Q3 2016 FFTW Quarterly Commentary: “I’m Still Standing”

21 Oct 2016

OVERVIEW

In this paper, we take a look at following topics:

  • Brexit wasn’t the only bump in the road that global markets were forced to navigate; in fact, political uncertainty was the dominant theme of the third quarter.
  • One of the most important developments has been in the world of central banking when the Bank of Japan (BoJ) unveiled a radical re-write of its monetary strategy.
  • The list of potential market moving events is long for the fourth quarter – but headlining the list is the US election which has the potential to underwhelm and overexcite even the most seasoned investment professional.
  • As we move toward year-end we see fiscal policy becoming a prominent theme in the market’s thinking and believe concerns around building financial imbalances within China could weigh on market sentiment.

Introduction

Elton John’s hit from the early 1980s “I’m Still Standing” is a fitting anthem for the quarter that has just passed. The UK economy did not grind to a halt after the vote to leave the European Union, although the currency is sinking like a stone. Appropriately enough the song was taken from the album Too Low for Zero which will no doubt strike a chord with fixed income investors that are becoming increasingly resigned to the idea that negative yields are the new norm.

Brexit is not the only bump in the road that global markets have been forced to navigate over the past three months. Political uncertainty has been a constant theme, oil prices have continued to yo-yo on the back of supply disruptions and talk of yet another production freeze and concerns around the health of the European banks have flared up on a couple of occasions. But despite all that, risk sentiment is still standing, although perhaps not dancing on European beaches ‘looking like a true survivor, feeling like a little kid’. Stocks moved sideways. Implied volatility has remained low by historical standards but has moved up more recently. up more recently.

 We think that confidence in the capacity of central banks to stabilize the system has been an important factor in driving the price action over the prior quarter, helping to insulate the market from shocks. It is interesting to note that the RMB has depreciated against the dollar through much of the year but without triggering the angst that we saw in January. However, central banks are being forced to consider ever more radical steps to continue supporting demand in a world in which there is a global glut of savings looking to find a home and too few companies looking to put capital to work. Structural forces are suppressing real interest rates and boosting asset prices.

Old hands in markets will recoil at the idea of a central bank setting the price of long-term bond – isn’t that what capital markets are for? However, that is the world we now trade in: the BoJ has established a target for 10-year Japanese government debt and it is willing to lend at a fixed rate over 10 years and buy away from market prices to deliver it. In truth the BoJ was already the dominant player in the JGB. The reason the BoJ has taken this step is because the market had become concerned that it would soon own all the bonds. What has changed is that the BoJ now has a more effective strategy for implementing monetary policy and a more ambitious goal: to over-shoot its target. All that remains is for Governor Kuroda or Prime Minister Abe to act and generate escape velocity in inflation. If and when they do that, the implications for yen assets could be profound.

We should be careful extrapolating from the serenity of the past quarter. Markets may not always dance to Elton’s tune. The market reaction to recent headlines that a consensus was building within the ECB to taper its quantitative easing (QE) program highlights just how sensitive current valuations are to the strategy pursued by central banks. After all, investors are not buying risk assets in expectation of solid growth in earnings; they are buying on the basis of a rock bottom discount rate applied to modest income streams as well as the promise of a central bank “put option”. The clear and present danger to risk assets remains a significant and sustained increase in inflation that would force the world’s central banks to retreat from their current accommodative stance.

Third Quarter Review

The dominant theme of the third quarter has been political uncertainty. In the United States, the presidential election raises the risk of a sharp reversal in the multi-decade trend of globalization and a destructive bout of protectionism. In Continental Europe, politicians continue to struggle with the pressures of the economic malaise and mass migrant flows, and an upcoming constitutional referendum in Italy threatens to topple Prime Minister Renzi. In emerging markets we have had ample evidence of instability: a failed coup in Turkey, the ongoing saga in Brazil and simmering tensions in South Africa. Last but not least, we have UK politicians and investors struggling to come to terms with the outcome of the Brexit vote. But despite that manifest political uncertainty the sky did not fall. Markets kept their nerve, comforted perhaps by the expectation that the world’s central banks would not be pulling away the punch bowl anytime soon.

The UK shocked global markets by voting on 23 June to leave the European Union. What happened next was just as surprising. Economists had expected the UK economy to slow sharply, as the increased uncertainty weighed on domestic demand. However, the data have confounded the consensus: the economy appears to be holding up just fine. It’s not entirely clear why the Brits kept calm and carried on spending. But the speed with which a new Prime Minister was appointed and the fact that his successor has not triggered the formal exit process probably had something to do with it. For companies and households in the United Kingdom it may have seemed that nothing much had changed, except that the currency plunged in value, paving the way for some imported inflation and a recovery in net trade. The UK may have dodged a bullet in the short run but the terms of Britain’s exit from the EU remain to be resolved. Initial optimism that the UK may find some way to nullify the outcome of the vote (by holding a second referendum or a general election) or would be able to agree a deal which protected key industries such as financial sector has started to fade. UK officials remain insistent that they will regain control over migrant flows and European officials remain insistent that there can be no free movement of goods and services without free movement of labor. As reality started to dawn, the pound started to slide and bonds sold off too – a market move that is more familiar in emerging markets.

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