Muddy Waters

….and Broken Britain is basking in a heatwave.

Last week’s US Labour Market report delivered a short-lived rally in yields. However, on reflecting that payroll growth remains robust and business confidence appears to be strengthening, it became apparent that there remains little evidence to substantiate a material slowing in US economic activity for the time being. This being the case, there is little to change the Fed’s recent messaging.

Meanwhile, a move upwards in oil and other commodity prices suggest that incoming inflation data is unlikely to deliver much moderation over the next couple of months. Indeed, building evidence of sticky inflation could make the case for further monetary tightening yet to come.

At the same time, it strikes us that most investors we meet are already positioned long in US duration. This means that yields are vulnerable to another leg higher, should data disappoint, leading to a capitulation with respect to these positions.

Although we can now see some value in 5-year, 5-year forward rates at 4.15%, we therefore continue to think that it is wise to wait until after next week’s CPI data is released before considering whether a tactical long trade in duration may look appealing.

Meetings with policymakers in the Eurozone this week left us with the impression that the growth outlook across the region is set to continue to slip in the coming six months. However, progress on bringing inflation lower is likely to be very slow.

At next week’s ECB meeting, we think that Lagarde will lower growth projections, acknowledging that the downside risk scenario described at the June meeting has played out over the past couple of months.

German factory orders fell last month at the fastest rate for 30 years (aside from the Covid pandemic). In particular, it appears that the German auto sector is struggling with competition from Asian producers, while a reliance on manufactured exports has exposed the economy to downside risks, as activity in China stalls.

The September ECB rate decision is a close call. However, what remains clearer is that it will be difficult to see rates cut next year with inflation likely stuck above the ECB target for a protracted period. In this sense, there is some discussion of stagflation risks amongst policymakers.

It strikes us that some of the optimism we detected earlier this year, after the Continent had avoided a nasty recession last winter on energy supply disruption, has now been replaced by a sense of concern that the Continent may be facing a couple of years of economic stagnation.

Ongoing outperformance of the US economy relative to Europe has led us to favour a long USD versus euro stance. However, with the rate around 1.07, we have started to reduce conviction, as intrinsically we would note that the dollar is at a point of relative over-valuation.

At the same time, it also seems like consensus positioning is now moving long USD and, from this point of view, we are more wary of a reversal.

Elsewhere in FX, it has also been notable to see Chinese authorities seeking to stymie depreciation of the renminbi, by posting a daily ‘fix’ well below the market exchange rate. However, we feel this intervention will only slow, not reverse, the slide in the Chinese currency, with policy still trying to support a weakening economy.

Meanwhile the MoF in Japan has also been verbally intervening to support the value of the yen. Unlike China, the fundamentals in Japan appear very robust and we see the yen as materially undervalued.

However, the Japanese currency continues to be undermined by BoJ policy, which is too accommodative. BoJ stubbornness negates anything which the MoF can effectively say or do, but as this is more widely understood in Tokyo, we think this FX pressure will help hasten a move towards the end of Yield Curve Control.

Meanwhile, it has been a week of pretty negative newsflow in the UK. Trains aren’t running, hospitals are cancelling treatment, our air traffic system suffered a meltdown and now our schools are literally falling apart. Birmingham City Council (Europe’s largest local authority) has declared itself bankrupt, and all around, it seems that a narrative of ‘Broken Britain’ is gathering momentum.

Cash is needed to fix each of these problems, but the deficit is already too high and practically speaking, the cupboard is already pretty bare. Public confidence in the Tory government continues to slip, notwithstanding Cabinet Minsters such as Gillian Keegan screaming that she is doing a’ f***ing good job’.

Politically speaking, it may be tempting to conclude that most of the Brexit-supporting wing of the Tory Party were always ‘a couple of sandwiches short of a picnic’ and so the quality of the current government was always likely to be pretty ropey. Yet it seems on a weekly basis, different Conservatives seem to be outdoing each other in their incompetence.

Given this backdrop, we continue to think that the pound should be vulnerable as the UK economy underperforms, even if this has not played out so far year-to-date. Of course, it is possible that this view of the UK is too negative and recent growth revisions have been higher, not lower. However, this still seems like a view to keep patience with.

Looking ahead

Next week we look forward to the ECB meeting and US CPI data as catalysts to drive price action. For now, we don’t see merit in taking a strong directional view in markets and are left watching and waiting, trying to maintain patience and discipline.

Should a surprise lead to an overshoot in price action then we may have an interesting moment to enter risk positions, but for now we think we can afford to wait for volatility to occur before jumping in. There remains plenty of data uncertainty for the time being.

We expect growth to moderate and interest rates to peak, but with curves inverted and positioning already long, it seems risky to become bullish prematurely at the wrong level.

Meanwhile, it seems like the consensus is now long of credit, with bears having capitulated over the summer. This could also make markets vulnerable to a re-pricing, were we to see a return of volatility.

In some respects, we feel that the narrative for the time being is of ‘muddy waters’. Certainly, this was also the theme at this week’s Burning Man festival in the Nevada desert, which was a complete washout this year, but then, it did not seem to stop some from trying to make the best of it….