Brexual healing

Summary

• Trade talk update — CNY's doing all the talking.

• Trade war feedback loop — Dudley gets dropped from Powell’s Christmas card list.

• Brexit update — Boris Johnson tries to pull a fast one on his opposition.

• Italy’s new coalition — More of the same?

• Pension funds — Rebalancing act.

• Developed markets — Critical week for the US.

Trade news over the week was broadly positive with several ministers from Beijing reinforcing the message that negotiations with the US were still alive. Trade sentiment shifted early Monday morning when President Trump tweeted that he had a phone call with Chinese officials who essentially “begged” him to keep the deal alive. Beijing denied the phone call taking place but was keen on pushing a similar narrative, emphasizing that trade talks for September were still on the table and that China would not retaliate further to the US’ retaliation. There has been a ton of interest on the daily fix of the Chinese Yuan (CNY) with depreciation pressures piling up since August when the US announced US$ 300 billion worth of tariffs on Chinese exports. If China allows its currency to depreciate, it signals a willingness to let the currency to absorb any impact from US tariffs. Ironically, this is exactly what is supposed to happen. One key advantage to a free-floating currency is the ability to insulate the economy from external shocks. Unfortunately, due to President Trump’s hostile remarks that China is depreciating its currency, the market has become increasingly sensitive to changes in China’s Yuan. A fact that became increasingly apparent in August when the CNY broke above 7 USD’s (which was a psychologically important level) and US equities plunged 3 percent (the worse sell-off in 2019). Fast forward to this week and markets are, again, on knifes edge, with all eyes focused on the CNY fix. The PBOC (Peoples Bank of China) has put in far more effort than most analysts expected into stabilizing and supporting the currency. The chart below shows the fix (white line) plotted with a Bloomberg estimate of the CNY based on fundamentals (orange line).

The main factor driving the divergence is the “counter-cyclical adjustment factor” (CCAF) which is essentially just an adjustment the PBOC makes to the current reference rate. What everyone should be focused on is how long China intends to continue setting the reference rate for the CNY significantly lower than fundamentals would dictate. This is unsustainable and many analysts have flagged concerns regarding how much attention the market has given the CNY fix. What’s interesting is that China has many other ways to discourage CNY appreciation and the fact that they are using the CCAF almost serves as a warning shot to the US. Beijing knows that it can sink Wall street overnight if it so chooses to. Work from Bank of America shows that the CNY would need to trade at around 8.20 USD to be able to cushion the blow from all of the tariffs. For the time being, Beijing appears to be content with letting the CNY gradually drift lower. However, should that change and the CNY begins to slide rapidly, that would undoubtedly turn western markets into a dumpster fire. Surprisingly, markets in the far east have held up despite tariffs going into effect over the weekend and the ever-growing unrest in Hong Kong. The national team (the Chinese government) has been less active in the market, allowing the market to revert to more fundamental based trading. Bill Dudley, a former president of the New York Fed, wrote an opinion piece on Bloomberg highlighting the risks of the Fed underwriting the trade war. The piece from Dudley kicks off with a subheading that reads “The central bank should refuse to play along with an economic disaster in the making” and that’s pretty much all you need to know about the piece. What Dudley was trying to get across was that the Fed shouldn't be reacting to the reaction function of the President, it should be reacting to the underlying fundamentals in the economy. He uses the example that “The Fed … wouldn’t hold back on interest rates to compel Congress to provide fiscal stimulus” just like the Fed shouldn’t be concerned that lowering rates will provide the President with the cushion needed to escalate trade tensions. The Fed faces the choice of either enabling the President to continue down this path of trade war escalation or, send a clear signal that the President bears the risk of a recession, not the Fed. Stable monetary policy has allowed for reckless trade policy and if this shift happens, we would undoubtedly see some very volatile markets. This opinion piece could be spun as a politically motivated piece that pushes the Fed to change the status quo. If the Fed stops underwriting the trade war, and the President takes the blame for the slowdown it could have a material impact on the US election. Protests have broken out across the UK as the British Prime Minister, Boris Johnson, pushed through his decision to suspend Parliament for a month — Effectively increasing the odds of a no-deal Brexit. Many of Johnson’s critics have referred to the latest decision to shut down parliament for a month as a thinly-veiled attempt to reduce the time lawmakers have to debate before Britain leaves the European Union (EU).  Although it is common practice for Parliament to be suspended before a new Prime Minister outlines his policies, many have criticized Johnson on the length of the shutdown.  Johnson has promised that Britain will leave the EU on October 31st come hell or high-water and, with parliament being shut down between September 12th to October 14th, it does look like the odds of a no-deal Brexit are now materially higher — Certainly many analysts have now made that their base case. Adding to worries, British manufacturing data, out on Monday, contracted to the lowest level in 7 years amid global trade tensions, a slowing economy and, undoubtedly, Brexit uncertainty. For the most part, these risks are intertwined, but the reality is, with a fraught manufacturing sector and growing uncertainty, the Bank of England may have to come to the rescue. 

The chart above is from Nordea’s Andreas Steno Larsen and shows how the ratio of manufacturing orders to inventory typically tracks BoE policy decisions. With the British Pound down about 3.5 percent since the start of the year, many analysts thought that the manufacturing sector would have bounced back (cheaper imports for foreigners). However, the weaker Pound has resulted in higher input costs for these companies, resulting in a shift from new production to unwinding existing inventories. In any event, the latest manufacturing print will not help allay fears that a no-deal Brexit will plop Britain into a recession. There was plenty of news out of Italy this week as a new coalition was formed between the 5-Star Movement and the Democratic Party. The biggest concern from the previous coalition (formed last year) was their fiscal exuberance and direct disregard for the European Commission’s limits on debt to GDP. For the time being, markets appear to be content with the new party despite the two parties being longstanding political adversaries. The reality is, there's a non-zero probability that this party lasts about as long as the proverbial “cat on a highway” as one analyst from Citi group put it. The news pushed Italian blue-chip stocks higher and Italian banks also rallied. The Italian 10-year bond reached a new low, trading below 1 percent. Now, some of the more astute readers may realize that the US (paying 1.5 percent) pays more to borrow than Italy, a far riskier country. That’s not entirely accurate, the two yields are quoted in their respective currencies and aren’t equivalent but, make no mistake, this still seems very low for how uncertain the Italian government’s future is. While markets appear to be happy that things haven’t gotten worse on the trade front, it’s tough to chalk up this weeks performance to just trade developments. This past month has been the best month for global bonds since the 2016 Brexit referendum. As a result, many pensions funds had to rebalance their portfolios by selling bonds and purchasing equities. Morgan Stanley has estimated roughly $US 30 to 40 billion inflows into equities from pensions in this last week of August/ first week of September. They also estimated around US$ 70 billion since the start of August has been rotated into equities. Luke Kawa, a cross-asset reporter at Bloomberg, noted that US companies with the most exposure to China underperformed the broader market. Reinforcing the above narrative. The chart below shows the relative performance of both.

September kicks off another round of trade escalations, aggravating the global slowdown and putting greater pressure on global central banks to ease. Both China and the US have increased tariffs, increasing the pressure for companies to attempt to redesign global supply chains. There might be some benefits from reallocation but the primary impulse is expected to result in a weaker growth profile. The shock to growth should result in deflationary pressure however, not all shocks are made equally (something the Bank of Canada pointed out in their last monetary policy report). A tariff shock does have the potential to increase inflation, although, in this case, the pass-through is broadly expected to be disinflationary. Forward guidance from the Fed and ECB have guaranteed some form of further accommodation in September. The ECB is set against an ever increasingly fraught backdrop where their workhorse, the German economy, has contracted for the second time in 4 quarters. The latest inflation prints out of Europe paint a similar picture in which the ECB is grossly below their inflation target and expectations continue to remain on the lower end. The US has a busy week with consumer sentiment, manufacturing, and jobs data all being released this week. The data should help paint a clearer picture of how the economy is reacting to elevated trade tensions. At some point, the performance of the economy is going to start to feed through to the Campaign rhetoric of presidential candidates. If the data misses this week, it will represent a kick to the stomach for the President and stoke further concerns of a recession given the recent inversion of the 2s10s curve. This week will also bring us a barrage of Fed speakers with Powell closing out the week before the Fed goes into a communication blackout. Meanwhile, in Canada, the Bank of Canada is widely expected to keep rates unchanged on Wednesday. America's hat has held up fairly well given the amount of exposure Canada has to the global economy. With that said, if things get worse in the US and the global backdrop doesn’t improve, it will be just a matter of time before the BoC joins the bevy of doves. Speaking of doves, the RBA (Reserve Bank of Australia) is also expected to keep rates on hold tomorrow. For what it's worth, many analysts are calling for a rally in equities. This is predicated on a combination of flows from pension funds rebalancing over the next few weeks and the continuation of trade talks. I’ll give you guys a break from talking about gamma this week — sorry to the propellor heads.  Tiago Figueiredo