You can't look at the UK market or the currency without taking into account the current state of Brexit. The postponement of the deal to October and subsequent election caused the Pound to drop. The stock markets have been taking this news fairly well staying in line with other major indices. The question now comes down to the data. Will there have to be a pronounced decline in UK data to prompt the British government to take early action against the threat of a no deal Brexit? News today shows that steps are trying to be made to prohibit that from happening, but without a sense of urgency it will be important to see how the vote goes.
Like many investors are probably thinking, I like the UK as an investment opportunity but am holding off in light of the political threat to the markets. This paralysis is going to seep into the economy as uncertainty continues. For this week I am going to keep an eye on the BOE governor to see what he thinks monetary policy will have to do in this interim period, and after.
Markets are again in the red this AM about the Yield curve going deeper into inversion. With the 10 year at a yield of 2.1% and the 3 month at 2.34%, it pays to keep your money in cash short term while avoiding locking in anything further out on the curve. This has been a sign of a recession in the past and has the markets starting to sell off as a result. Long term what does this mean?
If a recession is on the horizon it is almost guaranteed that the expected that the Fed will react. A curve that is this inverted is a telling sign that many investors are expecting the shorter end of the curve to come back in line with the expectations priced into the longer end of the curve. If these cuts do occur, and remain lower for longer, like we have seen in the past, there is a good chance of getting a rise in assets providing the yield that many investors require.
Banks will be one of the beneficiaries of lower rates. A steepening yield curve is where traditional banks earn their profits. While the curve is flat or negative they have to borrow at a higher rate then they are lending. This will slow their ability and desire to lend money, slowing the economy, and causing the Fed to look at lowering rates. ETFs like the KBW Regional Banking are becoming cheaper in the sell-off and starting to get a yield that is nearing the 3 month. As the market continues to price in the trade wars and recessionary fears, financial ETFs might be worth looking at. If the Fed goes on a program of interest rate cuts, the profitability metrics of these companies will increase, and the yield they provide will look more attractive.
With the elections over it is time for the top jobs of the new European parliament to be hashed out. The current climate of Europe after the elections is a bit mixed, but far from the greatest fears that could have manifested. The Traditional parties were uprooted with the Peoples' party and the social democrats (the usual center parties that take 50% of the votes) failing to get a majority for the first time. On the bright side it wasn't the far right euro-skeptics that have seized all the power. Though there have been gains in the far right in places like Italy, others like in Greece saw their extreme governments come back into the centrist realm (and markets moves accordingly).
This is no doubt going to introduce volatility into the markets in the near team but the implications of how a coalitions gets formed will have a much larger and lasting effect on the Euro and the underlying countries. By failing to integrate more, the union will be unable to prepare and react to another crisis in the region, or even a modest slowdown. With one of the main positions to be filled being that of the ECB head, the people who get placed into these roles will be a deciding factor in the valuation of the currency, spreads among member countries, and market valuations.
China beating GDP estimates caused a rally in Asian shares and provided some relief around the globe. The reading of 6.4% growth was flat quarter over quarter and beat the 6.3% estimates. This all sounds like good news for the global economy stabilizing and will provide the Chinese government with the ability to scale back on stimulus. The larger picture shows that the stabilization of growth came from the real estate sector (construction, white goods, etc.) which are partially a result of the lowering of the reserve requirements for banks. Local governments were also given a near 60% increase in special purpose bonds this year which will contribute to growth.
Concerns come into play when you look at the longer term horizon and ow the Chinese government will cope with slowing growth year over year. The current process of adding more stimulus to the markets has, and will continue to work, but due to the rising concerns over debt in the country, the government will be less likely to resume the financial crisis era levels of assistance.
Once again when determining the reliability of the recovery we had this year we need to look at the debt markets for signals of how stable and long it will last. Equities will be supported by the strength in the lending market or be forced to adjust to the limitations of debt fueled growth.
Today the US Jobs numbers come out for March. Estimates are around 180k jobs being created, which is strong coming off the back of a 20k increase last month. Markets will be looking at how this is revised to help make a determination of whether the global slowdown fears are past us and there is room for more upside in the markets. Since the start of the year markets have rallied at signs of growth returning not just to the US but globally.
The market staged a great recovery from the sell-off late last year, now that we are back to the levels we saw before the drop, growth is going to influence the markets more than recovery. If this growth trend continues and the Fed stays in its wait and see stance, the markets could have the potential for new highs. With markets getting optimistic, there is potential for some upsets, so the approach to adding to your positions should remain measured, and cash should stay on hand.
Today UK Parliament will discuss and vote on the alternatives to Brexit. This will no doubt bring volatility into the markets and have investors waiting on the side lines for more information. Bigger picture the talks of a global slowdown are increasing (the bond market is starting to take notice) which isn't being fully reflected in the stock market as of now. Equities did have a series of declines as markets started to factor in the dovish Fed comments as being pre-emptive over accommodative. The fixed income market might be telling us that more trouble is on the horizon.
The US treasury curve has inverted seeing the 6mo and shorter yields higher than the longer dated yields, out to the 10yr. This inversion makes many investors nervous about the future economic prospects because so many are willing to get less return for longer protection of their money. As we have seen in the past an inversion denotes fear, fear brings an increase in savings and less investment, and less investment brings a slowdown. The issue is more in the timing of these events and the severity. For investors this is a good time to get your cash ready to deploy as the fear of the slowdown starts to become self fulfilling. In deploying cash, this means paring back on some investments that have had good rallies in the past few months and possibly not rolling over longer term bonds that you may have maturing. I wouldn't recommend a total liquidation in your portfolio (probably ever) as over the long term staying invested is the best way to capture long term returns. This is more a move to re-allocate over the coming months or year.
In Europe there are larger factors at work. The Fear of Brexit is at the center of everyone's mind and looking longer term, the outlook doesn't get much better. The data coming out of the Euro area is pointing to a steady decline in economic activity. This is bringing up some of the fears that have plagued the region during the crisis in 2011/12. s you ca see with German bunds (the safe haven of the Eurozone) investors are willing to pay a small price to protect their money, for up to 10 years. The ECB has been a contributor to this trend by pledging to keep rates the same until at least the end of 2020 and to continue to buy assets under their purchase program (of which there aren't enough German bunds to buy at reasonable prices). The sectors that are hit by these declining economic conditions in the EU are banks and industrials. Longer term I want to buy into these sectors, but cooler heads must prevail. Industrials can offer some decent yields, and would be easier to buy and hold through a rough patch. The banking sector will need to strengthen its capital structures and eliminate the fears of sovereign debt risks before they start to look attractive. Moving higher up the capital structure might be a better option in the near term, looking for preferred shares or bonds of financials companies. The key here is patience, as in the US market, it is good to have cash on hand and wait for opportunities to buy into good companies being sold off as liquidity becomes more valuable.
This week will be dominated by the Fed interest rate decision and meeting. While there is no expected rate increase at this meeting, the conditions have changed drastically over the last few months. The markets are pricing in a 25% chance of a rate cut by the end of the year and no chance of a rate increase. The importance of this meeting will be the insights of what the Fed plans to do with their balance sheet reduction schedule. Investors will be looking at how the Fed plans to continue, or delay, the balance sheet reduction in the wake of global economic trends. Other central banks have made it clear that they plan to keep their balance sheets as is, or expanding. It will be important to see if the US continues to buck the global trend or not. If so this will keep assets coming into the US Dollar, and dollar denominated assets.
A second factor to watch this week (though still interest rate related) is inflation numbers. The UK in the midst of Brexit is going to release their numbers Wednesday, with the Pound relatively range bound there isn't too much expectation of inflation getting out of control in the near term. The next day the UK will announce its interest rate decision with no expected action. Japan and Canada will also provide inflation numbers with forecasts near the previous levels. Large changes to the upside in these numbers will create a conundrum for central banks as they prepare for lower growth. A shrinking inflation number will provide the central banks with an open field for more monetary expansion in the event of slowing growth.
A second vote in UK parliament is taking center stage today. After the defeat of the new Brexit deal, a vote on whether to go ahead with a no deal Brexit is being voted on. Many are hoping this is going to be defeated and leave the UK with a final vote this week on delaying the March 29th deadline. The likely outcome (given the relatively low volatility) is that the can will be kicked down the road. This will not be good for UK businesses and banks which will most likely hold back on lending and expanding businesses among the uncertainty.
Meanwhile in the rest of the world there is a picture that is being built outside the events of Britain. The global economy is showing signs of slowing, being offset by central banks coming out with more dovish language as the start of the year rolls on. This has many investors wondering if central bankers are coming in preemptively to get ahead of a coming slowdown or adjusting to one that is already starting. With central bank rate changes taking about 18 months to flow into the markets properly, the language and guidance they are giving more important in the near term than actual changes to rates or asset purchases. The reasoning will depend on the data and vary by central bank.
In the US, there is more of an assumption that the Fed is being preemptive. Data (with the exception of the last jobs report) has been supportive of the economy. Inflation expectations have come down, but not in a severe way that will show easing as imminent. Data coming out today (like PPI) will help to build the picture around the Fed's stance on interest rates longer term.
For other banks, like the ECB, there are more tangible steps being taken. While the Fed is looking to be 'patient'
The Pound rallied in early Tuesday trading in Asia as new that the European commission agreed to changes to the Brexit agreement. This is the final chance that the UK will probably have for negotiations with the commission before the end of March deadline. With a vote on the deals coming on Tuesday, there will be another vote Wednesday, should this one be rejected, to determine if they should leave without a Brexit deal. If none of those are passed then a delay in the Brexit will have to be voted on.
One thing to keep in mind, is that the macro picture we are seeing will not improve as a result of the Brexit outcome. So while we might see an increase in volatility in the event of a no deal, the Euro is still likely to suffer in the longer term as slowing global growth will test the central banks and their ability to soften the blow. These monetary policies will only be able to do so much with most central banks (the US being an exception) still near the top of their easing cycle. Fiscal policy and the ability for banks to lend will be the main factors in managing through the next slowdown. The Euro area is suffering in both of these areas because of the 'Doom Loop' where banks hold sovereign bonds, and the lack of political will for the better off countries in Europe to help direct capital where it is needed most.
This is where you could see some resurgence in the UK economy after the Brexit deal (the outcome of the deal will determine the length before growth comes around) where lending starts to open up as less uncertainty causes banks to boost capital. The outcome of this week could provide opportunities to look at buying UK assets over European ones as Brexit winds down and the overall macro economy is taken into account in Europe.
A string of data from the Eurozone is pointing to lower growth in the region. Sentiment was at a 2 year low, German business growth is expected to fall "well below" the 1.5% targets according to the central bank chief, and importantly, corporate lending in the region slowed.
According to the ECB, corporate lending declined in January exacerbating the downturn in the region. This is a start to the confirmation that the slowdown in the Eurozone is continuing and the moves by the ECB will have to be followed to see how they are able to react to these changes. The Fed chair is going into his second day of testimony to Congress, shedding more light on what the Fed is looking for in data and how they will react. The ECB will have to start thinking of what policy tools they can politically use in order to calm the fears of the Eurozone countries in the face of slower growth.