There are no solutions; there are only tradeoffs

Summary

• Narrative update – How does a rate cut in July change the narrative?

• Europe’s problem with negative-yielding debt – More on financial market tourism.

• Update on the Chinese economy – Is there enough gas in the tank to reflate the economy?

Equity markets reacted positively to Fed Chair Powell’s assertion that a July rate cut will be coming. In what appeared to be a "mission accomplished" moment for President Trump, Jerome Powell took a knee to the market and signaled that the next move in the Fed Funds rate would be a cut. Although to be frank, he couldn't have picked the worse week to do it. The incoming data over the last week served to undermine that case for a cut, with US inflation data printing above expectations, jobless claims coming in lower than expected and a blowout number in retail sales. When taken in conjunction with the hot non-farm payrolls a few weeks back and, the fact that Powell had retracted his view that the weakness in inflation was “temporary”, this was a bit of an egg in the face moment for Powell. Regardless, equity markets took the news in stride and, with the rate cut cemented for July, markets may go back to the good news is good news dynamic for the next couple weeks. Notably, bonds were not along for the ride with equities, giving us the first signs that the end of the everything rally we saw in the first half of 2019 is in sight. The move higher in bond yields likely reflects a combination of hedge funds and asset managers taking profits on positions as well as rates reverting to economic fundamentals (after all, the data over the last 2 weeks has been pretty solid). One cause for concern came from the 30-year US auction which showed there was little appetite for US debt at the current rate, sending bond yields higher. Although minor, this is yet another indication that there is some concern that the rates market may be overstating the odds of a cut, and the general push into longer duration assets is stretched. The latest update from the BofA fund managers survey confirms that, as was the case a few weeks ago, long US-treasuries continues to be the most crowded trade on the planet. A similar story unfolded in Europe with German Bunds rallying nearly 15 bps over the week, raising concerns of a 2015 style taper tantrum. The concern from here is that the incoming data, if stronger than expected, has the potential to push bond yields up too far, too fast. This is akin to lightening a match and throwing it into a bunch of kindling, where in this case, the match would be the economic data and the dry kindling would be the stretched positioning in interest rate products. Truth be told, following Powell's testimony, it looks like no one knows what to make of the Fed's reaction function past the July meeting (see chart below). Where we go from here is difficult to say, it appears the market now expects a 30 percent chance of a 50bp cut at the end of the July, highlighting that the market believes the Fed would rather pump stimulus into the system quickly rather than gradually. How the market reacts to a 50 bps will depend on the tone of the statement the FOMC delivers. What would be nice to see in the coming weeks would be the negative correlation between bonds and equities reassert itself, as yields drift higher and equities begin to respond more to the underlying data rather than the promise of a rate cut.

The latest troubling sign in financial markets comes from the high-yield market in Europe, where an increasing amount of debt has begun trading with a negative yield, raising questions about whether the more accommodative policy is capable of reflating the global economy. Recall that last week I mentioned that there was an ever-increasing presence of tourism in financial markets. I highlighted that investors are just dipping their toes in markets that have a higher yield to meet their required rate of return. Well, the latest headlines that a chunk of high-yield debt in Europe is now trading with a negative yield is a clear symptom of these financial market tourists. So something is wrong here – How can a riskier borrower be getting paid to borrow money? The bottom line is, if people are lining up to give you money, as a borrower, you are going to have the upper hand and will have more say on the rate that you get. That’s exactly what’s happening in Europe. These financial market tourists are distorting markets by giving money out to companies that under normal circumstances they would never give money to, thereby compressing the risk premiums. This type of behavior poses a clear financial stability risk in that some companies shouldn't be borrowing at these low rates given their risky nature. Since these market participants are "tourists", companies can't expect them to always be there to buy their debt when they need them to. Interestingly, when you consider all the above (the fact that companies are now able to issue at lower rates because of accommodative policy and increasing demand from financial market tourists), it should come as no surprise that a companies optimal capital structure would shift from equity to debt. All of these headlines that refer to the risks of rising corporate debt are valid, however, companies are just responding to the incentives policymakers have given them. One way in which companies alter their capital structure is by buying back their stock in the market. This is known as a share buyback. This is becoming increasingly popular considering the growing uncertainty regarding trade, with many companies preferring to return money to shareholders rather than risk investing in an environment with uncertain return/payoffs. Buybacks offer a great way for companies to return money to shareholders without having to commit to a dividend, however, they are becoming more expensive as equities continue to push higher. To bring it back full circle here, the main idea is that the search for yield dynamic (financial market tourism) has the potential to fuel even more share buybacks from corporations as their cost of debt continues to fall. In Market update 14 - Depth charge, I mentioned that one key support for the equity market has been the corporate bid (buybacks), which has pushed equity markets higher despite there being little desire from institutional investors to own them (due to late-cycle fears). The search for yield reinforces the case for the summer rally, providing support for buybacks which should eventually drag the institutional investors/asset managers back into the market due to the FOMO (fear of missing out) effect on returns. The chart below is the latest from Marko Kolanovic, head of derivatives strategy at JPM, and shows their inhouse estimates for systematic equity strategy exposure. They argue that there is a strong case for equities to move higher barring there aren't any extreme volatility events (like any further escalation in tariffs). The increasing search for yield dynamic will likely continue to support the US dollar given that US assets continue to remain the cleanest dirty shirt in the market.

With global inflation stalling, the latest data out of China helped allay fears that the Chinese economy isn’t falling off a cliff, although the response from the PBOC will be critical to reflating the global economy. Earlier this year (Market update #8 – Sniffing out the bottom), I was pushing a general reflation narrative wherein global growth had the potential to pick up once the Chinese economy got into gear. Of course, this narrative went off the rails rather quickly once President Trump announced that he was going to go through with US$ 200 bln worth of tariffs on Chinese goods. Since then, the global economy has continued to stumble towards a manufacturing recession with the epicenter of the slowdown coming from China. China has been one of the key drivers of the global economy over the past decade and thus when China gets a cold the rest of the world also coughs. Countries with the most exposure to China (Australia, South Korea, and the Eurozone) remain at the forefront of the global slowdown and, unfortunately, this is likely to persist. The lack of transparency and, for that matter, even a timeline for trade talks, suggests that negotiations will likely be dragged on for quite some time. The longer uncertainty lingers, the longer business investment will stagnate, ultimately lowering the global growth profile. Although central banks have responded by promising/delivering accommodative policy, falling inflation expectations suggest that there is little belief that the accommodation will be enough to reflate the economy. This ties back to the central bank ammo problem in which the belief is that, given that interest rates are so low, there isn't much more room for rates to go much lower. The world has seen what negative interest rates have done to banks in Europe (destroyed their net interest rate margins), and there is a real concern that policymakers are refusing to understand monetary policy and what goes on inside of it. On that somber note, I would like to point out that there is some hope for global inflation. On the margin, we've seen some positive activity data emanating from China which could be an early sign that the accommodative measures the PBOC (People's Bank of China) took earlier this year are working. Now, to what extent this stronger data serves to undermine the broader push for accommodation is yet to be seen. How the PBOC decides to go from here will be key for how global inflation develops over the coming quarters. A kitchen sink style stimulus package would help kickstart the global economy but would risk undoing all of the work that President Xi has done to try and reduce leverage and vulnerabilities in the economy. China's inclusion into the Barclays Bloomberg Global Bond Index and the MSCI World equity index earlier this year highlights the broader push Beijing is making to deepen Chinese financial markets (make them more accessible to foreign investors). Generally speaking, pumping their system with liquidity threatens to undo most of the problems Xi is trying to fix. Tradeoffs I guess, you just can't get away from them.

Tiago Figueiredo