Introduction
The FY 2018 has nearly come to an end and heavily hit the equity markets, as most indexes look like they will close below their opening at the beginning of the year. Three factors weighted heavily on the on 2018.
- Transition from mid to late cycle, with central banks pulling back on years of loose monetary policy. Last time this year central bank purchases government bonds were running at a pace of $2 trillion per annum. Today the number is zero and by Q1-2019, central banks will be net sellers
- Economies did not match expected growth. Beginning of this year expectations were high for synchronized growth. Nonetheless this year was coined by the divergence between the U.S. growth and the disappointing growth in pretty much the rest of the world.
- Geopolitical conflicts took the main stage, most prolific the trade-wars and the formation of a populist movement in Italy.
Economic Outlook
It is written in the stars whether 2019 will be the transition year of central bank late cycle into economic recession or not. Taking a look at the deflated markets there might actually be some upside to equities in 2019. More generally, the mix of low returns and higher volatility should again be a central feature. Unlike 2018, there is a high possibility of that pockets of value in fixed income will develop, notably in front-end USD and EUR. Furthermore the strategic risk-reward is shifting away from outright selling of fixed income and into steepeners. For broader markets, the market consensus seems to be that the dollar trend will turn down, though it may not be evident early on in either the euro or the yen.
Before setting out some possible themes and trades for 2019, we will shortly revise the main macro assumptions that we will be operating under.
Growth: neutral but with a modest upside flavor. While it may not feel that way, global growth in 2018 was likely the strongest since 2014 (3.8%, up from 3.7% in 2017). The trouble is the better growth was highly skewed toward the US, and much of this year has been spent revising (mostly to the downside) forecasts in much of the rest of the world. Some of the markets consensuses, while mildly upbeat are:
- In the US, we think strong supply side positives from the combination of deregulation and the 2018 tax reform will help sustain the recovery for longer than many think, even if we see growth slowing from 2018 levels.
- China is as tricky and sensible as it gets. Nonetheless the belief is that policymakers are expected to avoid any slippage in growth and that they will be successful at it.
- In the Eurozone, fiscal policy support (after years of drag) will help offset some of the external drags. Expect growth to stabilize.
- In the UK, growth forecast have been increased to 1.9% (from 1.6%) on a benign Brexit outcome and fiscal policy boost
Inflation: contained, but with material upside risks. Despite the pick-up in wages seen in many developed economies, there is still little risk of pass-through to headline inflation. Oil will also be a net negative for headline inflation rates next year, although prices are expected to stabilize and rise very modestly in 2019.
Monetary policy: less negative, if not yet positive. Uncertainty around monetary policy is especially high heading into 2019, though on balance the headwinds should feel less fierce than in 2018. To be sure, US quantitative tightening will remain in full swing and the Fed is not expected to end its balance sheet reduction until 2020. This means central banks will be net sellers for fixed income for the first time in a year. Against this interest rate policies will be mildly dovish, on balance:
- The FOMC will only hike twice in 2019, hence signalling a pause in the 3-year tightening cycle.
- The ECB and BOJ will hold rates steady again.
- The Bank of England will raises rates once in 2019 and once in 2020
- The RBA and Riksbank join the policy normalizers; not the RBNZ
Geopolitics: a big swing factor? The geopolitical calendar in 2019 is a busy one and the risks around the key events are finely balanced. Importantly, markets have not been especially good at trading geopolitical risks in 2018 and it is hard to see why this would improve in 2019.
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- US/CHINA relation. These two countries have been at it for quite a while and there is no reason to believe that this Tango will end anytime soon.
- Similarly no easy end to the current stalemate between the Italian Government and Brussels is to be expected. The May European Elections will be a key barometer of where integration is heading and there is no reason for optimism.
- On BREXIT, the base case assumes a more market-friendly outcome in the next term. But uncertainty is high and longer-term risks are still significant.
- Market Volatility
Looking back, the expected late cycle pick-up in volatility did arrive in 2018, though not always in the way envisioned. It came in a series of waves, rather than as a discrete event. Until very recently, the rise in macro implied volatility was still rather modest. And importantly, the increase in volatility was barely notable in interest rate markets. In the end, rising yields was a key driver for higher market volatility, although for the most part higher yields caused volatility shocks elsewhere, such as US equities (twice) and emerging markets.
Looking ahead, the case for a sustained period of higher volatility is still strong. Simply put, this is the time of the cycle when financial fragilities tend to be exposed. The figure below depicts a lagged measure of Fed accommodation against equity volatility (VIX). The two key takeaways are (1) Fed policy is getting closer to neutral and, given this, (2) implied volatility is likely to move higher than it is today. US equities in particular have been shielded from the macro headwinds thanks to the lingering effects of the 2017 US tax reform. But these factors will fade heading into 2019. Inevitably the mix of volatility in 2019 will be different than it was this year. This leads to the conclusion that rates volatility will play a bigger role next year as policy and economic uncertainty, inflation risks and supply begin to chip away at a prolonged period of compressed term premia and low inflation.
Steepening Curves in 2019
In the past few months the debate with regard to the relative risk rewards of USD 5s30s steepeners compared with outright selling of USD back-end rates has been intensive. The general view has been that both make sense, but as we head into 2019 the steepener trade looks the better risk-reward on the medium-run horizon. Looking ahead to 2019, with a mature, and potentially cresting, US economic expansion and the Fed reaching a potential inflection point as rates hit neutral, the year-ahead possibilities are perhaps more two-way than they have been since the immediate aftermath of the crisis. Does the expansion continue into overheat territory as the Fed stops at neutral and/or the Phillips’ curve finally starts to take hold? Do we experience a “Goldilocks” expansion period as supply-side productivity gains allow growth to continue absent inflation pressure? Or does an overly aggressive Fed, trade war, overseas risks, equity correction, or a combination of any of these or more send us into recession? In 2019 the market sentiment will swing frequently and at times wildly between all three scenarios depending on the economic and political developments. Nonetheless similarly to last year to last year there is a high conviction on the shape of the curve. This is why steepeners, more specifically 5s30s can be specifically profitable. The main arguments for this strategic approach are:
- Fed Priced In: Since the summer, the major push back to a steepening strategy view has been that the curve always flattens in a hiking cycle, and that the current hiking cycle will continue into 2019. While certainly true, the market is largely priced for this. OIS markets are currently priced for ~2.5 more hikes by year-end 2019 (including a likely hike at this month’s FOMC meeting), which would put the Fed funds rate at the low-end of what is considered to be the Fed’s “neutral” zone. On the curve, end of 2019 forwards are still priced for 2s10s at ~20bps and 5s30s at ~35bps. In addition, if one looks at the 2004-2006 hiking cycle, the curve flattening hit its trough in February 2006, about 4/5s of the way through the cycle with 4 months and 3 hikes left to go. From the start of the hiking cycle, to February 2006, 5s30s flattened by ~170bps. Over the last four months of the hiking cycle (which saw another 75bps of hikes) 5s30s actually steepened by a little over 20bps.
- Term Premium: The belief is that in 2019, we will see term premium injected back into the Treasury market. Since the 1970s, term premium has, in our view, been on a long-term downward trend due to increased central bank transparency and credibility, culminating in post-crisis forward guidance and a secular move lower in the uncertainty related to both monetary policy and economic data. However, as the chart below shows (plotted from 1990), within that long term decline, term premium bottoms into or near the first Fed rate cut of a cycle, with the notable exception being the Taper Tantrum. The belief is that we may be at or near that part of the rate cycle, even if we aren’t necessarily forecasting a turn towards recession in 2019. But with market participants increasingly split over the near- to medium-term direction of the economy and markets (overheating/Goldilocks/recession), investors will need to be compensated for rising two-way risk, pushing term premium higher. Additionally, as the Fed moves towards data dependence, and away from forward guidance, central bank transparency will decline and the range of potential Fed outcomes should widen. Term premium should rise on this basis alone.
- Volatility: While it is not clear which leads, term premium and implied volatility tend to move together. Conceptually, both implied volatility and term premium can be interpreted as investor compensation for uncertainty. To that end, increasing uncertainty, as discussed in the prior bullet, should lead to higher volatility, something we have already seen in FX and equity markets. In 2019, higher rate volatility as well, additionally supported by slower growth in the US and, in some cases, the slowing expansion of, or outright decline in, central bank balance sheets are to be expected.
- Supply: In the long end, markets should remain concerned about increasing Treasury supply, as the Treasury is expected to take a pause on increasing nominal auction sizes at some point in 2019. Nonetheless the market could interpret such a pause as a “pullback” in supply, and in turn bullish for rates. But Treasury’s monthly gross coupon issuance will still be significantly higher than it was at the beginning of 2018 – meaning that even if Treasury pauses or slows the increases in auction sizes for some time, the amount of outstanding Treasury debt will still be growing at a rapid pace. Importantly, these headwinds are apparent even though no major fiscal policy expansion is expected in 2019, given Congressional gridlock. The expectation is that the growth in outstanding Treasury debt weighs most heavily on the back-end. Thus far, from a par perspective, Treasury has increased front-end auction sizes the most. But when taking into account duration, and the maturity/rolldown profile of existing Treasury debt held by the public (ex-Fed), the back-end will be growing at a faster pace than other sectors. For example, by the end of 2020, the size of the 10- to 30-year sector that is held by the public is expected to grow by ~58% since the beginning of 2018.
- Demand: In addition, there are reasons to remain very concerned about foreign demand for the Treasury market, particularly in the context of rising supply. This concern is especially focused at the long end, where foreign investors are already infrequent buyers of 30yr Treasury bonds (since January 2016, foreign investors have bought an average of 9.5% of 30yr bonds at auction). But, with both prohibitive hedging costs and questions about the durability of the USD rally into 2019, foreign demand will be tepid across the curve going forward, at a time the supply outlook means the US needs additional buyers more than ever.
In sum, the front end of the US curve is already priced for additional Fed action from here on. Supply and demand dynamics, along with the possibility of term premium returning, point to a steepening bias in 2019. The expression of this could be a 5s30s curve, given the view that the long-end will be more impacted by supply and looks even less attractive to foreign buyers.
Italy and Europe
2019 is likely to be another year dominated by politics in Europe, and politics will be dominated by Italy, as every widening in BTPs, every interaction with the Commission, and every political event will be seen as a de-escalation, or a step toward the Italexit event horizon. Markets are already very pessimistic, nonetheless the direction of travel is toward greater pessimism and wider spreads – too much can go wrong between now and European elections, which will be seen largely as a trial run for Italian elections. Nonetheless concerns about a 2012-style contagion seem low.
With no surprise most market participants have been short BTPs. For those looking for proxies with better carry: short EUR FX (vs CHF or JPY), long EUR FX volatility, short Austria, long Schatz.
Euro Exit = (Crisis + Euroscepticism)
One thing is certain: a country leaving the euro will only do so in the midst of a crisis, supercharged by capital flight. But would the decision to leave be the cause of that crisis or the response to it? The concern is, of course, that the process is non-linear; that a country might be sucked increasingly quickly toward a point of no-return, as economic pain, Euroscepticism, and capital flight feed on each other. Italy is the only country in Europe where such a process looks like it could gather speed in the near future. It is not in crisis now, but shocks are unpredictable, it is already relatively Eurosceptic, and markets are on edge. Of course, if a level of crisis is a necessary condition to set such a circle in motion, a crisis in Italy could easily become a crisis in other countries too. We look at contagion risks below because Euro break up is not only a BTP theme. It has been the major theme of 2018, and looks likely to be the major theme for European markets again in 2019.
How much bad news is in the price?
An approach to this framework is to directly look at the probabilities of Italexit and possible losses given default. The table below shows that markets attribute Italexit a probability of 30-40% in the next ten years, depending on the LGD on the BTPs ( compared to an alternative of holding bunds).
A guide to anticipating an Italian crisis in 2019
But what about the tactics, if you’re interested in direction of travel? There are no great secrets here. Trying to think in a possible escalation sequence, some of the accelerators to have in mind include:
BTP idiosyncratic risks. BTPs do not just reflect expectations. They have real effects. Wider spreads feed into broad financial conditions, are constantly commented in the press, and tempt politicians to blame Eurocrats for weaponising the markets against them. BTP idiosyncratic risks are the most likely early crisis-accelerators, in particular:
- A failed BTP auction or a poor syndication could quickly turn uncertainty into something much more serious. The new government entered in late May, and has enjoyed lighter H2 supply so far. This is expected to step up in January.
- Ratings downgrades are likely in 2019. Fitch and S&P did not move this year, although S&P downgraded its outlook to negative in October. Italy is two notches above ‘junk’ with these two, while the buffer is just one notch with Moody’s. The next reviews may be around March. A downgrade to a middle rating below BBB-would risk unlocking substantial selling, especially of the ~€630bn of BTPs held abroad.
Debt sustainability concerns. There is no magic level where markets might start to worry about the long-term affordability of Italy’s debt. The chart above illustrate that debt sustainability is not at the core of any budding crisis at this point. Italy rolls about 15% of its debt every year, so the average cost of financing does not rise exceptionally quickly even if markets demand higher yields in a challenging year.
Government ‘reaction function’ to market/economic stress. Finance minister, Giovanni Tria, indicated that 400bp in 10y BTP/bund spreads might be a level where action would be taken to reduce pressure on financial conditions. Although that does not imply budget cuts, markets might expect something in that direction if that level were tested. Conversely, if nothing were done, confidence could leak away quickly. Mr Tria has also recently assured markets that there is a ‘safeguard cushion’ to guard against budget slippage if growth disappoints and that 2.4% is a ‘maximum ceiling’. The way this is spelled out in a final law could be important for restoring Mr Tria and Italy’s credibility with markets.
Global/European growth. External demand is important for Italy: export demand adds up to 26% of GDP. Slower growth increases the likelihood of budget slippage, confrontation with the Commission, and ultimately Italian sentiment toward Europe and the Establishment. The debt sustainability analyses that show debt/GDP continuing to fall in coming years rely on some economic growth.
European elections… Salvini’s League and the French Front National explicitly intend to sit together in the European Parliament, and others could switch from current formations to join them. It is unlikely that ‘Eurosceptics’ would be able to form the largest bloc. But they may be significant enough to present a serious challenge to the European order, making further progress on reforms to strengthen European contagion firewalls and financial stability almost unthinkable.
… and European elections as warm-up act to Italian elections. New elections are likely in Italy in 2019, especially if a right/centre-right coalition can sustain 45% or more in the polls. The European Parliament campaign will be a key test of how far the League and M5S will try to develop and exploit eurosceptic feeling, and their results will be a vital test of how successfully such strategies might be carried into national elections.
In/out referendum. The end game for Italexit would almost certainly involve a referendum, if a government does not wish to be accused of staging a coup. In Italy, a binding referendum on an international treaty is unconstitutional (article 75). A non-binding advisory referendum would be possible, however (the vote on EEC membership in 1989 is a precedent). Greece’s 2015 bailout referendum, which was eventually ignored, and the UK’s 2016 Brexit referendum, which was not, were both non-binding. A promise to present a referendum would dramatically raise risks in the short-term.
Italexit as campaign pledge? Could we jump straight to the end game like this? Unless elections were held in deep economic crisis, this is surely highly unlikely. Could it just be good tactics for a politician who has already concluded that leaving is in the national interest to try to accelerate the agenda by causing a crisis? This is far-fetched. A risky policy is more likely to cause trouble the more markets think you will be in a position to carry it out. But the more likely you are to win, the less you will want to cause trouble that may just complicate things for you. Although Mr Salvini enjoyed campaigning in a ‘Basta Euro’ t-shirt in 2017, that was before he became the leader of the centre-right and serious contender to be next prime minister.
What about crisis-brakes?
Investor risk appetite. As with any positive carry trade, BTPs are expected to tighten if the risks outlined simply fail to emerge. This would naturally put the crisis- Euroscepticism spiral into reverse.
TLTRO-iii. The ECB will probably have to offer long-term funding to guard against worsening in financial conditions in Italy, and to replace TLTRO-ii money before it slips below one year maturity. Markets expect an announcement in March or April and tender in June. This may encourage carry trading, at least short-term in short-dated paper. It is possible that the ECB will design incentives carefully to encourage banks to behave as it would like them to, which, if effective, may discourage sovereign carry trades.
Early elections. Early (H1) elections are unlikely, but could raise the possibility of a right/centre-right coalition to replace the populist coalition. This may be welcomed by markets because it would concentrate accountability and replace the M5S with partners perceived as more business-friendly and less eager to raise spending.
Contagion
Interlinkages: Opacity, Bubbles, Finance, trade, and the Eurosystem. It is worth recalling that contagion in the Subprime Crisis and the Sovereign Crisis alike was rife largely due strong but opaque financial-sector interlinkages. Asset price bubbles and private leverage were a key vulnerability, especially in Spain. Spanish households and firms have cut debt by over 60pp of GDP since 2010?
i) Finance. Even though the ECB has made an effort to buy back most of the Italian debt, markets will seek out direct financial interlinkages most quickly. Spain and France are the most exposed. Total portfolio and FDI exposures sum to around 8% of GDP in both cases. As a cross check, the BIS puts French banks’ consolidated exposures to Italy at €270bn (11% of GDP). But a large part of this will be due to local claims of separately capitalised and funded subsidiaries such as BNL and Cariparma. Consolidated claims of Spanish banks on Italy are 5% of GDP.
ii) Trade. Italy as a consumer market for a remaining EMU would clearly suffer in Italexit. Total exports to Italy from other EMU countries, of which only a proportion will represent final demand, are around €175bn (1.7% of GDP). The most exposed countries are The Netherlands (3.3%), followed by Germany and Spain (2%). A competitive devaluation in the case of Italexit would risk stealing market share from other EMU countries across industries, but might be fought against via trade policy.
iii) Eurosystem holdings. BTPs held by the ECB and Eurosystem are probably not big enough to be systemic. Europe’s ‘big’ exposure to Italy is the Target 2 balance (€489bn in September, see sidebar). We assume that in any break-up, the ECB would be able to monetize a loss in such a way that this would not become a systemic problem.
Firewalls: ECB OMT, PSPP, and the ESM
If Italy finds itself under pressure but does not want to leave the Euro, OMT and the ESM are almost certainly enough to cope. Italexit is a risk only if the strings attached are unconscionable. The key question, therefore, is whether firewalls are large enough to protect the rest of the currency area from Italexit contagion.
National budgets. The first line of defence would be the national budgets. The commission will surely allow significant forbearance in the surveillance process for such an event and cross-border exposures are not so large that it is clear the cost of an Italexit crisis would push debt/GDP to levels where markets would cease to finance. Portugal is a possible exception, but its direct exposure to Italy is relatively low.
ECB PSPP/OMT, and ESM. If this is too sanguine, in such a crisis, the ECB could use its deep pockets to support in several ways. Indirectly, re-starting quantitative easing would be very likely to be justified by the inevitable deterioration in economic conditions. In principle there is little doubt about the capacity of OMT to smooth through any Italexit turmoil together with the ESM, whose €400bn lending capacity is prima facie more than enough to guard against Italexit contagion, even allowing that this headline figure would be reduced due to questions over some of its major shareholders in a crisis. The fly in the ointment is both OMT and ESM support would require an ESM programme to be approved. Italy, with its 17.8% of ESM voting rights could veto any such programme and may find that it is in its strategic interest to threaten maximum disruption in any exit process.
Trading Italexit
Short BTPs. There is a near-term upside risk for BTPs because November has been a hard month, while in December PSPP flows are friendly and political risk may quiet down. But into next year the high probability of too many of the risks listed above materialising to be sanguine. In particular, we do not expect the budget to embed any formal brakes. Economic downturn makes budget slippage likely. A spiral of escalation between a hardline Commission and scapegoating by the government is foreseeable, which could heighten tensions into the European Parliament elections, where we expect populist-nationalists to perform well.
Trade recommendation: Short 10y BTPs vs 10y Germany at 287bp. Target 400bp. Stop at 265bp. Carry and roll down to be short is -20bp/month.
Top contagion trade? Short EUR FX, long EUR FX volatility, Short Austria, long Schatz. The multi-asset screener (published by Deutsche Bank) below highlights possible value in banks and periphery as lower-carry trades to proxy a short BTP view. Iberia and banks look like they might be susceptible to some catch-up with BTP spreads.
Where the cost of a short is the cost of carry, it is natural to consider this the ‘premium for an option on Italexit escalation’, and we can work out a ‘payout ratio’ for a terminal scenario to compare them. A number of flight-to-quality trades are likely to benefit from Italexit and offer positive carry or flat carry, however.
- Benchmark: short BTPs. 10y BTPs carry and roll around 15bp per quarter negative (to be short). With BTPs at 308bp this gives a scenario payout ratio of 11.5x.
- The best contagion trades are in currencies. In particular, short EUR against risk-off currencies such as CHF and JPY, although long USDEUR should also work and it is a trade you are paid to hold.
6. Brexit – Deal or no Deal?
For all that is known, the Brexit has been discussed from all angles possible. In their current form, the proposed Withdrawal Treaty (WT) and Future Framework (FF) political declaration suggest a ‘softer’ Brexit outcome relative to current market pricing. Any extended transition period (into 2022, say) – where the UK has left the EU but retains status quo access to the Single European Market (SEM) – would further reinforce this, even if the eventual long-run economic settlement is more accurately depicted as a ‘harder’ Brexit. Some of the favourite trades (with fat-tails payoff) are:
Trade 1: pay Nov2019 SONIA, more risk inclined investors may want to add paying Feb19 SONIA
November 2019 MPC-dated SONIA only discounts 21bp of rate hikes. It seems a very strong view that the MPC will hike if they have resolution of Brexit in a pro-risk manner, and whereas markets call has previously been May 2019 for the next hike, there is every prospect of February being the date. Given there is just 4bp discounted in February 2019, this is good risk/reward as a pay.
Paying November 2019 SONIA, discounting 21bp of hikes, seems an even safer way to play this, and will still profit from any February move (which surely will see a full extra hike discounted in 2019). A May hike will still see this make ~20bp profit.
Trade 2: 3s20s flatteners in Gilts
3-yr Gilts are the richest point on the curve, trading around the repo rate already (0.75%), which is itself set to rise on resolution amid markets revising up growth forecasts. In the absence of global recession this value is just not justified, and this as a stringent global growth bearish author. Moreover, 3-yr Gilts are not eligible for the 2019 buybacks that occur (the BoE will only buy Gilts > 3 years to maturity). The biggest redemption in the next three years occurs in March, and the BoE cash holding of £20.6bn will be immediately reinvested via QE of a likely £3bn/week (our trading desk estimate). This QE is very important to note in a world which is tightening liquidity conditions (eg the US balance sheet is shrinking), and a reason our shorts vs Europe are at the front end and not along the curve.
Meanwhile, 20y rolls better than 30y, and in buyback scenario analysis in past years has been shown to be a strong performer when buybacks are ongoing. Long 20y carries & rolls marginally better than 30y, so at the margin is a better long point, especially when we see global forces steepening up 10s30s curves in Europe, US and Japan – if possible we will avoid the 30y point. This costs 0.7bp/3m carry and roll to run.
Trade 3: pay 1y1y UK inflation at all-time highs. A 100bp home run trade
Trades like these they do not appear to often and those seeking them just pay away premia for events that do not transpire. The newest possible home run trade could be a 100bp mover. Pay 1y1y inflation in the UK at 3.74%. This looks strong risk/reward. It trades more or less at an all-time high and has recently spiked as markets have become wary of a ‘risk off’ Brexit. This is just WRONG. And shows that the memory of the market is too short. Inflation is peaking in the UK anyway, economist forecasts a peak in next two months of 3.4%yoy, before gently gliding down to 3.0% at the end of 2019. Moreover, no demons are predicted in the data, with another 3.0%yoy forecast for 2020. I submit that if we are at 3% on a gentle glide down all summer/autumn, which makes for falling inflation volatility, markets will not price 1y1y inflation much above 3%, and perhaps a bit lower. A target of 3% would mean 75bp value, and a move to 2.75% would unlock 100bp of value. It is rare to suggest that there is 100bp of value in anything (unless making a major call such as short credit as big macro theme). There is one major mistake the markets are making, namely that a harder Brexit is risk off and means weaker FX and higher CPI. It does not. Yes, import prices will rise as FX falls, but corporates will be the buffer to the consumer, because we will be in recession conditions. In 1992, the pound ended its ill-fated membership of the Exchange Rate Mechanism. The 16% fall in trade-weighted sterling led a consensus calling for inflation to take off. Markets called this 100% wrong, because the UK was coming out of recession and there was no ability to pass through the import price rises. UK RPI dropped from 4% in summer 1992 to 3.2% by end 1992 and troughed at 1.2% in mid 1993. Crushed. It is extremely unlikely to be any different now. A hard Brexit scenario and big fall in £ is surely associated with weaker growth – our call is recession on no deal/hard Brexit. As such, we have a glorious opportunity to fade everyone who has put 2 and 2 together and got 5, without looking at the underlying economy, and just looking at a normal import prices vs CPI chart, which in any NORMAL circumstances will be well correlated.
FX trades: Sterling – risk premium to be squeezed
The evolution of relative Brexit outcome probabilities in the latter part of November – a greater likelihood of a ‘softer’ Brexit outcome (a WT with an extended transition period or a ‘remain’ vote) vs a ‘harder’ Brexit outcome (No Deal or a revised, minimalist Eurosceptic WT) – suggest Sterling valuations should be higher.
Fundamentally, Sterling has been seen through the lens of the risk premium, which in turn is almost solely a function of uncertainty. With more uncertainty, the greater the risk premium and the weaker Sterling has become. For sure, uncertainty is extremely high. But, at some point, valuations will reflect a probabilistic model of outcomes. This is where the value lies in owning Sterling.
A greater likelihood of “remain” or a “soft-Brexit” outcome and a much reduced chance of “no deal” Brexit suggest Sterling valuations should be higher; potentially considerably higher. Reduced uncertainty can also see a greater focus on a much-improved twin deficit metrics and possible BoE rate hikes.
This leaves low delta GBP/USD calls in a favourable position. In spot we forecast for a change in Sterling sentiment as uncertainty declines, through short EUR/GBP and long GBP/CAD positions. The latter position chimes with our core North American theme of late cycle policy tightening and ebbing growth. EUR/GBP reflects our expectation that political risks will shift to the Euro area in ’19 and ECB policy normalisation is delayed.
Trade 4: Short EUR/GBP | Target 0.84, Stop 0.9150. Spot reference 0.8890
Trade 5: Long GBP/CAD | Target 1.8450, Stop 1.6350. Spot reference 1.6940
Trade 6: GBP/USD 6 Month 1.50 Digital Call = 4.0% (spot ref) 1.2828
The asymmetric (upside) risks to inflation
While the base case is no meaningful pick-up in inflation in 2019, risks are skewed to the upside when markets are not pricing much change. Late cycle pick up in wage growth and an easing in fiscal policy just as economies reach full employment. At the secular level, the combination of populism and trade protectionism is inflationary, all else equal. Possible volatility trades could be 5y5y USD BEIs, SPGBei23s and 10y10y USD volatility.
In most countries, inflation has consistently come in below forecasts from analysts and, more importantly, central banks – on balance. 2018 was no exception (see figure below). The bias on inflation has also made markets more inclined to be bullish bonds, with the US a key exception last year. Economists are again calling for a generally tame outcome for inflation in 2019. While US core inflation is expected to remain above the Fed’s forecast there is no case for any further acceleration. Cyclical and secular forces of disinflation are weakening
That said, we can’t help but think the risks around the inflation base case are significantly skewed to the upside. The reason is that many of the cyclical and secular forces of low inflation are under threat. Importantly, markets are not priced for much deviation from this low and stable inflation equilibrium. In the US for instance, both 10y term premia and interest rate volatility are at or very near record lows dating back to the 1960s. Inflation markets seem equally unfazed judging from most breakeven inflation curves.
So just what are these forces of disinflation that are beginning to turn? Let’s start with the cyclical drivers:
- The G10 unemployment rate is currently at its lowest level since 1974. It is hard to know what the right “full employment” level is and there are measures such as the employment-to-population ratio in the US which imply labour markets are less tight than they seem. Still, from its peak in 2010 of 8.1%), G10 unemployment has been falling by nearly 0.5% per year, the fastest, most persistent decline in unemployment since the 1960s.
- More compellingly, there are signs of stronger wage growth in many advanced economies. The BIS Global Wage Heat Map below shows the general trend in wages has been mostly up in 2018. Indeed, as we look back on this year, this broad-based improvement in wages is surely high on the list of potentially important and certainly surprising (to many) macro trends.
- Fiscal policy is turning more growth supportive – at a very late stage of the business cycle. Naturally, much of the focus of fiscal policy has been on the US. Indeed, today’s gap between the unemployment rate and the budget deficit has only been repeated once in post WWII history, in the late 1960s. Ironically, that was a similar period of inflation complacency. But the tilt toward easy fiscal policy (and away from easy monetary policy) is not just a US phenomenon. The swing from fiscal tightening to loosening in Italy will be more than 1% of GDP. In the UK the figure is close to 0.7%. Even Germany is expected to loosen fiscal policy in 2019.
A few trades that look interesting to take advantage of these asymmetric risks include:
- Buy USD 10y10y volatility. Very attractive valuations, cheap carry and less supply of vega in 2019 make this trade good risk reward.
- Buy US 5y5y inflation either via TIPS breakeven or inflation swaps: attractive entry levels, a stabilization in oil prices and increased supply in 2019 imply good risk-reward for positioning for upside inflation risks.
- Buy SPGBei23s at 91bp on breakeven. Target 135bp. Six-month roll and carry is approximately +12bp at trend inflation of 1.2%.
Global EM: long deficit high yielders vs. short commodity low yielders
In 2019, trading global EM FX will be about the balance between the expected flow of global savings and the nature of synchronised global growth. Savings are expected to ‘Crowd In’ to high carry EM deficit countries once the market recognises that US growth is rewarding savings less for funding the US twin deficit. Synchronised global growth to continue to unwind, which would leave us bearish on lower carry EM countries which are exposed to manufacturing and commodities is expected. In CEEMEA long TRY/ZAR, in LatAm long BRL/CLP and in Asia long IDR/CNH.
The story of 2018 for EM was a liquidity shock driven by US fiscal issuance (Crowding Out) and the Fed’s Quantitative Tightening (The Portfolio Balance Channel). According to Jim McCormick current account, real policy rate and REER buffers mean that EM can now absorb those shocks better than in the past. EM now offers better protection and compensation for deteriorating global liquidity. Counterintuitively, ‘Crowding In’ implies global savings will favour EM deficit countries. EMs most dependent on capital imports will actually attract most capital because of valuations and growth potential vs. commodity EM. $463bn of net global savings will seek the best expected relative return. Peak US growth in combination with cheap EM assets means the US twin deficits will struggle for funding relative to the rest of the world. Synchronised global growth will likely continue to unwind in 2019, as global growth decelerates from 3.8% to 3.6%.
The key point to make there is that last year two thirds of the improvement in global growth came from the commodity producing economies across G10 and EM. The boom was highly commodity and manufacturing intensive, so the slowdown will likely see those economies suffer more on a relative basis. CNH shows high manufacturing (29%) and Global Value Chain (48%) exposure, while CLP and ZAR have high commodity exposure (68% and 44% respectively). So we go short those on RV.
At the same time as the housing, capex, manufacturing and auto data have softened in the US, aggregate EM fundamentals have fared relatively well, with EM return on equity and profit margins rising to 12.7% and 9.9% respectively (left chart below). This pushes the ‘Crowding In’ theme further, especially with EM equities looking relatively cheap having underperformed developed markets by 19% this year.
Taking a relative value EM approach is key as global risk assets are still vulnerable, including credit and equity. Risk assets contend with peak global earnings growth (now ~17% from ~21% February), scarce global QE flow excluding reinvestments and wage growth eating into the profit share. Therefore a suggestion would be to hedge long TRY, BRL and IDR exposure with short ZAR, CLP and CNH.
Cross Asset Valuation Snapshot
A year-ahead process is never complete without a lens on long-term value. Some key points:
1) Equities are not that rich when you look outside the US
The expensiveness of US equities has been a key discussion point for some time. This year did see some de-rating of the S&P, but it still looks rich. Other developed markets are also in the expensive zone, if not notably. Against this, many EM markets look cheap, especially compared with bubble-like levels in 2008. India is an exception.
2) European fixed income is expensive, EM is cheap, US is “fair”
European fixed income remains very rich on a real yield basis. US real yields are now firmly positive, which will be important as uncertainty builds. Many high-yield EM markets now offer decent value for fixed income investors. Turkey FI looks expensive, but only if current high inflation levels are sustained.
3) The CNY is still expensive while the US dollar is getting there
Despite the 6% drop in the CNY basket in 2018 the currency remains expensive from a longer-term perspective. The US dollar is also getting expensive, if not yet notably so. Against this, the Turkish lira is the cheapest currency, a significant turn compared to early 2018. The yen is also very cheap on a longer-term basis, although it may need some movement from the BOJ to change this.
4) Credit: expensive, but some value in EM
DM credit looks universally expensive, especially when compared to equity. EM credit looks better value, Mexico and Turkey especially.
5) Housing markets remain very expensive in small open economies
The balance between low inflation and high house prices remains an issue for many small open economies. Canada and Norway have started raising rates despite some housing stress. We’d expect Sweden to follow suit in December and Australia in 2019.
Sir of Finance 