Money Matters March 28, 2017

Three weeks ago, we suggested the global economy was entering a significant new phase in which aggregate monetary policy would start to tighten. We saw this as a consequence of an impressive, and broad-based, pickup in growth. In particular, the manufacturing sector emerging from a multi-year slump (in no small part because of commodity price stabilisation) and both consumer and business sentiment significantly improving (confirmed by this week’s Eurozone PMI). The question for investors was then whether this would derail the raging bull market for equities.

From a tactical perspective, the last fortnight has thrown up two more potential skid risks. First, the oil price falling back below USD 50 per barrel on the back of rising inventories. Second, increasing concern that the “Trump trade” may end up a damp squib.
shutterstock_279048509UNITED STATES
S&P 2,344 -1.44%, 10yr Treasury 2.35% -8.82bps, HY Credit Index 325 +6bps, Vix 14.77 +1.68Vol

After 109 trading days without closing down by more than 1%, the S&P 500 finally ended its low drawdown streak – losing 1.24% on Tuesday. This prompted a move higher in the VIX volatility index, which breached 14% intra-day (the first time since November). It should be said that market moves are still modest (stocks are down by less than 1% for the month of March and the VIX is only at its 18th percentile).

A catalyst for the negative performance, which extended to the USD, was a bad week for Donald Trump. The FBI confirmed they were investigating ties between Trump campaign officials and Russia, before Republican leaders were forced to drop a healthcare reform bill (post market close on Friday) after failing to garner sufficient support. This represents a significant blow to Trump’s credibility and therefore the faith that he will be able to deliver on tax reform and other stimulus promises.

A closer inspection of the bond market suggests investors might have been moderating expectations for a Trump structural growth revival for some months already. The 2s-10s yield spread on US Treasuries peaked around the time of the FED’s December interest rate hike, and has since declined some 20bps. Therefore, although short-term yields have continued to move higher, reflecting near-term FED policy, the market has failed to extrapolate a sustainable normalisation further forward. In other words, fixed income investors have stepped back from a view that Trump’s government will change the longer-term potential for the US economy. From a data perspective, existing home sales fell more than expected in February but new home sales positively surprised.
shutterstock_372417841 (1)EUROPE
Eurostoxx 3,419 +0.42%, German Bund 0.37% -3.20bps, Xover Credit Index 297 -17bps, EURUSD 1.087 -0.55%
The composite PMI for the Eurozone surged to a 6-year high in March at 56.7 indicating that despite political noise, European sentiment is strong and improving. Meanwhile, the last round of the ECB’s TLTRO financing programme far exceeded expectations with EUR 223.5bn allotted (versus EUR 125bn expected) across 474 banks. This was taken positively as take-up suggests the financial sector expects a continuation of recent loan demand growth.
In the UK, headline inflation for February came in at 2.3%, ahead of expectations and the highest level for over 3 years. This came alongside retail sales declining 1.4% in the 3 months to February, the largest decline since 2010. Both data points continue a trend of pressure on consumption and a modestly deteriorating British economy. In addition, Prime Minister May set Wednesday as the day she will notify the EU of the UK’s intention to leave the union under Article 50 of the Lisbon Treaty.
Russia cut interest rates for the first time in 7 months, surprising the market with a 25bps reduction to 9.75%, on the basis of declining inflation.
HSCEI 1,034 -0.41%, Nikkei 1,898.00 +0.26%, 10yr JGB 0.06% 0bps, USDJPY 110.160 -1.20%
The People’s Bank of China is continuing its surgical tightening of liquidity in sections of domestic markets where it feels excesses are at risk of accumulating. On Monday the 7-day repo fixing rate increased to 5.5%, the highest level since 2014. This is in-keeping with the central bank’s objectives of withdrawing excess liquidity from certain areas of the financial system, to avoid the build-up of excessive risk taking and the associated accumulation of systemic risk, as well as exacerbation of the issues of capital outflows (which the government appears to have tamed in the short term).
The key point of analysis here lies in the detail. We note that the gap between the ‘general’ repo rate, R007, which covers all counterparties including what can loosely be described as the shadow banking sector, and the DR007 repo rate, applicable only to banks, has widened further in recent days. This adds weight to the argument that the PBOC is sticking to it word, by focusing its efforts on draining excess liquidity from the riskiest parts of the system, rather than implementing a broad-brush tightening regime to deflate the economy.
India’s Prime Minister Narendra Modi continues to march on with his war on corruption and black money. After November 2016’s demonetisation programme, which forced billions of dollars’ worth of wealth kept in hard currency to be declared officially for the first time, the government has now passed a bill in the lower house of parliament granting tax officials new rights to hound down those whose finances arouse suspicion. The Income Tax Department now has a broader remit covering property assets, which were previously a haven for ill-gotten wealth, tax inspectors can now carry out search and seizure operations with far less red tape, while assessors can now challenge those accused of misfiling retrospectively all the way back to 1962.

The Finance Bill 2017 is not a headline grabber by any means. Rather, it is another small step taken by the Modi government as part of delivering on sweeping reforms to tackle rampant corruption and improve tax collection, ultimately leading to a larger government budget for spending on crucial infrastructure and public services.
Sri Lanka’s central bank raised interest rates by 25bps on Friday, the first change to monetary policy since the 50bps hike back in July 2016. The Standing Deposit Facility Rate was increased to 7.25% and the Standing Lending Facility Rate raised to 8.75%. 

Policymakers cited rising core inflation, which hit 7.1% YOY in February on the back of drought conditions, and the impact of changes to the country’s tax structure, as the key reasons behind the tightening. Credit growth also continues to run at undesirably high levels, with private sector credit expanding 22% YOY in 2016, despite medium term domestic borrowing rates increasing by 200-300bp during the year. 

The central bank played down the need for further tightening, commenting that the move was “precautionary”, and that recent improvements in the fiscal deficit and higher market rates “reduced the required adjustment in policy rates”. Despite the central bank’s dovish optimism over the future rate path, given the stubbornness of credit growth and the recent spike in inflation, the risk for domestic interest rates likely remains to the upside.
For the 20th consecutive meeting, the Philippines’ central bank kept interest rates on hold, with the overnight borrowing rate left at 3.0% in line with consensus. After three consecutive monthly upward revisions, the central bank trimmed its inflation forecasts by 10bps to 3.4% and 3.0% for 2017 and 2018 respectively. While rates are expected to remain fairly stable in the near term, the longer-term direction is likely to the upside, with the central bank commenting that inflationary pressures are “tilted toward the upside”. In line with consensus, Taiwan’s central bank maintained interest rates at 1.375% for the third consecutive quarter. Policymakers highlighted persistent uncertainties in the external environment, though were sanguine on domestic demand.
Saudi Arabia’s saw its sovereign credit rating downgraded by Fitch to A+ for AA-. The agency cited the continued deterioration of public and external balance sheets, as well as doubts about the extent to which the government can implement its reform program.
The RBNZ in New Zealand left rates on hold at 1.75%.
shutterstock_571083418LATIN AMERICA
MSCI Lat Am 2,622 +0.56%
The Brazilian government is racing against the clock to approve the pension reform before entering a new electoral cycle (presidential election in fall 2018). The government had to remove state and city employees from the proposal for pension reform. Given the controversial nature of the pension reform, it is not surprising that it would have to be watered-down to lower political resistance in Congress. The risk here is that this change opens room for other changes, including for the federal government. However, it would be very positive if the government could pass the reform making only this concession. In Brazil, Prosecutor-General Rodrigo Janot called for the opening of an investigation against nine ministers of President Michel Temer and the two former presidents, Luiz Inácio Lula da Silva and Dilma Rousseff. This represents another blow to the government of Temer, who has already lost eight ministers, mostly to scandal. However, these clean-up operations (Petrobras, Lava Jato, Odebrecht…) underline the independence and strength of Brazilian institutions and so far the 2 key figures of Brazil’s structural reforms President Temer and Finance minister Meirelles have been untouched by the investigations. Brazilian industrial sector confidence rose to 54 in March, the 3rd consecutive month of improvement. 

In order to meet this year’s consolidated primary deficit target of 2.2% of GDP, the Brazilian government will have to increase some existing taxes and cut spending to fill the 58Bn BRL gap.
Argentina emerged from recession earlier than expected as 4Q16 GDP came in at +0.5% QOQ.
The Chilean economy grew by 0.5% YOY in 4Q16, its slowest pace in 7 years. The 2016 annual figure came in at 1.6% YOY, leading to the slowest three consecutive years of growth since the early 1980s. GDP was dragged down by the fall of gross fixed capital formation by 5.0% YOY. Private investments are the key to reigniting economic growth and only a political change in November could prop up business confidence. In the meantime, some support should come from increases in the copper price and monetary policy, as inflation slows and the easing cycle (2 25bps rate cut in January and March) should continue.
MSCI Africa 862 +1.51%
Inflation in South Africa fell to 6.3% YOY in February, helped by ZAR strength and a good agricultural season (+83% maize volume, food inflation came down to +10% YOY vs. +12% in January). Core inflation fell from 5.5% YOY in January to 5.2% YOY. As CPI is getting closer the SARB target band, we can expect an easing monetary cycle to kick off in 2H17. South Africa’s current account deficit narrowed to near 6-year low at 1.7% of GDP in 4Q16. This was mainly explained by the rally in commodity prices, a fall in imports (weak domestic demand) leading the trade balance to swing positive. The CAD averaged 3.3% of GDP in 2016 compared to 4.4% in 2015.

These 2 data points are supportive of our thesis of a cyclical recovery in South Africa and the bottoming out of the economy in 4Q16-1Q17. The 19% rally in the ZAR/USD over the past 12 months also reflects this inflection point. However, structural change and enhanced GDP growth potential can only come from political change during the ANC elections in December.
The World Bank announced USD 57Bn of financing to Sub-Saharan Africa over next 3 years. This will come in the form of grants and interest-free loans for the world’s poorest countries and the IFC, financing arm of the WB to the private sector.
Egypt’s 5-year CDS tightened to 330 bps after falling by around 120 bps since the start of 2017, reflecting the rapid improvement in the country’s risk perception. However, this risk premium compression didn’t benefit the currency that is flat YTD vs. the USD.
Nigeria’s central bank strategy of flooding the retail and forward markets with USD drawn from the FX reserves seems to be working as the gap between parallel and official rates is closing. The NGN dropped below 400 NGN for 1 USD in the black market last week. 

Having said that, no one has any idea of the corporate FX backlog and one can suspect it can wipe out most of the USD 30Bn reserves of the CBN. In addition, there is still no signal of an imminent change in the floating of the NGN nor the ability to repatriate portfolio flows. The increased FX supply has only come through the forward market, which equity investors cannot access directly and the spot FX market still trades less than USD 2Mn/day. 

It looks like the CBN is providing a short-term answer to a structural problem. Even if the CBN were to temporarily solve the FX problem, Nigeria is facing many more structural challenges (dependence on oil, terrorism, debt, infrastructure deficit, weak institutions, power shortages, virtually bankrupt power and banking systems…).

Source: Alquity Global Market Update



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