RMG Wealth Management

RMG Investment Bulletins


By Stewart Richardson on 09/07/17 | Category - Europe

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The bond markets are having a bit of a hissy fit, and as noted last week, this seems to be primarily driven by a position adjustment as speculation rises about the ECB's normalisation path. We also noted last week that the moves in the bond market had affected the FX markets, with the Euro perhaps slightly ahead of events. We thought we would take a closer look at the Euro this week, with our main conclusion being that the Euro is at a very interesting juncture.

First, let's have a look at the EUR versus the US Dollar. Chart 1 below goes back to 2014. After the significant decline between May 2014 and March 2015, the Euro has basically been range bound mostly between 1.05 and 1.15. We have highlighted two types of resistance. A horizontal line that sits around 1.1465 and we note that there has not been a weekly close above this level for about 2 1/2 years. We have also shown a modestly bearish trading channel connecting the spike highs of August 2015 and May 2016, and the upper boundary of this channel sits at 1.1450 (falling by 3 pips a week). So we have a strong resistance area at and just below 1.15 compared to last week's close of 1.14.

Chart 1 - EUR/USD Exchange Rate weekly chart


There is a bullish case to be made for the Euro, but this depends on the European Central Bank. If the ECB turns more hawkish than the markets expect, then we have to believe that the Euro will break above the 1.15 resistance area. If this were to occur, then there would seem to be little - technically speaking - to hold the Euro back from a sustained advance. We'll get to this bullish case shortly.

As you can imagine, the advance from 1.05 to 1.14 has caught the attention of many. Speculative traders (hedge funds), as measured by IMM data, are now holding the second largest net long Euro position since the financial crisis, as can be seen in chart 2 below. History shows that when position becomes too extreme, a reversal is usually close at hand.

Chart 2 - EUR/USD Exchange rate with IMM Euro positioning


It's not only the hedge funds that have fallen in love with the Euro in recent months. Chart 3 shows the EUR/USD FX rate alongside a bullish sentiment indicator of small traders. The 10 day average of bullish sentiment is currently 83% bullish, which is fast approaching levels that usually indicate exhaustion and potential reversal in the Euro itself.

We have taken this chart back to 2009 to illustrate one time when an elevated bullish sentiment was not a constraint on further Euro gains. As can be seen, by early June 2009, bullish sentiment reached the 80s and yet the Euro continued to rally from the low 1.40s at this time to a high of above 1.50 in October 2009. Furthermore, if we look at the same 2009 period in chart 2, we can speculators were also net long the Euro in early June.
As we should all know, there are no failsafe investment and trading methods in financial markets. No one method is 100% perfect. That said, when hedge funds are aggressively long the Euro and small traders are very optimistic, this should usually be seen as a contrarian opportunity which would have served well since 2010.

Chart 3 - EUR/USD Exchange Rate with bullish sentiment (10 day average)

Could we see a repeat of 2009 whereby the Euro can rally further despite extremely bullish positioning on the part of hedge funds and small traders? We think this depends upon the words and actions of the Federal reserve and the European Central Bank. Back in 2009, although both central banks had slashed their main interest rate to the zero lower boundary and the Fed was quite aggressively expanding its balance sheet. Let's also not forget that at that time, it was very much seen that the Global Financial Crisis (GFC) had originated in the US, and that the troubles for Europe were actually still ahead of them.

We should also remember that the ECB was still somewhat Bundesbank like with Jean-Claude Trichet in charge. As can be seen in chart 4, Trichet not only raised interest rates in the Summer of 2008 (literally weeks before the collapse of Lehman Brothers) because inflation was above 2% and even despite equities being in a bear market. Furthermore, Trichet also raised rates twice in 2011 to head off inflation even as the sovereign debt crisis was brewing. Our point here is that although IMM positioning and small traders bullish sentiment gave false signals in mid 2009, the ECB was very different at that time compared to the ultra-dovish Draghi today, and the Fed was hosing the system with liquidity whereas the ECB was not.

Chart 4 - Fed and ECB interest rates and balance sheets
Although we think that the recent rise in the Euro can be explained by the increasing optimism towards the Eurozone post the election of Macron in France, and noting the continued tailwind from an egregious German current account surplus, we simply do not think that Draghi is Bundesbank like. You can see this in the chart above. Draghi became President of the ECB in November 2011, since which time ECB policy has been significantly more aggressive than the Fed. 

In our minds, to see the Euro break above the 1.15 resistance area, we either need to see a continued aggressive allocation by large investors away from the US (because of Trump's policies?), or we need the ECB to clearly articulate an end to both QE and negative interest rates within a reasonably short period of time. We believe this to be a low probability outcome as we continue to believe that Draghi will remove his highly accommodative policies at a very slow rate, not wanting to hurt the economic recovery that he will feel he has worked so hard to achieve.

At the same time, the Fed continues to stick with its narrative of gradual tightening which at the moment seems to mean one more rate rise this year, starting the process of balance sheet reduction perhaps as soon as September and three rate rises next year. The market, as it has done for years (and rightly so) is under-pricing the Fed, and is only pricing in a 50% probability of another rate rise this year, and only one rate rise for 2018. At some point, either the Fed caves in or the market has to price in a more hawkish policy.
So, although the bond market is rightly having a hissy fit about whether the ECB is moving towards the exit too quickly, we think that Draghi will try and dampen down these concerns (he can still hide behind the too low core inflation rate). We still think that future relative policies between the Fed and the ECB will favour a stronger US Dollar, and with the market now long the Euro, there is definitely potential for a position squeeze if this view is correct.

We would also note that the Euro is bumping up against resistance against the Pound Sterling as well. The chart below shows this cross rate on a weekly basis.

Chart 5 - EUR/GBP Exchange Rate weekly chart
So how do we play the Euro at this juncture? We do fundamentally have a bit of sympathy with the bullish scenario. A few weeks ago we showed the following chart between US and German 5 year bond yields and explained that we were positioned for German yields to rise more than US (we are long 5 year US bond futures and short 5 year German bond futures). Our base case scenario for the next few months is that the global economy continues to nudge on from here and that G10 central banks (excluding the Bank of Japan) will be removing stimulus and/or tightening policy in a measured way. In this scenario, we expect the current spread to remain around the 2% area in which case we earn a 2% return without any capital appreciation.

As readers will know, we also think that the Fed will continue tightening until something breaks. In this scenario, the Fed has a lot more room to ease than the ECB, and US yields would decline towards those seen in Europe, and we would earn our 2% carry and some (perhaps a good deal of) capital appreciation. In this more bearish scenario, which we have been pencilling in for later 2017, the Euro should gain against the US Dollar, at least for a period of time.

Chart 6 - US and German 5 year bonds 
So although we do actually have a bit of sympathy with the bullish Euro thesis, we just don't think the time is right today. We think that markets are today under-pricing the Fed and over-pricing the ECB, and that those bullish of the Euro may be caught in a squeeze if market sentiment to either the Fed or the ECB has to change.

Presently, we have very little exposure to the Euro. The momentum has clearly been Euro positive since April and if we see signs of this reversing at clear resistance, we will look to put on some tactical short Euro exposure. However, we are trying to exercise patience in implementing this trade, as a break above 1.15 could happen, in which case we would go with the break given our sympathy to the larger bullish Euro potential.

As noted above, there are no failsafe investment methods to trading. All we can say about the Euro at the moment is that A) it is trading up to significant resistance, B) our work indicates that there is room for a tactical reversal from this resistance as the markets are potentially mis-reading the central banks and have become too optimistic on the Euro, C) if the ECB is seriously looking to remove policy accommodation, a break of 1.15 could open the way to a serious move to the upside and D) patience is a virtue but we expect to have more clarity relatively soon. We will of course update you with any actions we take in the funds we manage.

By Stewart Richardson on 11/06/16 | Category - Europe
Five of the last six Summers have seen European troubles bubbling to the surface. It appears that this year, Europe is again struggling to contain some wildfires that have just taken hold. Indeed, after four months of relative calm in financial markets, these European problems could well be the events that shatter the global peace.
The most obvious and immediate European problem is the UK's Brexit vote on 23rd June, and momentum has clearly swung away from the remain camp in the last two weeks. What was seen as only a minor risk for financial markets has quickly become a huge potential risk and prices have begun to adjust. In our opinion, this is not just an issue of migration but a problem of the average man on the street simply does not feel that their lives have improved materially since the Global Financial Crisis. There are a huge number of voters who feel completely disaffected and simply want change. This is not an issue unique to the UK. Huge numbers across Europe and the US are in the same boat and the risk of a series of anti-establishment votes in the next year or so is growing.

Aside from the Brexit vote, it is interesting to note that a recent Pew Research poll showed that 61% of French voters hold an unfavourable view towards the EU, compared to only 48% in the UK. This comes only a couple of days after the anti-establishment 5 star movement in Italy polled extremely well in first round mayoral elections, Rome in particular. In fact, although there have to be concerns about France, Greece and Portugal, it is Italy that is most likely to upset the political status quo. PM Renzi has proposed a referendum for October in which the public are basically being asked to back the Government's proposals on structural reform. Renzi has promised to step down if he loses the vote, and with the current strong polling for the 5 star movement and the deep seated scepticism over structural reforms, this referendum could become very important for the EU project.

It has to be said that being an expert on European politics is a fine art nowadays, and the ebbing and flowing will continue over the next few months, that much we can be sure of. But what does it mean for markets?

Here, we have to bring in the ECB and what's happening with the European banks. For years, we have questioned the efficacy of the extremely unorthodox policies of Central Banks, and it would appear that the huge QE programme and negative interest rates being pursued by the ECB are really squeezing European Banks. Certainly, investors seem to be in agreement with this, as European bank shares are closing in on multi-year lows and close to testing the crisis lows seen in 2011/12.

This is potentially a major issue as bank lending to the real economy is closely correlated with their share price performance as can be seen in chart 1 below. It would appear that the ECB are either unable to generate a sustainable improvement in the way banks support economic performance or are in fact hampering this very important dynamic.

Chart 1 - European Banks
If the correlation indicated in this chart holds, bank lending in Europe is set to start declining again. It has always struck us that despite record low interest rates, the private sector is not increasing borrowing by that much. This is probably a combination of demographic forces and businesses simply not seeing good long term investment opportunities. Clearly, an escalation in EU problems as highlighted above will do little to improve business and household confidence. Furthermore, the ECB has recently been keen to point that despite the current low/negative interest rate environment, banks will have benefited from making capital gains on the Government bonds they hold. That brings us on to the European Government Bond market.

In this world of such unorthodox central bank policies, we're beginning to wonder what constitutes a bond market bubble. However, we know that a milestone was reached in the last few days. As seen in chart 2 below, the yield on all outstanding German Government bonds has fallen into negative territory. Although yields can fall further, this is simply insane. At the risk of pointing out the obvious, what this means is that collectively all holders of German Government bonds are guaranteed to lose money from here until all current outstanding bonds mature. Yes, a few lucky traders may profit from short term trading, but nominal losses are now guaranteed and inflation adjusted losses will be much larger.
Chart 2 - The yield on all outstanding German Government Bonds
With 2 year and 5 year German bonds yielding minus 0.54% and minus 0.43% respectively, and the 10 year bond trading down to a yield of only 0.01% at one point on Friday, clearly the negative interest rates and QE is distorting the market, and as claimed above, hurting the banks and arguably the economy. So, what does the ECB do? Maintain current policies and hope the outcome changes for the better? Cut rates further into negative territory and increase QE in the hope that more extraordinary stimulus will suddenly change the outcome? Or, do they admit defeat, and wind down QE and begin to raise rates back into positive territory?
It appears that none of these options are particularly palatable. Doing nothing or more will not help the banks and maybe not the economy, but raising interest rates may well pop the bond bubble - which will end any more capital gains for banks which was perhaps one of the few things going right for them in recent months. Even if the ECB stays on the same course, who's to say that the political risk does start to impact the periphery bond markets. With two year bond yields negative in most EZ countries, and ten year yields at or near all-time lows in France, Spain and Italy, there is no political premium priced in at all.
From a different perspective, what happens if the message from the bond market is right, i.e. deflation? What happens if Europe is on course for Japanification (in fact, the Italian economy has underperformed Japan on some measures over the last two decades!). Well, then we think that the increasingly anti-establishment feeling noted above will only worsen, and at some point the voters of a EZ member will vote for decisive change, which will see bond prices come under significant pressure throughout most of the EZ.
As for equity prices, as can be seen in chart 3 below, these have simply not been able to benefit from either negative interest rate or QE.
Chart 3 - European equity market versus ECB balance sheet and deposit rate
All of the above indicates to us that the status quo that has seen European asset prices (bond in particular) perform well since the nadir in February could easily be shattered at any time. Voters are increasingly angry and are close to demanding big changes. However, the ruling elite in Brussels and Frankfurt are desperate to maintain the status quo. In this increasingly fragile environment, is it any wonder that investors are shunning European equities and chasing yield in both Government bonds and corporate bonds (where a massive buyer emerged this week - the ECB - will this really end well?).
We have been tentatively positioning our funds in the last month or so for an increase in risk premiums in European assets. We have been long 10 year German bonds versus a short in Italian bonds for a couple of months and a few weeks ago we bought long dated put options on the Euro versus the US Dollar. We believe that it is now time to increase the size of our trades that will benefit from rising risk premium across European assets. Because we believe European bonds are in a bubble and that spreads versus German bonds will widen as political risk rises. As such, we have now sold short 10 year Italian and French Government bonds. We have also introduced a small short position in European equities.
In terms of the bigger investment playing field, rising risks in Europe will likely impact Emerging Markets. We have been selling EM currencies against the US Dollar and have introduced a small short EM equity exposure as well. If we are proved correct in taking these bearish positions, the big question is will US equities also succumb to bearish global trends. If they do, then frankly the investment environment will become a lot more difficult than many expect, and US recession risks will rise rapidly. However, in the next few weeks, our attention is focused on Europe and Emerging Markets, where the status quo appears to be very fragile indeed. 

By Stewart Richardson on 13/03/16 | Category - Europe
Back on 12th December (in our note titled "Some Dangerous Signals Appear in Financial Markets", we outlined what we thought were two potential scenarios for 2016. In the note, we said "we believe that the best scenario for equities is more of the same seen in the last year or so, i.e. roughly sideways with intermittent bouts of volatility... What is our worst case scenario? A large bear market with the dramatic declines seen this August providing a foretaste of what is to come."
So far, markets seem to be following our best case scenario. Having declining rapidly during January and early February, markets have embarked on a stellar rally that has brought equity markets to within touching distance of breakeven for the year. When trying to rationalise the 10% rally in equity markets in just four weeks, we would first point to the fact that markets were very oversold and due a sharp rebound. But the driver in recent sessions has to be the cumulative effect of yet more monetary stimulus from major central banks, especially the ECB - of which more below.
As an aside, we struggle to understand a narrative of improving fundamentals in support of the recent market rally. Earnings expectations in the US have collapsed at the fastest pace since 2009, with Q1 2016 forecasts cut from +5% year on year  to -8.3% today (see chart 1 below). Over the same period FY2016 earnings forecasts have been cut from +10% to 2.7%. With expectations for the second half barely touched by analysts, we expect full year estimates to drop further as analysts play catch up. With US share prices outperforming earnings yet again, the market continues to re-rate, becoming more and more expensive.
Chart 1 - US Q1 2016 Earnings expectations
Moving on, last week was a big week for Central Banks; no change from Canada, a surprise rate cut from New Zealand and a broad based stimulus programme from the European Central Bank. Unlike December when the ECB over promised and under delivered, the package announced by Mario Draghi was more comprehensive than expected. Without going into the details on what was announced, which have by now been widely covered by numerous commentators, we will consider the market's response to the post meeting press conference as well as a wider perspective on where we see central banking to day.
As is always the case with Mario Draghi nowadays, it is the tone and subtle nuances that come out of his press conferences that seem to matter most. The tone of the prepared remarks were the usual narrative that we have come to expect. Their job is to basically get us to believe that they have everything under control, that they are doing all the right things, and given time everything will be ok. Furthermore, although they admit that their policies are new and therefore experimental, they can control any unintended negative consequences. We therefore need to look to the Q&A for any genuine insight.
In our view, the first questions were planted. The length of the answers and the communication from them tells us a lot about the bigger picture. Here are a couple of quotes;
"From today's perspective, and taking into account the support of our measures to growth and inflation, we don't anticipate that it will be necessary to reduce rates further."
"Does it mean that we can go as negative as we want without having any consequences on the banking system? The answer is no."
On whether the ECB could have used a tiered deposit rate system to try and push rates further into negative territory, Draghi said "in the end the Governing Council decided not to, exactly for the purpose of not signalling that we can go as low as we want to on this. So the Governing Council, although it gives a positive judgement about the past experience, is increasingly aware of the complexities that this measure entails."
In Central Banking speak, we don't think Draghi could have been clearer. Interest rates have finally hit the floor. Throughout the press conference, we think that Draghi gave an air of slight resignation. He has delivered his final comprehensive package of stimulus, and any new measures in the future are likely to be no more that tinkering. To some extent, this view was shared by the market, as equities and bonds sold off after the usual knee-jerk rally, and the Euro strengthened substantially.
Stepping back, we believe that the situation of the ECB being finished with stimulus measures reflects Central Banking generally. Yes, we may see the Bank of Japan tweak interest rates lower in the months ahead, but unless there is a financial market collapse, central banks have no more fire power. This reflects not just where they are, but also the lack of response from the real economy to all the unorthodox policies of recent years, and increasingly, the negative response in the markets and the media to new rounds of stimulus.
All of which brings us back to the central question in markets. Just how much are markets being supported by extremely unorthodox central bank policies, and are they vulnerable to significant losses if investors believe the central banks are now out of ammunition and losing their power to force markets higher. We remain of the opinion that QE and zero or negative rates have done little for the real economy, but have allowed large companies to issue record amounts of debt, partly to finance share buybacks.
The chart below courtesy of Yardeni Research shows the quarterly level of buybacks annualised and the rolling 4 quarter sum. Although the quarterly level has not quite reached the level seen at the last market peak in 2007, the four quarter sum has remained at a high level for well over a year now. This persistence in large buybacks has helped the market levitate in recent quarters. We are not against buybacks per se, but we are against companies leveraging their balance sheets purely to buy back shares. This cannot be good for the remaining shareholders especially when the US suffers its next recession.
Chart 2 - US Share buybacks
We have maintained for some time that the next recession is likely to be devastating for the corporate sector and therefore the equity market, as companies have accumulated debt at an unsustainable rate, as can be seen in the chart 3 below (courtesy of Soc Gen). Not only are current earnings going to struggle to service all this new debt (see the gap between net debt and EBITDA), but a recession will impact earnings to the degree that defaults could rise rapidly. Of course, as defaults rise, companies will be forced to massively curtail their back programmes and in some cases eliminate them.
Chart 3 - US corporate net debt 
So to round up, we feel that central banks are pretty much all in, and increasingly impotent to help either the real economy or the financial markets. The corporate sector is more leveraged than ever before, having wasted resources on buybacks, and have been the only buyer of equities in recent years. The virtuous circle of cheap funding, debt issuance and buybacks is dependent to some degree on investors believing in Central Bank omnipotence. If markets think that central banks are becoming ineffective, then equities are vulnerable to our worst case bear market scenario, which would likely usher in a new recession and therefore impede companies' ability to borrow to buy back shares.
We view the recent rally as a selling opportunity, and as noted last week, we are now simply trying to finesse our market timing to add to our modest short positions. A  renewed risk-off phase will also be reflected in the RMG FX Strategy mandate.

By Stewart Richardson on 06/03/16 | Category - Europe
Financial markets have enjoyed a very robust recovery in the last three weeks. In our opinion, the rally has not been driven by any fundamental improvement in economic growth or corporate or emerging market prospects. The mid-February lows had clearly created an oversold condition that has now been alleviated, and the improving sentiment has coincided with a downgrading of imminent economic and geopolitical concerns. After a 10% rally in equities in three weeks, what happens next?
The big event of next week is the long awaited ECB meeting, at which Mario Draghi is widely expected to announce another round of stimulus. There are some who are concerned that he may under deliver, similar to what happened in December. There are others who believe he has learned from that mistake, and will over deliver; a sort of nuclear response in his battle against deflation. For our part, we think he has set the bar quite high, but we will just have to wait to see what he does. Of greater interest to us will be the market reaction. If financial markets react negatively (as they did recently when the Bank of Japan cut rates into negative territory), then Draghi's credibility takes another hit, as will the global ultra-easy monetary policies of QE/ZIRP/NIRP.
So, let's have a look at what's priced in by the markets. It appears to us that the bond markets are expecting something quite aggressive, such as a tiered deposit rate allowing a deeper cut into negative territory. In this scenario, it is easy to see a headline deposit rate cut to minus 0.50%, or in a really funky move, perhaps even nearer to minus 0.75%. With German 2 year and 5 year yields currently at minus 0.54% and minus 0.34% respectively, anything less than at 15 basis point cut to the deposit rate (currently at minus 0.30%) could be seen as a disappointment, see chart 1 below.
Chart 1 - German bond yields versus the ECB deposit rate
In the FX markets, it would appear that investors are pricing in less than bond investors. Chart 2 below shows the EURUSD exchange rate alongside speculative positions of traders on the futures market. We have also marked on the chart the December ECB meeting. Clearly, traders are holding a significantly reduced short Euro position heading into next weeks' ECB meeting compared to December.
Comparing the current position of the FX and bond markets, someone is wrongly positioned. Either Draghi over delivers and pleases the bond markets, and the FX guys are not bearish enough on the Euro. Alternatively, Draghi under delivers, proving the FX guys right and the bond market wrong. For what it's worth, we think that the odds are slightly in favour of Draghi disappointing, and Government bond yields may jump higher like they did in December, which could easily help the Euro spike higher as well.
Chart 2 - The EURUSD exchange rate and traders positioning on the futures market
What about equity markets, and other risk assets? Well, let's assume that developed equity markets all move roughly together as has been the case in recent months, and we'll take a look at the European equity market in chart three below.
First of all, we have marked what may be an important resistance zone which capped European equities before QE was announced and has acted as first support and then resistance since last August. In the lower panel, we have also shown the 15 day rate of change. This may be slightly cherry picking as this 15 day period starts with the February low, but it is rare that an index can continue to advance so rapidly for longer periods, and at the least, the rate of advance will slow. If the ECB disappoints, equity markets in Europe (and perhaps globally) will reverse some or all of the recent gains.
Chart 3 - Eurostoxx 600 Index
So, as we see things today, fundamentally not much has changed in recent weeks. Equity markets and other risk on assets have rallied strongly from the oversold condition apparent three weeks ago, and are now overbought. It will take a very positive market reaction to any ECB stimulus next week to keep the party going. We expect a sideways market at best now in the short term, with the risk that the last few weeks have been nothing but a robust bear market rally that is set to end shortly.

By Stewart Richardson on 05/12/15 | Category - Europe
It has become clear that certain events this December would likely generate a heightened degree of volatility and could set the tone of markets as we move into 2016. Four days into the month and we are certainly seeing a few thrills and spills.

Top of the bill last week was Mario Draghi. We wrote extensively about this two weeks ago highlighting how the ECB had been extremely vocal in communicating a big increase in stimulus to the market. We explained how we thought the short Euros versus US Dollars had become an extremely crowded trade (and therefore vulnerable to a reversal higher in the Euro) and that European government bond yields were fully pricing in an aggressive easing (and so also vulnerable to price declines which means higher yields).

A lot has been written about the ECB and so we won't rehash all of it here but, by only cutting the deposit rate by 10 basis points to minus -0.3% and only extending QE officially to March 2017 (an extra 6 months), Draghi woefully under delivered. Having been hailed as the messiah of central banking, what went wrong? We can only speculate, however it seems highly likely that the Germanic block did not support much, if any, further stimulus. This could be because even the ECB staff forecasts were broadly unchanged from the last set made in September, therefore neutralising the argument for new and aggressive stimulus.

Whatever the reasons, Draghi and his trusted lieutenants had whipped up the market into a frenzied excitement over the possibility of big bazooka sized stimulus package and they only delivered a pea shooter size package. Markets were understandably disappointed and a massive position adjustment took place in relative illiquid trading conditions. The Euro rose by about 3% against the Dollar as shown in chart 1 below, which is one of the largest daily moves since the inception of the Euro.

Chart 1 - The Euro versus the US Dollar
It was also carnage in the European bond markets with German yields higher by 13 basis points in the two year and nearly 20 basis points in the five and ten year bonds. With a huge sum of Government bonds trading with a negative yield on the assumption that the ECB would move to an even more extreme policy stance, any disappointment was bound to have been met with a sharp decline in price and so higher yields, as shown in chart 2 below.

Chart 2 - The German 10 year bond yield

Draghi did make a speech late on Friday that was seen by some as an effort to re-establish his credibility and persuade markets that he will do whatever it takes. However, we think the damage has been done. There may be no limits to policy in theory, but as we've seen with the Swiss National Bank in particular, there is a practical limit, and the market knows this. Nobody knows exactly where the practical limit is, and frankly central banks should not want to get near it as, by the time they reach it they will have lost any credibility they may have left when they have to abandon the policy.

Moving on, it was a big week for data in the US, with important manufacturing and services sector surveys along with the monthly employment report. The business surveys were disappointing, especially the manufacturing sector. The employment report showed another decent month for job creation in November, albeit of the low paying variety and of the part time variety.

Of immediate interest to everyone will be that the employment report will do nothing to stop the Fed from raising interest rates on 16th December. Indeed, the speech and testimony from Chair Yellen last week fully indicates that she wants to raise rates. So, in simple terms, the Fed rate hike is now fully factored in by the market. What we may hear from the Fed will be their expectations for how far and fast they may raise rates. We are very comfortable with the view that they will raise rates very slowly. In fact, they will tell us they are data dependent, and we still hold to our view that they will raise rates twice (December and again in March), and that will be it. By Q2 next year, we expect the US economy will remain soft enough for the Fed to pause in their rate rising cycle.

Employment is actually a lagging indicator as is inflation so, although these are the key indicators that the Fed have to watch to fulfil their legal mandate, they are not the indicators that will tell us what will happen to the US economy in the future. As noted above, two key business surveys released last week were disappointing. The manufacturing survey, that has been struggling for some time, fell below 50 which indicates a manufacturing recession. The services survey fell more sharply than expected, but remains well above the key 50 level.

It has to be said that neither of these surveys are perfect predictors of the future. What had been puzzling a few people of late was the disparity between the two, i.e. manufacturing struggling alongside the services sector at historically high levels. The fact that they both fell in November and the manufacturing survey is now in recession territory should be seen as a potentially worrying development. Indeed, when we compare the manufacturing survey with the year on year performance of industrial production (lagged by 6 months - see chart 3 below), we do worry that the industrial sector can slip further in the next couple of quarters. If this does happen, then economic growth could easily be sluggish enough to encourage the Fed to move the side-lines early next year

Chart 3 - US Industrial production (year on year and lagged 6 months) versus manufacturing survey
The way we see the backdrop at the moment is that the Fed is planning a dovish hike as the US economy is at risk of slowing from an already modest pace. The ECB have probably fired off its last stimulus for the time being and badly missed market expectations. At best, markets will be stable in the months ahead as economic growth muddles through and there are no exogenous events to grapple with. At worst, the US economy (along with most of the emerging market complex) is slowing further and volatility increases.

What this means is that it will be very difficult, as it has been all year, for buy and hold investors to make any returns. It is also interesting to note another high profile hedge fund closure indicating how difficult it has been for active managers to make money. In these frustrating times, we believe that it makes sense to be flexible, avoid consensus trades and be aware of potential market dislocations that can be very painful. 

By Stewart Richardson on 25/10/15 | Category - Europe
Having written our usual weekly commentary as part II of a Big Picture series, we weren't prepared for writing about the barrage of monetary stimulus that was unleashed at the end of last week. We have also found this commentary harder to write than we had suspected, partly because it's not immediately obvious why Draghi needed to act now.
The obvious thought process on the back of more global stimulus is to just say buy stocks and sell the Euro. Indeed, this is the likely outcome in the weeks ahead. However, we continue to believe that more of the same will have diminishing returns and that the unintended consequences or risk of running more extreme policies are becoming greater. We will set out below some market thoughts as well as some concerns. We will save our real criticism of central bank policies for the final part of our Big Picture series.
So, Mario Draghi made some pretty big commitments. He said that the ECB was "willing and able to act by using all instruments available". He confirmed that they would be able to cut the deposit rate further into negative territory. And although he does not target the exchange rate, we all know he has wanted a weaker Euro since May 2014, and his rhetoric and style tells us that he wants the Euro to weaken again. The two obvious takeaways from Draghi's comments is that European equities will go up (or at the least outperform) and the Euro will weaken. We have bought European equities and sold Euros versus the US Dollar post the ECB meeting.
The chart below shows the Eurostoxx 50 index and we have drawn a line around the 3300 area which has acted as both resistance and support on a number of occasions. The break above 3300 last week would appear to be important and we expect more strength to come in the next few weeks at least. 
The next chart tracks the performance of the Euro versus the US Dollar. As can be seen, the Euro, having fallen by 25% into March this year, has been tracking sideways to slightly higher for a number of months. It would appear that the bigger US Dollar bull market is reasserting itself, and with Draghi sponsoring this move, we expect a test of the 1.05 lows quite quickly, and ultimately a move to parity.
But what of the larger picture here? Despite an improving growth picture in recent quarters, and the likelihood that both growth and inflation will tick higher in the next couple of quarters, Draghi chose to pre-announce substantial action. Is he truly worried that the risks emanating from China are large enough to warrant such action? Or, is he trying a bit of shock and awe; perhaps trying to weaken the currency which he stated is important to growth and inflation?
If Draghi's main aim is to weaken the Euro (and that is certainly the view in the FX market), then he risks igniting another wave of competitive devaluations (a.k.a. currency wars). This would be bad news for global growth and ultimately could be bad news for equities despite what appears to be a very bullish market buoyed on by the ECB. Of course, this path is not set in stone, but it is easy to imagine other countries wanting to keep their currencies weak if the Euro falls substantially on the back of ECB largesse.   
What was interesting on Friday was that when China cut interest rates and reserve requirements, not only did equities add to the ECB inspired gains, but commodities and Emerging Market currencies EMFX) rallied too. However, commodities and EMFX soon turned tail and closed lower for the day which was bearish price action in our opinion. Fears that commodity demand will remain weak if the Chinese economy is still struggling is part of the explanation. However, a strong Dollar can also be blamed as we all remember how the strong Dollar was a significant driver of weakness in these areas over the summer.
A major risk in the weeks/months ahead is that Japan and China capitulate and move to weaken their currencies along with the Euro. This would encourage similar action by other central banks and unleash a wave of deflation that will likely be coincident with poor returns from commodities and EMFX, perhaps followed by US credit and equities and ultimately all risk assets.
We doubt that this is what Draghi really wants, but his words and now potential actions appear to be designed to weaken the Euro. Historically, currency wars and other beggar-thy-neighbour policies are a disaster for the global economy and also financial markets. If other central banks refrain from following Draghi down this path, then perhaps the next few months will be benign and risky assets can outperform. However, we think the risks of an escalation in the currency wars (that have been percolating for several years) is higher than many would like to admit, especially in polite central banking circles.
So, for moment, we are happy to be bullish the Dollar against the Euro and also selected Asian currencies. As noted above, we have also jumped on board the bullish European equity bandwagon. We will continue to be flexible in our approach as we are not sure how robust the equity rally really is (i.e. we see this as purely a central bank inspired rally that could fizzle out quicker than many expect). Ultimately, we see currencies as the tool of choice for central banks, and this represents opportunities for macro managers in what is likely to be a low return environment interspersed with bouts of volatility.


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