ECB: TAPERING DISCUSSION PREMATURE
Last week, Bloomberg quoted ECB officials as saying that the ECB would gradually – in increments of EUR 10 billion – wind down its asset purchases before its QE programme ends in March 2017. This could be the ECB testing the waters. If markets can cope with this, tapering could address the ‘scarcity issue’, in particular with respect to the bonds the central bank can buy in the market. Markets did react, of course. Eurozone government bond yields rose, but at 5-7bp, the repricing was not dramatic.
We think the ECB will not taper its QE imminently. Firstly, while the officials quoted by Bloomberg said an informal consensus to taper has built among policymakers; they did not rule out that the programme would be extended past the current end-date. Secondly, the ECB quickly said in an e-mailed statement that the governing council had not discussed this. If the ECB was really testing the markets, it should have waited longer with such a reaction.
Thirdly, the scarcity issue must be addressed anyway since at the current EUR 80 billion monthly pace, the market might well run dry even before March 2017. Ironically, the recent increase in yields means fewer bonds are trading at yields below the ECB’s deposit rate. It increases the pool of eligible bonds to buy. Finally, we do not think that the economy, inflation and inflation expectations are strong enough for an early tapering. Core inflation at only 0.8% YoY shows that the ECB is still far from its target of inflation of just below 2%. At 1.37%, longer-term inflation expectations have barely moved off their record low of 1.25% (see chart).
So any discussion on tapering seems premature. Of course, the programme will be trimmed once quantitative easing is no longer needed. But for now, we think tapering does not solve the scarcity issue and that inflation and inflation expectations are too low for the ECB’s comfort.
US LABOUR DATA SHOULD KEEP THE FED ON COURSE FOR A HIKE
September’s 156 000 net new jobs fell short of market expectations and marked a slowdown from the previous four months. However, we think this report was not weak enough to change the market perceptions of US monetary policy. The probability of a rate rise in December has increased lately to 64%, although this does not yet fully reflect September’s jobs data.
The unemployment rate rose by a notch to 5.0%, but this was the result of a higher participation rate, which is positive. The gain in average hourly earnings was the strongest since January 2010 (see chart). If wage inflation peaks at a lower level in this cycle as companies become more cautious on hiring to defend their margins, it would bolster the argument for a cautiously moving Fed. But for now, this data should support the Fed in its willingness to raise rates in December.
EMERGING MARKETS: STABILISATION IN CHINA, LOWER INFLATION IN BRAZIL
China’s economy is stabilising. The official manufacturing PMI showed a slight improvement from the numbers seen through 2015 and early 2016. Combining the official and the Markit data, the ‘super-composite’ has been unchanged for three straight months. Thus the PMIs have stabilised at fairly muted levels. The risks are that the economy weakens as the effects of the strong monetary and fiscal stimulus wear off. This bears watching.
In Brazil, some indicators have started to improve. The Brazilian real recently strengthened, while the OECD Cyclical Leading Indicator rose sharply. However, households are suffering from falling employment and lower wages, while the credit cycle is negative. The need for fiscal austerity should further hamper any recovery. Thus, the case for rate cuts is clear, in our view. A move could come as early as the next monetary policy meeting on 19 October.
ASSET ALLOCATION: CURRENCY SWINGS
Two currencies took the spotlight in the past week: the British pound and the Mexican peso (see chart). The starting points for UK Brexit negotiations seem to have hardened and currency markets took note. The pound fell sharply, so we were too early in closing our short sterling versus the US dollar. But we feel strengthened in our view that political and economic uncertainty will weigh on business investment and the UK economy.
In line with many emerging market currencies, the peso fell in 2015 on lower oil prices, possible rate rises in the US and weaker growth in China and in global trade. But while many emerging currencies have stabilised or improved lately, the peso fell further. Markets see Donald Trump’s ideas as risky for US trade, with a focus on Mexico, which could also suffer from lower remittances. With polls shifting in favour of Hillary Clinton, the peso has recovered. Such moves signal the peso is the prime proxy for asset markets for the US election outcome. A strong peso should damp the prospect of further interest-rate rises in Mexico as economic activity slows.
In the US, early on in the third-quarter company earnings season, results have beaten estimates. Forecasts are for near-zero growth in earnings per share. These modest expectations will likely be exceeded, but looking at the estimates for next year’s earnings, the hurdle is higher. Although we think the outlook for earnings is improving at the margin, we also believe current US equity valuations are unattractive. That said, our underweight in global equities is focused on Europe where the earnings outlook is weaker and political risks linger.
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 See also What the U.S. Elections Mean for Global Financial Markets: A Roundtable Commentary, October 2016