Ma­jor cen­tral banks nudge their po­si­tions


KUWAIT: Midyear, things are pro­ceed­ing more or less as ex­pected back in Jan­uary. Eco­nomic growth is hold­ing up well in most economies. Pol­i­tics are not much of an im­ped­i­ment, though risk fac­tors re­main in the back­ground and may be ris­ing. Brexit ne­go­ti­a­tions are still a ques­tion mark, pri­mar­ily for the UK. Qatar’s dis­pute with its neigh­bors is a fac­tor cer­tainly for some GCC eq­ui­ties.

More im­por­tantly, the Trump agenda on tax cuts and eco­nomic stim­u­lus re­mains an ex­pected plus for US eq­ui­ties, even if not for this year. How­ever, as we ap­proach the US Con­gres­sional mid-term elec­tions of Novem­ber 2018, the mar­kets will want to see con­crete ac­tion, surely for rea­sons eco­nomic but also to avoid a Repub­li­can set­back in the elec­tion. The lat­ter would likely be seen as de­lay­ing, or even de­rail­ing, the cur­rent pro-busi­ness agenda. US pol­i­tics are bound also to loom larger, be­cause the above will be tak­ing place against a back­drop of a US Fed­eral Re­serve rais­ing in­ter­est rates fur­ther and em­bark­ing on the next leg of un­do­ing years of quan­ti­ta­tive eas­ing.

The Fed has re­cently sig­naled strongly that it in­tends to start re­duc­ing the size of the mas­sive port­fo­lio, which amassed over sev­eral bouts of quan­ti­ta­tive eas­ing since 2008. The port­fo­lio to­day stands at $ 4.3 tril­lion (Trea­suries, Agen­cies and mort­gage-backed se­cu­ri­ties) ver­sus un­der $ 1 tril­lion prior to 2008. The wind-down will be very slow and grad­ual, start­ing prob­a­bly in Septem­ber 2017 and in amount of $ 10 bil­lion per month ini­tially. Still the Fed and the mar­kets will want to see and re­as­sure them­selves that the unwinding of the un­prece­dented QE(s) will not cause un­due mar­ket or other dis­rup­tions.

Chair Fed Janet Yellen seemed con­fi­dent re­cently that re­duc­ing the bal­ance sheet grad­u­ally would have min­i­mal/spread-out im­pact on long term rates Fur­ther­more, if one takes Fed rhetoric at face value (and the lat­est dot-plots), the Fed should be hik­ing the fed­eral funds rate once more this year (25 bps), and about 3 times in 2018. The mar­kets, and we, do not share that view at this point, in large part be­cause US in­fla­tion, as well as EU in­fla­tion, con­tinue to dis­ap­point on the low­er­side of their 2.0% tar­gets.

The world econ­omy is still ex­pected to grow at 3%-plus this year, with US GDP growth above 2.0%, EU close to 1.5%, while China should main­tain 6.5% growth. The last data from the US is con­sis­tent with this out­look, June pay­roll em­ploy­ment added 222K new jobs, unem­ploy­ment was lit­tle changed at a low 4.4%, and wage growth re­mains tame, with steady y/y rises of 2.4%.

The uncer­tainty around the Trump agenda and the strength of the eco­nomic re­cov­ery are the other fac­tors gen­er­at­ing mar­ket doubts for the US in­ter­est rate fore­cast ahead. The mar­kets seem to be look­ing for just one 25 bps in the next 12 months, to June 2018, and that with about 50% prob­a­bil­ity. While at the same time, the signs from other ma­jor cen­tral banks, in par­tic­u­lar the ECB, have pointed to the end of ag­gres­sive ac­com­mo­da­tion soon, and to the pos­si­ble ta­per­ing of bond pur­chases per­haps by end of year.

The re­sult of the above, i.e. Fed hikes, has been a grad­ual rise in short term in­ter­est rates, with the US 2-year reach­ing a yield of 140 bps for the first time since 2008. The longer ma­tu­ri­ties, which re­main very well be­haved, have seen their rate rises con­tained thanks to low in­fla­tion and re­pressed Euro­pean yields. How­ever, long rates are fi­nally see­ing some up­ward pres­sure from signs of the Fed unwinding its bal­ance sheet, as well as from fi­nally higher Euro­pean rates. The lat­ter were freed up by signs that the ECB was about to “taper” or stop its pur­chases in 2018. 10-year US rates rose to 2.38% re­cently, while Ger­man 10-year Bunds jumped to 58 bps af­ter start­ing the year at 18 bps. None­the­less, rises in long rates are still ex­pected to be grad­ual thanks to a grad­u­al­ist Fed and ECB, when its time comes, as well as low in­fla­tion. In fact, US rates fell slightly since, fol­low­ing Janet Yellen re­cent dovish com­ments on in­fla­tion.

In­fla­tion is con­tained and be­low tar­get and the re­cent down­ward pres­sure on oil prices means an­other bout of soft in­fla­tion data. Oil prices in fact were the main sur­prise or de­vi­a­tion from ex­pec­ta­tions ear­lier this year. Oil prices re­main un­der pres­sure, notwith­stand­ing an ex­ten­sion by OPEC and its part­ners of the ear­lier pro­duc­tion cuts into 2018.

Oil prices are off 14% from the start of the year, and Brent is well be­low $50 pb. With the OPEC pro­duc­tion cuts act­ing slowly on sup­ply, and with still ris­ing US pro­duc­tion (pri­mar­ily from shale oil), the mar­ket has had a very dif­fi­cult time get­ting to bal­ance. Bal­ance was ex­pected by mid-year but now seem pushed to 2H2017, if not next year. This prospect has pres­sured GCC eq­uity mar­kets, or at least pre­vented them from do­ing bet­ter. At the same time, the diplo­matic row be­tween Qatar and 3 GCC mem­bers (Saudi, the UAE, Bahrain plus Egypt) has also un­set­tled some in­vestors. Th­ese are some of the fac­tors re­spon­si­ble for the year-to­date un­der­per­for­mance of the re­gional mar­kets, ver­sus in­ter­na­tional mar­kets. Saudi was helped to a large ex­tent by it con­sid­er­a­tion and po­ten­tial fu­ture in­clu­sion in the MSCI emerg­ing mar­kets, an­nounced in June.

The change in rel­a­tive cen­tral bank po­si­tion has also pres­sured the USD re­cently, in par­tic­u­lar ver­sus a ris­ing Euro. The USD is off 8.4% against the Euro, 2.6% against the JPY. As men­tioned above, eq­ui­ties are per­form­ing well gen­er­ally. The US head­line mar­kets are up close to 8% ytd, while in Europe the DAX (Ger­many) is up 7.9% on the year. Mod­er­ate growth, low in­fla­tion and slowly ris­ing in­ter­est rates (to­ward “nor­mal­iza­tion”) seem to be work­ing nicely for eq­ui­ties, though val­u­a­tions are get­ting rich in some mar­kets and rais­ing eye­brows in some in­vestor and pol­icy cir­cles (BIS, Fed...).

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