Saturday, September 20, 2014

Economic Summary for the week ended 20th Sep 2014

Latest market views from the BlackRock Investment Institute
This week is set to be a key one for risk assets as we head towards the final quarter of the year. On the geopolitical side, Thursday’s Scottish referendum and the Ukraine situation dominate the headlines.
Less tweeted about, but equally, if not more, important, is the spectre of real central-bank divergence as we head into Wednesday’s Federal Open Markets Committee (FOMC) meeting in the US. Over the past week, these looming developments have reversed the recent positive momentum in markets. For equities, it was a down week. The S&P 500 fell back below 2000, while Europe’s recent European Central Bank (ECB) resurgence came to a grinding halt. Spain was hardest hit, both in stocks and bonds as the potential repercussions of a ‘Yes’ vote in Scotland raised claims for the unofficial Catalonian referendum to be granted more prominence by Madrid. Italy was also weak, partly on profit-taking from the ECB-fuelled peripheral asset rally, which reminded us that Prime Minister Renzi faces a testing time in the coming months for his reform drive.
Elsewhere, this week in France will see a confidence vote and speech from President Hollande on reform. However, for once the UK is centre stage, with markets finally waking up to the closeness of the Scottish referendum. Last Sunday’s poll giving the Yes campaign the lead for the first time sent sterling from 1.63 towards 1.6 against the dollar. By the end of the week, however, it was back above 1.62. Various polls in recent days show the result as too close to call. The only certainty is that the referendum will lead to changes in the UK, regardless of whether the result is a yes or a no. So currency volatility in sterling is likely to continue.
All eyes on central banks
Away from the UK, this is a key week for the US Federal Reserve (Fed). Recent economic data has shown steady improvement, but only limited signs that the drop in unemployment is feeding through to rising wages – the main focus for the Fed. This has allowed bond markets to remain largely sanguine. Two-year yields have risen over the summer and the dollar has embarked on a broad-based strengthening, but the longer-dated end of the yield curve has remained very range bound, until now.
The past week has seen the first signs that the extremely low bond-yield environment of the summer may now be shifting, with the 10-year bond moving up 15 basis points to 2.6%. On an absolute basis, 2.6% is still very low, but remember we started the year at 3%. The backup in yields has been quick and comes at a time when US equities are at record highs. The front end of the US yield curve has moved to price in earlier rate hikes, with June now favoured. In our mid-year outlook, we saw the Fed as the main threat to risk assets in the autumn. So far, that has been overshadowed by the ECB. But now it’s the Fed’s turn again, with this month’s FOMC meeting. Analysts’ eyes will be on whether the phrase ‘considerable period’ is again used. The 2017 ‘dots’ (the Fed’s own projections of where interest rates may be) will also be released, possibly giving more insight as to the likely terminal rate.
Back in Europe, this week sees the first TLTRO allotment – the targeted long-term repo operation announced by the ECB back in May. A total of up to €400 billion will be allotted to banks, with conditions to encourage lending to ensure the money enters the real economy. The original LTROs were successful at stopping the liquidity crunch that was enveloping the European banking system two years ago, but did little to spark lending activity, as most of the funds went into the ‘carry trade’ of buying peripheral government bonds. The TLTRO takeup is likely to be large, but questions remain about what banks will actually do with the money. Meanwhile, German bund yields are back above 1%, pulled up by the move in Treasuries and some realisation that sovereign quantitative easing is not a done deal.
China and Brazil reverse their rallies; Japan a bright spot
Further afield, emerging-market (EM) equities’ recent performance reversed, led down by China and Brazil.
For China, concerns over the government’s GDP targets are back, with recent economic data showing industrial weakness. China’s equities rally has gone long way, but needs a short-term catalyst to keep it going, given the economic reality of rebalancing. This could raise pressure for more government or central- bank easing support. The convergence of A-shares and H-shares has been helped by the ‘Shanghai Connect’ test trades, whereby offshore investors can now buy domestic equities. Similarly, the Bovespa has given back some of its exponential rally – a rally driven purely by hopes that political opposition can create another ‘Modi moment’. This has been enough for the equity market to defy the reality of a rapidly deteriorating economy on its way to stagflation with zero growth, but the risks are clear. For broader EMs, this compounds the risk of a more hawkish Fed that has seen EM currencies weaken versus the dollar. It is important to watch the ‘fragile five’ to see if the currency sell-off accelerates. Within Asia, our preferred area, Korea, has struggled recently, in part because of the weaker yen.
Finally, one bright spot in global equities is Japan. The Topix outperformed other major indices by rising over 1% last week. Having been range-bound all year, the dollar/yen has moved quietly, by 5 points to 107, and the Topix has pushed over the key threshold of 1300. With a weak yen, and news due about government pensions, Japan looks set to continue its stealth outperformance as markets’ attention stays firmly fixed on developments in Edinburgh and Washington.

Monday, September 15, 2014

Economic Summary for the week ended 11th Sep 2014

Last week was eventful, both in terms of policy and economic data. Equities were typically up between 0.5 and 1%. In the US, the S&P closed above 2000 for the first time and managed to sustain that level throughout the week. European equities rose by 2-3%, helped by the actions of the European Central Bank (ECB).
In Asian markets, both Japan and China were strong, boosted by confidence that China was doing reasonably well from a policy and growth perspective. The main laggard of the week was the UK, on evidence that the Yes vote in the Scottish independence poll was gaining ground. The biggest impact of this was on sterling, which saw considerable weakness, particularly against the dollar.
On the fixed- income side, both government and corporate bond yields drifted higher, largely on profit-taking but also on concerns that the US Federal Reserve’s view is becoming increasingly hawkish, making an early rise in interest rates more likely. The other main theme across markets was the stronger dollar, most in evidence against sterling, but also versus the euro, the yen and emerging-market currencies.
Quantitative easing – by another name
The key event of the week was the meeting of the European Central Bank (ECB). There had been much speculation that we would see the ECB establish a quantitative easing (QE) programme, as economic data over the past few months had shown sustained weakness in the core heartlands of Germany and France, and inflation was slipping below the 1% level.
The ECB did take action by cutting interest rates, but more meaningful was the ECB’s announcement that it would purchase asset-backed securities – this was dubbed “private QE” by the market. While there was some disappointment that the purchase of government bonds hadn’t been announced, it is quite possible that we’ll see this further down the track. Overall, this action was taken positively, and is obviously supportive of European banking because it helps free up the bank- lending channel. It is also positive for European equities, where we believe markets are among the cheapest on a global basis. The weak euro also helps corporate earnings.
Geopolitical crises dominate politics
On the politics front, last week’s focus was the Nato meeting in Wales. The focus was twofold: the approach to dealing with Russia and Ukraine, and a more coherent plan for the crisis in the Middle East. On the first point, despite the announcement of a brief ceasefire, we expect to see ongoing friction on the Russia/Ukraine border. This isn’t currently creating a huge amount of volatility but, given Europe’s dependence on Russian natural gas, especially as we approach the winter months, energy supply could cause problems. In the Middle East, pressure is building on western governments, particularly the US, to articulate a more coherent plan of action. The challenge is that this would require working more closely with the Assad regime in Syria, and negotiations with Assad could involve Russia. So in some ways, the two crises are linked, which gives a sense of how difficult the situation is from a political - negotiation perspective. While events in the Middle East have also had little impact on markets yet, with crude-oil reserves still high and the oil price weak, this could turn around pretty quickly, especially as the winter months approach and demand increases for heating supplies.
The implications of Scottish independence
The biggest focus in terms of market volatility here in the UK is the Scottish independence vote. The referendum takes place next week – on the 17th, with the results available two days later on the 19th. (I would draw your attention to a 10-page document our BlackRock Investment Institute produced in March, which runs through the implications of a Yes vote.) The key focus is the currency, where Chancellor George Osborne has made it very clear that he would not be willing to let Scotland use sterling on a longer-term basis. It’s worth pointing out that nothing would happen immediately following a Yes vote, because the first date at which independence could take place would be March 2016. But it seems likely that a Yes vote would create a great deal of volatility and uncertainty, particularly in terms of currency, and exactly how much of the gilt market Scotland will own.
A Yes vote would also have implications for a number of large companies that are currently headquartered in Scotland, as they would need to decide where to base themselves.
Policy highlights in the coming week
In the UK, house-price data, retail sales and industrial production figures will be published. Given the focus on the strength of the UK, and the potential for interest-rate rises, these will all be considered important pieces of the economic jigsaw puzzle. So we may see some volatility based on these releases. In the US, official releases include retail-sales data, and in the eurozone, inflation data, which has so far been a key influencer of ECB policy. Last but not least, it’s clear that the geopolitical issues described above will not go away any time soon and will continue to generate news headlines and cause volatility. But at this stage, markets are not paying a huge amount of attention to events in Ukraine and the Middle East.

Wednesday, September 10, 2014

Economic Summary for the week ended 9th Sep 2014

Market movements
August was an excellent month for investors in both bonds and equities. We saw government bonds in Europe rise sharply with the best monthly performance since the beginning of 2012. This also helped US Treasuries produce strong returns. In Europe, returns were variously 1.9–2.0% for the month as a whole. US Treasuries were up 1.2% and gilts rose 3.5%. This hauled credit up with it.
Of particular note was the recovery in US high yield, which posted a positive return of 1.8% for the month after outflows in July. For equities generally, markets were led by the S&P 500 index, which breached 2000 for the first time.
This represented a 4% rise, with financials outperforming. European stockmarkets were variously up between 0.5–2%. The UK market was up 2.1%. In emerging markets, Brazil was the star performer, up nearly 10% as people scented a political change coming. Indian and Chinese assets also rose. Only commodities were weak: copper was down 3%; sugar fell 5%; corn was flat after a weak July; and Brent crude oil was down 3.1%. The most important event was in currencies – the dollar strengthened, particularly against the euro, which declined nearly 2% against the US currency.
Quantitative easing for Europe?
Policy (or expectation of policy) linked all these developments together, as has been the case for the last two to three years. In August, we heard the admission by European Central Bank (ECB) Governor Mario Draghi – speaking at the Jackson Hole retreat – that the ECB was beginning to be concerned about the decline in European inflation expectations, which indicated a move towards some form of quantitative easing (QE). This was key to the stronger performance of European bonds, with 10-year German bond yields dropping by 27 basis points in August. French yields dropped by 28 basis points, from very low levels. People now hope the ECB will move towards implementing sovereign QE. However, real policy action remains some way off.
The first step along the way will be approval - possibly as early as Thursday of this week - of the beginnings of a programme to purchase asset-backed securities. This is a relatively small market in Europe, some 500 billion euro, so the injection that the ECB could make in terms of existing stock would be stretched over a period of time. The expectation is that the ECB would buy new asset-backed securities, and help companies reduce their cost of funding as a consequence.
Sovereign QE is some way off and we saw, as expected, a rather cutting response from Germany’s finance minister Schaeuble, who suggested monetary policy had reached its fullest extent in Europe. This is consistent with everything we’ve seen in the dance of ECB policymaking over the last two or three years: an initial proposition from Mr Draghi, followed by a period in which the hawks object, followed by a re- examination of still-softening data and a grudging acceptance. Nevertheless, I think we’re several months away at least – it may be the middle of next year – from full-on quantitative easing in the sense of buying sovereign debt. However, the markets anticipate, and that’s what we saw in relatively thin volumes in August.
Policy highlights in the coming week
In the coming week, the ECB has its meeting on Thursday this week. On Friday, payroll figures are announced in the US. Regarding the ECB, the market will be focused on whether or not the bank actually announces the beginning of QE, and Draghi’s remarks at the following press conference.
In the US, there is some expectation, given the softening trends in retail data and personal consumption, that the payrolls number will be sufficiently low – around 200,000 or below – to mean that the Federal Reserve’s meeting on 16 and 17 September will produce no significant change in the outlook.
One other central-bank policy point to note in August was the Bank of England’s (BoE) Monetary Policy Committee voting by seven to two in favour of retaining interest rates as they are. This was the first time under Governor Carney that the vote was not unanimous.
We believe that the BoE is slowly moving towards some form of tightening, but that this is several months away from materialising. Monetary policy is still wholly supportive and will remain so. This means holding cash is a rather painful experience, with bonds likely to continue to perform strongly, and equities even more so, particularly if good funding markets continue to allow buybacks of shares and cash-funded M&A activity. The only major fly in the ointment is geopolitics, especially developments in Ukraine. Here, the line in the sand that would lead to risk expanding well beyond Russian equities would be Europe and the US agreeing sanctions that would exclude Russia from the Swiss settlement system. If that happens, then I think we will see further escalation of geopolitical risk, but at the moment it’s more talk than walk as far as the markets are concerned. We continue to watch Ukraine and the build-up of Russian soldiers there, as it is the key threat to a pro-bonds, pro-equities, anti-cash environment.