Asset Allocation: The big picture
While geopolitics and plain vanilla politics have been exerting huge influences on markets as we head towards summer, the macro news has continued to range from lacklustre to disappointingly poor. The ECB meeting in early June drew more press comments on how dull it was and on what President Mario Draghi did not mention, rather than on new information he imparted.
Market-moving macro news has, of course, also been appearing. This was particularly evident after the surprisingly weak non-farm payroll (NFP) employment data, which triggered some fairly rapid adjustments to forecasts of the timing for the next Fed hike, as well as aiding the dips of both Bund and UK Gilt yields to new all-time lows.
May’s weak NFP figures consolidates an increasingly apparent trend that employment growth is slowing. What is concerning, is that the US labour market has been, since 1960, a reliable leading indicator of upcoming turning points in the business cycle.
While jobs data is notoriously volatile, and employment trends throughout this particular US recovery have not stuck to predicted paths, it is difficult to perceive the jobs news as an economic positive.
The tensions in European politics have given markets plenty to ponder, from the EU referendum in the UK to presidential elections in Austria, a second general election in Spain and other polls throughout Europe. The migration crisis is worsening, as are the already strained relations with Turkey. Political volatility could trouble capital markets for many weeks and months to come.
With much investor focus on European politics, there has been relatively little consideration for the investment implications of November’s US presidential election, despite the real possibility that Donald Trump has a chance to succeed Barack Obama.
If Trump wins the race to the White House, then he would probably have a Republican-led Congress too. This might, in turn, give rise to the possibility that some of his more ‘ambitious’ proposals could have a chance of being passed. These are the sorts of ‘tail risks’ that could make markets tense.
Focus: What is the US yield curve telling us?
Despite many episodes of huge ‘excitement’ in bond markets, much of it stomach-churning rather than exhilarating, bonds have long been considered the more sedate of asset classes. But all financial market participants acknowledge that what goes on in bond markets matters acutely to their markets, and would dismiss bond trends at their peril.
Yield curves have historically been held in particularly high esteem, because of their power to foretell recession by inverting six to 18 months beforehand. According to the Federal Reserve Bank of New York: “The yield curve has predicted essentially every US recession since 1950, with only one ‘false signal’.… in 1967”. In 1996, the Conference Board even added the yield curve spread to its index of leading indicators.
Several things about today’s US Treasury market are worth noting and might advocate a higher-than-usual degree of caution. Over the years, there was a dramatic change in the make up of US Treasury ownership, with foreign ownership increasing dramatically over the past 20 years in particular. But with quantitative easing the Fed’s holdings of Treasuries have surged.
Another key difference is the highly unusual interest rate environment. US short rates have never before been anchored at the lower bound for so many years, and across the curve, yields are at extreme low levels.
After a false start (ended by the taper tantrum in 2013), the US curve has been in a steady bull-flattening trend since the summer of 2014, with short rates nudging higher and 10-year yields trending lower. With 10-year yields at historic lows, it is hard to envisage a sustained move to inversion without some sizable, and possibly sharp, rise in 10-year yields as was seen after the infamous Fed tightening in 1994. Or will the change in Treasury ownership, or the fact that the Fed owns such a vast quantity of US Treasuries, mean that the curve shape will move differently, even as the economy judders towards any future recession?
Risk-free rates have fallen ever lower, pushed by the disappointments in US economic growth. Inflation expectations, through the inflation swaps market, have also been falling, perhaps giving the Federal Reserve something else to consider as it steps back from immediate rate hikes.
While the EU may have also deferred decisions on the need for further measures, it did surprise many by not making any changes to its economic forecasts apart from core inflation which was, once again, revised lower.
Low core inflation, has been a feature of the euro-zone since pan-European data were first compiled, not least because of the influence of low-inflation German data, which represents the biggest share of the Harmonised Index of Consumer Prices (HICP). From January 1999 to August 2007 – before the onset of the financial crisis – average annual headline HICP was 2%, and average core was 1.7%.
The euro’s inception in 1999 was about a year after the Asian crisis, when the oil price dipped to historical lows of about $10 a barrel, although it then set off on its multi-year rise towards the $150 level. This rising trend was surely positive – or at worst not negative – for EU inflation generally.
Many commentators argue that oil’s ‘super cycle’ has ended, and with the considerable weakening of the OPEC oil cartel’s influence, as well as the shale revolution, a lower oil price could become the new normal. Although oil’s price trend might not be upwards, there is concern that price volatility could remain high, which would not be any help to the ECB in its aims for higher inflation.
The possible postponement of Fed hikes will have prompted differing responses from policy makers across the world. A stronger dollar/weaker yen is what the Bank of Japan (BoJ)would like to see. However, with fiscal initiatives delayed, including the proposed increase in VAT, markets have been left disappointed and inflation expectations have fallen further which, in turn, threatens a rise in real rates.
Attention turns to the BoJ to see what actions it might announce that could deflect or deter upward pressure on the Japanese yen. Direct currency intervention, certainly not supported by the G20, is unlikely to be very successful. Since the BoJ’s decision to move to negative interest rates, the dollar/yen has moved markedly higher. When markets perceive a central bank to be powerless, or ‘pushing on the string’, tensions and strains tend to increase.
For Chinese policymakers, dollar depreciation is possibly welcome, as it alleviates some of the downward pressure on the renminbi, although the prospect of a slowing US economy is not exactly good news for the Chinese economic outlook.
The Chinese authorities have done well to clearly communicate that the focus should now be on the Chinese currency’s trade-weighted basket, rather than just the USD/RMB rate. However, old habits die hard, and it is apparent that much attention is still paid to that particular pair. The S&P 500 has repeatedly fallen sharply in the days and weeks following any lurch upward in the USD/RMB fix, suggesting confidence in the stability of USD/RMB is fragile, and fears of rapid capital outflows have not gone away.