THE UK REFERENDUM: NOT DOMINATING OUR POSITIONING
Positioning for the outcome of the UK referendum is riddled with difficulties, in our view. This is effectively a binary event with potentially large consequences for the markets. Given the virtually unpredictable outcome, we have chosen to not let this factor dominate our overall positioning. Yes, we are generally defensively positioned, but the rationale covers more than just the UK referendum. Political risks are one reason for our underweight in European equities versus the US and Japan and our short sterling versus the US dollar, but there are other political risks than the UK/EU ones and there are fundamental factors for this underweight as well. We regard low inflation as a headwind for corporate earnings. Moreover, dividend pay-out ratios look unsustainably high.
FED TOO DATA-DEPENDENT?
Federal Reserve chair Yellen’s semi-annual appearance before Congress did not contain much news. She stuck to the more recent cautious tone of the Fed and stressed that the risks were asymmetric: even if inflation were to remain persistently low or if the labour market were to weaken, there was only limited room for lower policy rates. However, in the case of an overheating economy with rising inflation, the Fed could readily raise interest rates.
Headwinds such as economic and financial developments outside of the US, subdued household formation and meagre productivity growth should, for some time, keep interest rates below the levels that are expected in the longer run, according to Yellen. She repeated that the Fed foresees only gradual increases in interest rates. But what is gradual?
With current Fed policy more focused on the upcoming economic data than ever before, this gradual pace is open for debate. The latest data may have had too much of an influence on the Fed’s recent views. The labour market would be a prime example. Yellen reiterated that it was important not to overreact to one or two weak reports. She mentioned robust labour market developments in the first quarter and said that there were tentative signs that wage growth was finally picking up. According to Yellen, GDP growth has been uneven in recent quarters.
Indeed, growth was weak in the first quarter, but for the moment, we expect stronger consumption in the second to lead to a decent rebound, resulting in an average growth rate for the first half that does not differ much from the trend of recent years. Still, the Fed, which in May had prepared markets for an imminent rate hike, has basically backtracked after May’s weak jobs data.
Expectations for a rate increase are low. Fed funds futures discount only a 10% probability. In fact, this market has odds of more than 50% for a rate hike in only early 2017. So is policy action in July off the table? Not with the current heavily data-dependent policy stance, in our view. But the stars must align fully for the Fed to tighten policy next month. That would mean
- a victory for the pro-EU ‘remain’ camp in the UK referendum
- a strong labour market report for June (to be released on 8 July)
- more signs of an economic rebound
- signs of rising inflation.
Taken together, this looks like a big hurdle for now. However, on inflation, the Fed appears to be gradually getting towards what it is aiming for. Core CPI inflation, which lacks the volatile prices for energy and food, has been above 2% for several months now. The Fed’s preferred inflation gauge, the PCE deflator, tends to undershoot headline CPI inflation, but with that measure at 1.6% YoY in April, it is not far off the Fed’s 2% policy target.
CONCERNS ABOUT CHINA AND JAPAN REMAIN
Money and credit growth has lost pace in China. According to the Bloomberg data series of outstanding total social financing which started in 2005, the 11.5% annual growth rate was the weakest on record. As we have mentioned in earlier strategy updates, we think this measure underestimates credit growth in the Chinese economy.
May saw some moderation in house price gains, although the pace remains unsustainably high in the major cities where a bubble appears to be building. Second and third-tier cities still face a massive overhang of unsold homes. From a longer-term perspective, more moderate credit growth and house prices are welcome; in the short term, we will have to see how the economy copes with these headwinds. Remember that the massive surge in credit and house prices in the bigger cities only stabilised economic growth. It did not lead to reacceleration.
In Japan, the value of exports and imports was heavily impacted by the recent appreciation of the yen. For the impact on GDP growth, we should look at volumes, where the trend has been much less dramatic. For corporate earnings, the drop in export and import values means that it is no surprise that forward earnings estimates for Japanese companies have fallen sharply.
Another weakness has been recent consumer spending. Supermarket sales fell by 1.3% YoY in May and department store sales were down by 5.1%. If anything, it is up to consumption to drive the economy forward. Foreign trade is challenging with the Chinese economy slowing and the yen having strengthened. Employment growth should provide purchasing power and low unemployment should support wages. But the spring wage negotiations have disappointed and actual wage growth has been minimal. This may matter for the Bank of Japan.
A stronger currency and a weak economy should induce the bank to boost stimulus. The next policy meeting at the end of July will be accompanied by new growth and inflation forecasts by the Bank of Japan. It will occur after the Upper House elections and most likely follow an announcement of additional fiscal stimulus. Since the forecasts are likely to include lowered inflation estimates, the BoJ may finally feel encouraged to step up the easing measures.
ASSET ALLOCATION: LONG USD VERSUS JPY CLOSED
This position had been based on the expectation of further monetary easing in Japan and a waning risk-off environment. The yen traditionally functions as a safe haven in times of market volatility. After the risk asset sell-off in February, we implemented the position. But the yen continued to strengthen, even though risk assets recovered, as investors did not leave the haven in favour of higher risk and return prospects. A more dovish Fed, inaction by the Bank of Japan and uncertainty about the UK referendum outcome kept pushing the yen higher. As our stop-loss level was reached, we decided to close the position.
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