Money Matters 4th July 2017

DAMNED IF YOU DO, DAMNED IF YOU DON’T
Despite continued momentum in global growth over the past 6 months, government bonds have rallied alongside equities. Last week, hawkish soundbites from central bankers prompted a spike in bond yields, a surge in the EUR and GBP and pushed most equities lower.

In the US, 3 key members of the FED commented on financial market valuations:

Chair Janet Yellen “(asset prices are) somewhat rich if you use some traditional metrics like price earnings ratios”.
Vice-Chair Stanley Fischer “high-risk appetite has not led to increased leverage across the financial system, but close monitoring is warranted”.
San Francisco FED Chief John Williams “the stock market seems to be running pretty much on fumes.”

In the UK, (not for the first time) Mark Carney appeared to change his tone by stating the current inflation overshot “can only be temporary in nature and limited in scope” and “some removal of monetary stimulus is likely to become necessary”.
In the Eurozone, Mario Draghi also stressed the state-dependency of policy, saying “as the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instrument”. Moreover, this weekend, Bundesbank President Jens Weidmann commented “at the moment we see that the economic situation is rather positive…if this sustainably passes on to inflation rates then monetary policy needs to be more taut, and it’s not about putting full brakes on monetary policy, but to lift one’s foot off the gas a little”.
UNITED STATES
S&P 2,423 -0.61%, 10yr Treasury 2.31% +16.14bps, HY Credit Index 340 +5bps, Vix 11.05 +1.16Vol
There was a host of economic data out of the US, with a modestly positive bias: whilst durable goods and pending home sales disappointed, measures of consumer sentiment improved alongside the Core PCE index and personal income. This may have contributed to the 15bps sell-off in 10 year yields. However, it was interesting to note the front end of the curve moved much less; the US 2 year was 4bps higher and therefore there was little change in expectations for FED action in the near term.
In equities, there were large divergences in performance at the sector level:

Financials rallied after the second round of the FED Comprehensive Capital Analysis and Review cleared nearly all major banks (Capital One the exception) to return capital to shareholders. Citigroup doubled its dividend, with Bank of America, Morgan Stanley and JPMorgan also announcing significant uplifts.
Technology stocks broadly fell (NASDAQ 2% lower), as the “profit-taking” trend continued and the EU fined Google’s parent Alphabet USD 2.7bn for antitrust violations. The NASDAQ has nonetheless still outperformed the S&P 500 by around 6% YTD.

The state of Illinois (5th largest in the US) is racing against the clock to avoid becoming the 1st US state to have its credit rating cut to junk. The state legislature was unable to reach a spending deal for a 3rd consecutive year and all 3 major rating agencies have a negative watch.
This week we have the minutes to the last FOMC meeting, the July employment report and speeches from FED governors Fisher and Powell.
EUROPE
Eurostoxx 3,468 -1.00%, German Bund 0.47% +21.10bps, Xover Credit Index 245 -13bps, EURUSD 1.140 -2.04%
At a speech on Tuesday in Portugal, Mario Draghi was interpreted as having signalled an imminent reduction of the ECB’s asset purchases, saying “reflation dynamics (were) slowly taking hold”. The EUR gained around 2% against the USD and the German 10-year Bund posted the biggest gain in yield since December 2015. This was despite a concerted “backtrack”:

Reuters reported ECB “sources” commenting that Draghi had intended to signal tolerance for a period of soft inflation rather than imminent policy tightening.
Vice-President Constancio stated that the ECB needed to persist with current policy because “if we adopt, as in the U.S., a broader concept of unemployment (which in the U.S. they call U6) then unemployment in the euro area is at 18% whereas it is at 9 (percent) in the case of the U.S. which would imply that the slack is then bigger than we could judge some time ago.”

Indeed, Eurozone HICP inflation for June declined to 1.3% (from 1.4% in May) at the headline level and registered 1.1% at the core (versus 0.9% in May) – well below the central bank’s 2% target and inconsistent with an aggressive tightening. Moreover, temporary factors over the coming months are likely to continue to weigh on price growth. Perhaps, the minutes of the June ECB meeting, to be released on Thursday, will deliver some clarification.
The Eurozone Economic Sentiment Indicator (ESI) touched a 10-year high of 111.1 in June (from 109.2 in May and having reached 111.8 in August 2007). Optimism was broad based in the survey, which measures corporate and private householder sentiment.
In the UK, Q1 GDP was confirmed at 0.2% QOQ. After fledgling signs of a slowdown, there is increasingly robust evidence of the British economy coming under pressure, particularly at the consumer level:

The savings ratio (proportion of income that is saved) is at an all-time low of 1.7% of gross disposable income.
Real wage growth is negative, as imported inflation outpaces wage gains.
Lending conditions are tightening and consumer confidence is declining (GfK Consumer Confidence Barometer fell by 5pts in June to -10).

Nonetheless, a speech from Mark Carney prompted sharp gains in GBP and Gilt yields, on the interpretation of a more hawkish stance. Although 3 members of the MPC voted for a hike at the last meeting, we continue to believe the UK will not raise rates. Deputy Governor Cunliffe confirmed his view that it was not the time to alter policy on Wednesday and we do not see Carney’s comments as changing his stance. The discord does, however, show the tough position faced by the country – managing inflation from a weak currency against a deteriorating domestic environment. To be fair, there is also very low unemployment, which some members believe could prompt wage growth in the near-term.
ASIA
HSCEI 1,040 -0.71%, Nikkei 2,005.00 -1.42%, 10yr JGB 0.09% +0bps, USDJPY 112.840 +0.97%
China’s NBS Manufacturing PMI accelerated to 51.7 in June, up from 51.2 in May, surprising to the upside. The production sub-index rose to a 43-month high of 54.4, while new export orders rose to a 76-month high of 52.0.
Industrial profits also showed signs of strength, with growth accelerating to +16.7% YOY in May, up from +14.0% in April, despite lower PPI inflation.
On 1st July, the Modi government rolled out its transformational Goods and Services Tax across India, the country’s first unified tax structure in the post-independence era.
The GST has the potential to be truly transformational for India. The new tax structure abolishes the greatest barriers to interstate trade. This effectively unifies India as a single common market similar to the EU, as opposed to the outgoing system whereby trading across state lines required negotiating an international-style tax border.
Companies that previously were forced to operate elaborate networks of warehouses and distribution centres so as not to pay multiple layers of tax will now be able to rationalise their operations. Foreign direct investors will now face far simpler decisions in how to set up their Indian presence.
Another key dimension to the GST is the incentivisation of much higher tax compliance. Companies will now prefer to work with suppliers that have paid their fair share of taxation, so as to benefit from an input credit, rather than go with the cheapest supplier available, who potentially had been able to offer such a low price by evading taxes. This will erode the entrenched competitive advantages of the unorganised sector and accelerate the development of India’s organised companies. At the same time, this will significantly raise India’s dismally low tax compliance rate, with a current estimate of less than 1% of the population paying income tax.
In the short term, there will inevitably be an adjustment period where companies are forced to adapt to the new structure and the accompanying electronic reporting system.
LATIN AMERICA
MSCI Lat Am 2,544 +2.04%
The Brazilian equity market shrugged off the General Prosecutor’s formal charges of corruption against President Temer. The indictment would need to be signed-off by the Supreme Court, by a special judicial committee in the Lower House and the Lower House for a full vote. As of now, a majority of Congress doesn’t support removing Temer. It would require 342 votes and the clear-cut opposition amounts to only 95 representatives.
Brazil’s National Monetary Council reduced its Inflation target to 4.25% for 2019 and 4.0% for 2020, with a margin of tolerance of +/-1.5pp. This is the first time in 14 years that this inflation target range has been lowered. This is perfect timing as inflation expectations are well anchored below the current official target. Last week, the market revised IPCA expectations to the downside for 2017 to 3.48% (-16 bps), and to 4.30% (-3 bps) by YE18.
Historically, inflation crippled real GDP growth in Brazil, thus such a commitment from a credible central bank is positive. Lower inflation could pave the way for lower nominal interest rates.
Brazil’s current account surplus totalled USD 2.9bn in May, better than the USD 1.2bn surplus recorded in May 2016. Over 12 months, the current account deficit receded to USD 18.1bn (1.0% of GDP). The strong trade surplus has helped to maintain low current account deficits.
Large surpluses are to be expected in the months to come but a rebound in domestic demand and lower commodity prices tend to produce slightly weaker readings.
However, things are not improving on the fiscal front in Brazil. The central government posted a primary fiscal deficit of BRL 29.4bn in May, above consensus. The central government posted a primary deficit of BRL 35.0bn in 5M17, up from BRL 23.7bn in 5M16.
Now that the fiscal ceiling rule is in place and GDP growth is still sluggish, the government has no other choice than to increase taxes or cut discretionary spending to reduce the primary fiscal deficit. This is also why pension reform is the only sustainable way to stabilise the debt trajectory and comply with the fiscal ceiling rule.
Colombia’s central bank cut interest rates by 50 bps to 5.75%. The continued deterioration in leading economic activity indicators together with prospects of inflation temporarily converging to the target band of 2% – 4% led to an acceleration of the easing cycle. The monthly proxy for real GDP averaged 0.7% in 5M17, consumer confidence (-17%), oil production (-6%) and real commercial credit (-3%) are all down in May.
The economy has been growing below its potential rate of 3% – 3.5% for two consecutive years. After a 50% devaluation of the COP in the past 3 years and a period of fiscal tightening (FARC peace agreement and VAT hike mainly), the national accounts start rebalancing, inflation has peaked and GDP growth is bottoming.
AFRICA
MSCI Africa 827 -1.70%
South Africa’s President Jacob Zuma will face a no-confidence vote on the 8th August. The key question of whether the vote will be held as a secret ballot is said to be “receiving consideration” according to the Speaker. In the meantime, the country reported a R9.5bn trade surplus for May, a 4th consecutive monthly surplus and an increase on April’s R4.97bn, driven by the export of more vegetable products. The positive data had little effect on the markets however, with all eyes on the ongoing ANC national policy conference.
Fitch affirmed Egypt’s country rating at ‘B’ with stable outlook, balancing Egypt’s large fiscal deficit, high government debt/GDP ratio, with progress on the reform agenda. On the note of reform, the Egyptian President ratified capital gains tax freeze extension for three years and approved stamp duty on stock exchange transactions for both buyers and sellers, set at EGP1.25 per 1,000 for the first year, rising to EGP1.5 in the second year and EGP1.75 in the third.
Kenya’s inflation fell to 9.21% YOY in June, down from 11.70% in May, partly due to a drop in food prices (YOY food inflation fell from 21.52% in May to 15.81% in June). Provisional quarterly GDP estimates for Q1 2017 however showed growth slowing to 4.7%, down from 5.9% in the same period of 2016, due to contraction in agriculture following the drought and a slowdown in lending.
In Nigeria, maize prices rose 83% to a one year high due to an armyworm invasion. Separately, Nigeria completed a third capital raising this year via the LSE, to plug its c.USD 7.7bn budget deficit. The five-year, 5.625% bond issue which was aimed at the Nigerian Diaspora, raised a total of $300 million and brings the total capital raised this year to USD 1.8bn. Also, the French government announced that it has set aside about EUR 1bn to be invested in Nigeria’s oil and gas industry.