Month: December 2018

The main issue of the week is the Federal Reserve Meeting, which will see the Federal Open Market Committee (FOMC) raise rates once again, but the more critical element will be any pointers on the forecast for next year, given recent speeches advising the Fed is closer to a ‘neutral’ rate.

With Wednesday’s session of Federal Reserve policymakers their last of 2018 and, arguably, the most significant. They are predicted to raise rates for the fourth time this year to a range of between 2.25 and 2.50 percent, but is what they signal for next year that should help shape asset allocation decisions for 2019. 

The most recent comments from Jay Powell, the Fed chair, that the level of interest rates are “just below neutral,” was accepted by some investors as a sign that the Fed was readying to employ this week’s meeting as an opportunity to dial back its forecasts for how much further it will raise rates next year. 

Mr Powell’s press conference will be closely scrutinised. Policymakers meet against a backdrop of a flattening yield curve, developing cracks in credit and increased volatility in equities. Investors will watch to see if the central bank is becoming more cautious about the outlook next year for the US economy where the impact of tax cuts will diminish and the risk of slowing global growth prevail.

 

Will it be a quieter week for the pound? 

The pound is set for further turbulence until at least January 21 as unknowns about the UK government’s Brexit plans multiply following a tumultuous week for UK politics and for the currency. 

Sterling picked up both declines and successive gains of about 1.5 percent throughout last week. December 10 proved to the be the third worst trading day of the year for sterling when the currency saw a 1.3 percent decline provoked by UK prime minister Theresa May’s judgment to adjourn a parliamentary vote on the government’s Brexit deal. This sent the pound to its lowest levels against the dollar since April 2017.

In the final week before Christmas, UK gross domestic product (GDP) and consumer price index (CPI), plus US durable goods, are other important data points. Corporate news has practically dried up ahead of the festive season, with only a few names on the calendar.

After four years and a €2.6tn bond-buying binge, the European Central Bank’s experiment in seeking to salvage the Eurozone economy by swelling its balance sheet is about to end.

Few policies have been so contentious during Mario Draghi’s management of the ECB as “quantitative easing” – its vast programme of bond purchases aimed at overcoming economic stagnation.

A parallel of the unorthodox moves by other leading central banks such as the US Federal Reserve and the Bank of England, it was fiercely contested within the Eurozone, where more prudent northern member states did not want to take on the political risks identified with weaker southern counterparts.

Mr Draghi overcame the protests of ECB hawks to impose QE, and last year the Eurozone grew at its most rapid pace since the crisis. With growth in the Eurozone having slowed, and serious risks emanating from within and outside the region, Mr Draghi wants to cement his dovish message that the ECB will continue to reinforce the economy by alternative measures and that monetary policy is still years from normalcy.

But what the bank does with the €2.6tn of bonds acquired under QE is another issue and produces a practical difference to the degree of monetary policy tightening, irrespective of when the ECB adjusts interest rates.

Another factor will be how the bank handles any shift in interest rates – which have been at record lows since the spring of 2016. Its main interest rate is zero while its negative deposit rate means it still costs Eurozone banks 0.4 percent to hold their money within the ECB’s system of national central banks — an enduring manifestation of the topsy-turvy post-crisis world. So far the ECB has declared it expects to keep interest rates on hold “at least through the summer of 2019”. Any deal over new communication is not confirmed.

But, with the data indicating that the region’s growth is waning, economists expect the bank to declare the risks to the economy are now to the downside. Markets have already started to bet that rates will not rise until 2020 and that the reinvestments stemming from QE will continue for two to three years.

Sentiment on world stock markets recovered, with European bourses fighting back from the preceding session’s substantial losses, but investors remained confronted with an interminable list of political risk elements which added to apprehension about slowing global growth.

Nonetheless, returning hopes for an improvement in trade relations between Washington and Beijing – with rumour that China was planning to cut tariffs on US cars – supported European stocks and US futures gain momentum as the session progressed.

That took place after a clear finish for indices in Shanghai and Shenzhen. Wall Street’s S&P 500 was forecast to rise by 0.9 percent.

The Stoxx index tracking European carmakers rose almost 3 percent. But an 18-month closing low for Tokyo’s Topix came as an indication of the wider unease. Expectations for further turbulence continued, not least in the potential context of a disruption of a disorderly Brexit, and unease at Italy’s budget standoff with the EU and strife in France.

The dollar drifted off its highs, with the index tracking it down 0.3 percent and just under 97 points, leaving its year-to-date advance at 5.2 percent. The pound found support — ticking up 0.4 percent to $1.2613 — having fallen to its lowest level since April 2017 on Monday, when parliament’s vote on the government’s deal on the Brexit terms was postponed.

The baffling intricacy of Brexit has put many foreign investors off either buying or selling sterling of late. The latest twist — UK Prime Minister Theresa May’s decision to postpone the parliamentary vote on her EU divorce deal — vindicates those who have opted to stay away.

Asset managers have struggled to generate returns throughout the year and there is little appetite from international investors to jeopardise any profits on the pound — a key factor in the market’s recent inability to push the currency out of its tight recent range.

It is not only the complicated long-term path forward that is foxing overseas investors; jerky intra-day moves are also off-putting.

Hedge funds, normally regarded as the investors most likely to take on tricky bets, are wary of picking a likely direction for the pound when the outcome appears so binary. Choose the wrong path, and those hedge fund managers know they will face awkward questions from clients keen to understand why they had taken on a trade so dominated by political uncertainty.

Even macro funds, which bet on currencies, bonds and stocks, have performed well this year and are unlikely to want to risk their gains on a perceived coin toss. Some funds have tiptoed into options, paying out on either a large fall or a large rally, depending on their view.

Derivatives markets are pricing in a high degree of uncertainty in the pound, with expectations for potential price swings concentrated on the one- and three-month time horizon. Even some who invest in the long term are cautious about buying sterling on the cheap.

The pound has also had to compete for investors’ attention amid a gloomy global growth outlook and the impact of trade tensions between the US and China.

The extended market turbulence has led dealers to ratchet dramatically back bets on Federal Reserve interest rate rises over the impending years, with the biggest implied odds now on a protracted “pause” through 2019….

Fed funds futures, derivatives contracts investors used to speculate on interest rates, now show that there is a 63 percent chance the Fed still raises interest rates later this month — down from over 80 percent in mid-September — and growing prospects of a central bank “pause” through 2019. But the biggest reappraisal of Fed interest rate rises is for 2019, with more investors now deliberating whether the central bank will rest on its hands for most of the year.

Assuming policymakers follow through with a quarter-percentage point increase thereafter in December, Fed funds futures are pricing in approximately a 40 percent chance the central bank doesn’t touch interest rates again next year, and a 33 percent probability the Fed only lifts rates once.

Markets are estimating a bare 2 percent chance that the central bank raises rates by the three times it implied in September. Futures contracts indicate traders now foresee the Fed to cut interest rates further in 2020.

Nervous investors are shying away from taking big risks on the pound because of confusion around Brexit, sending the cost of hedging against future price fluctuations in the currency soaring to its loftiest levels since the UK voted to leave the EU.

The pound has been the prime market bellwether since the 2016 referendum, lifting and dipping in line with each revelation as London and Brussels duel over the terms of withdrawal. But as time ticks away and the political stakes rise, the currency is becoming less erratic, not more.

Sterling has been range-bound in the last few weeks, lingering at about $1.27 since the summer. Even positioning in the currency, which illustrates the direction investors predict the exchange rate to head, has deviated in recent weeks. Investors reduced their bets still further on a depreciating pound last week.

With nervous traders are shifting to the derivatives markets to hedge and hypothesize how Brexit will play out over the next three months. The movement indicates markets expect MPs to vote down Prime Minister Theresa May’s Brexit agreement on December 11 but are less certain what will take place next. Some regard it as already too late to take out insurance.

And what is undeniable is that longer-term investors are assembling on the sidelines, afraid to see their returns for the year threatened by an unstable market.

The FTSE 100 hit a two-year low as fears of disintegration in US-China relations left the benchmark nursing its biggest daily drop since the Brexit vote.

A 3.2 percent deterioration in the blue-chip benchmark took the index back to levels last seen during the during the dot-com boom 18 years ago, in a sell-off that put the FTSE 100 on course for its worst year since the global financial crisis in 2008. 

Similarly, the FTSE 250, which investors hold as more representative of the UK economy, could not avoid the trend and closed down 2.8 percent.  The market having been spooked by the harm an enduring trade war could do to global economic prospects hitting share prices in the UK and abroad. 

The precipitous deterioration in London-listed stocks came alongside the worst day for European equities since the direct aftermath of the 2016 Brexit vote. The broad Stoxx 600 index shed 3.1 percent, with Germany’s Dax falling 3.5 percent and France’s CAC 40 sliding 3.3 percent.

Sterling strength continued the pressure on UK stocks. With falls for the pound having counterbalanced political uncertainty earlier in the year and UK, stocks moved to record highs in May as expected as three-quarters of FTSE 100 constituents’ revenue comes from outside the UK. 

But investors have decreased their bets on the probability of a no-deal Brexit in recent days after the European Court of Justice’s advocate general said Britain can rescind its notice to quit the EU without requesting agreement of other surviving member states. 

Brussels is to set out proposals to enhance the usage of the euro in “strategic sectors” such as energy, commodities and aircraft manufacturing, to confront the pre-eminence of the US dollar as the world’s reserve currency. 

The European Commission has put out a master plan to advocate a “stronger international role” for the euro, as a consequence of the policies sought by Donald Trump, which have highlighted the desire to strengthen the EU’s economic sovereignty. 

The policy framework calls for further political pressure for energy contracts to be denominated in the single currency. And advocates channelling euro-denominated financial trades through registered platforms and promoting the development of an EU payment system. 

Brussels wants EU capitals to safeguard that contracts made within the framework of intergovernmental energy agreements are likewise denominated in euros. Over 80 percent of the EU’s energy imports are priced and paid for in US dollars.

The European Commission is addressing the power of the dollar in the international financial system, noting that it has grown into the prevailing currency for derivative operations. 

Brussels’ strategies include extending the frameworks of the laws that compel some derivatives contracts to be exchanged via platforms known as clearinghouses, to support the formation of liquid pools of euro-denominated securities. 

Its recommendations are, set to be examined by EU leaders at a summit meeting in Brussels later this month. Arguing that stimulating the global adoption of the euro reflects the bloc’s political, economic and financial weight in an increasingly multi-polar world.

Successive rounds of melancholy and enthusiasm have characterised emerging markets over the years and the preceding few months have not departed from this pattern.

Negative factors such as rising US interest rates, a stronger dollar, enhanced global trade concerns and a possible rejigging of global supply chains have prompted a change in attitude. Slowing growth in China and Europe has merely added to the list of apprehensions.

A somewhat indiscriminate sell-off contributed to a bear market – a deterioration of over 20 percent – in EM equity between January and August. The equity market, measured by the MSCI EM index, is now down to 10.3 times forward earnings, from 13 times, with trailing earnings growing in double digits annually. While this ebbing tide has lowered all boats, the upside is that this has produced attractive entry points for some emerging market countries.

Several situations merit scrutiny. For example, Brazil’s political direction has changed following the presidential election victory of Jair Bolsonaro in October. Markets rallied in the run-up to the votes and in their immediate outcome. But the days when Brazil was the twinkling star of the BRIC’s (Brazil, Russia, India and China) seem long passed. After riding the wave of the commodity super-cycle during most of the 2000s, growth has been subdued since 2011.

Turkey and Argentina, which have meanwhile seen sharp depreciation in their currencies, and may be seen as bargains. Argentina passed an ambitious 2019 budget that targets a fiscal balance before interest payments, and some support has returned. The peso gained 10 percent in October and bonds rallied after an improved IMF deal and a more orthodox monetary policy.

Turkish assets have also rebounded but challenges remain. If policies were put in place to provide sustained macroeconomic re-balancing, the equity market has the potential to double.

Yet, instead, the deceleration in growth will be marked and foreign financing needs remain elevated. With public and private debt redemptions now totaling about $65bn for 2019. Yet neither Argentina nor Turkey is out of the woods yet and risks continue to run high.

Powerful trends continue to play out in emerging markets, such as the enlargement of the middle class in Asia. In the next seven years, another 1bn people are expected to join the emerging middle class. Of this, about 90 percent are expected to be Asian, of which about 500m will be Indian and 300m Chinese.

This should continue to reinforce not solely the custom and infrastructure sectors across Asia but likewise the materials and commodity-producing countries, such as Brazil and Russia. These broader themes will help ensure that emerging markets provide compelling investment opportunities in the forthcoming years.

The impetus behind China’s significant determination to open its economy 40 years ago was the desire to entice foreign direct investment. 

Strong inflows followed and helped reconstruct the Chinese economy. But these are now being transcended by a newer font of capital that is flooding into the country’s financial markets. 

The transformation in focus from direct investment into industries towards portfolio flows into stocks and bonds reveals much about how China is advancing and how it is exercising greater sway over the world’s financial system. 

Its domestic stock and bond markets – which rank as the worlds second and third largest, respectively have long been insulated from the outside world because of China’s strict capital controls. 

But this year much has evolved. Foreign asset managers, sovereign wealth funds and central banks have strengthened their total holdings of Chinese domestic stocks and bonds dramatically. 

For the first time, such inflows are running at about the same average monthly level as foreign direct investment, which amounted to $91.8bn in the first nine months of the year. 

There are several reasons for the transformation. One is that by opening investments in renminbi to foreigners, China aims to push for the international usage of the currency so it can cut its dependence on the US dollar.

In the chain reaction of the financial crisis in 2009, Beijing recognized the exorbitant privilege that the US derives by having the world’s reserve currency. And determined to buttress the international presence of its own.

With Chinese bonds now set to be included to international indices that act as benchmarks for big institutional investors, meaning asset managers have limited choice but to expand their exposure in China.