system, though is fairly immaterial in size compared to the PBOC’s use of reverse-repos.The most noteworthy aspect of the SLF tightening is that the overnight rate was tightened by 35bps versus only a 10bps increase for the 7 day and 1 month rates. 

This is a clear statement of intent from the central bank that it wants to shift the banking sector further up the maturity curve of funding sources, in an attempt to reduce the dependence on short term liquidity. In addition, unconfirmed reports have suggested that those banks failing the PBOC’s macro-prudential assessment (MPA) will now be charged a 100bps premium to the SLF rate (the MPA was introduced in 2016 and allows the central bank to set higher reserve requirement ratios for banks that are in worse positions in terms of a range of factors including capital adequacy, asset quality or liquidity). 

The measures follow the increase in the medium-term lending facility rate in January and confirm the intentions of the central bank to begin tackling leverage in the banking system and reduce the susceptibility to a liquidity shock. The focus of the central bank has been quietly shifting towards prudential risk management for over a year now, with policies announced in 2016 to regulate off-balance sheet wealth management products and punish lenders with weaker risk-management practices by increasing the cost of deposit insurance for them and reducing the rate paid on their reserves held at the central bank. 

In summary, we do not view these measures in the traditional sense of a central bank tightening interest rates to reduce inflationary pressures in an overheating economy. Rather, these are targeted measures designed to de-risk and de-leverage the banking system, without excessively curtailing credit growth or creating downward pressure on economic activity. There is also the need to prevent lax domestic liquidity conditions spilling over to create currency depreciation pressure.
China’s Official Purchasing Manager’s Index came in above 50 for January at 51.0, staying in expansionary territory, though decelerating from 51.9 in December. We note that seasonality effects from the timing of the Lunar New Year suggests there are minimal new insights to be drawn from this data.
India’s Finance Minister announced the budget for the upcoming financial year, containing very few surprises and with an overall ‘business-as-usual’ feel. The fiscal deficit target was the only significant departure from market expectations, set at 3.2% versus expectations for a 3.0% deficit, which would have been in-keeping with early promises for the government on fiscal consolidation that have now been pushed out by a year. 

Importantly, the key aspects of the budget continue to move in the right direction – the fiscal deficit continues to shrink (though less than expected) and the quality of government spending continues to improve, with a greater focus on infrastructure investment rather than subsidies. 

This week there is an RBA meeting in Australia at which no change to policy is expected.
MSCI Lat Am 2,565 +0.67%
Brazil’s unemployment rate climbed to 12.0% in December from 11.9% in November, coming in above consensus. Brazil’s industrial output increased 2.3% MOM in January and flat YOY, driven by vehicle production.
Those two indicators are consistent with a consumer cycle lagging the industrial cycle and consensus pricing in too much of a straight V-shape recovery. Unemployment has yet to peak, consumers are still highly levered and with 14% benchmark rate, disposable income after debt service is shrinking, while profits of industrial companies are driven by inventory rebuilding, lower wage bill and strong operating leverage due to a low cost base.
Brazil’s consolidated nominal budget deficit declined to 8.93% of GDP in 2016 from 10.22% of GDP in 2015. This trend of rising budget deficit above inflation was unsustainable, which is why the fiscal ceiling reform was so important. As a chunk of Brazil’s public spending comes from social security spending, its reform is also much-needed to contain the debt trajectory under control.
Argentina’s treasury minister Dujovne expects FDI to double in 2017 from last year’s USD 4Bn as international investors should be attracted by the upcoming auctions for renewable and non- renewable energy projects.
MSCI Africa 803 +1.24
Kenya’s central bank kept the benchmark interest rate unchanged at 10% on the back of inflation hitting an 11-month high in January at 6.99% YOY, close to the upper target range of 7.5%. Food inflation rose for the 8th consecutive month to 12.54% due to continued droughts.
6 months after coming to power, Youssef Chahed Tunisian prime minister announced a set of reforms aiming to get the economy back on track. Since 2011 and the Arab Spring revolution that led to a transition to democracy, Tunisia has struggled to enact economic reforms meant to curb public spending and help create jobs, while two major militant attacks in 2015 hit the tourism industry, a major source of income. The 40-year old prime minister announced a reform of inefficient and lose-making SOEs and a plan to cut 50,000 public sector jobs (currently 650,000) annually until 2020. These savings will reduce the budget deficit and can be redirected towards development projects. Tunisia received the support of several international institutions like the IFC (the World Bank’s development bank) who committed USD 300Mn per annum to Tunisian’s private sector.
Nigeria’s capital imports fell to a 9-year low to USD 5.12Bn in 2016, down 47% YoY. USD scarcity is pushing the unofficial NGN rate lower (NGN 500 per USD last week, vs. 309 at the official rate), making imports more expensive and hurting Africa’s biggest economy’s industrial sector.
The Nigerian government is trying to ease the pressure on the national accounts by raising a 15-year USD 1Bn Eurobond, USD 300Mn diaspora bond and negotiating a USD 1Bn loan from the World Bank. The yield and conditions required by international investors to lend to Nigeria remain unknown but are likely to include a floatation of the NGN. The 60% gap between the black market and the central bank rate is crippling the Nigerian economy, creating hyperinflation, dislocating allocation of capital. If nothing is done, Nigeria is heading for a 2nd year of recession.
Ghana’s new government uncovered that it has inherited an additional USD 1.6Bn in debt (mainly in SOE balance sheets). With this hidden debt, the budget deficit inches “closer to double digits” as a percentage of GDP. We don’t know yet if this debt was also hidden from the IMF team in Ghana in charge of supervising the country following a USD 750Mn loan. The Ghana 2030 bond in USD tumbled 2% on the news.
Most indicators in South Africa are pointing towards a moderate cyclical rebound for 2017-18. After 34 consecutive months of contraction since October 2013, the SARB’s business cycle leading indicator started posting positive growth rates in August 2016 and has maintained an upward trend for four consecutive months. The Standard Bank economy wide PMI has remained above the 50 neutral mark for four successive months since September and the Barclays manufacturing PMI for January increased by 4.2 points to 50.9.
Information sourced from Alquity


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