RMG Investment Bulletins
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Due to travel commitments, this week's note will be a little shorter than usual.
Back on 1st July, we set out our thinking that the US Dollar's rally from mid April was looking a little tired and that a period of correction or sideways consolidation was likely. Chart 1 below illustrates that the past month or so has taken the form of a sideways movement.
Chart 1 – Daily US Dollar index chart with 50 day moving average
Talk that Donald Trump is unhappy with the Fed's plans to continue raising interest rates and that he would like a weaker Dollar have not been enough to hurt the currency. The strong economy (growth of 4.1% annualised in Q2) and attractive interest rate differentials compared to other developed countries, along with signs that China is happy to see the Yuan weaker, continue to encourage capital flows into the US. We think that this can continue in the months ahead.
The same type of sideways consolidation is apparent on the EUR/USD cross. Looking at the weekly chart (plotted in chart 2 below), we also see a zone of current support (that was previously resistance) in the 1.15+ area. If this level were to be broken on the downside, we think that the Euro could fall quite a way. Other developed currencies such as Sterling and the Aussie Dollar as well as select EM currencies have been, on balance, a little weaker than the Euro which we think adds weight to the thesis that the US Dollar will break out to the upside at some point.
Chart 2 - Weekly EUR/USD chart with 40 week moving average
But we don't think that the Dollar is ready to break out just yet. Positioning data shows that speculative accounts have in fact been building long US Dollar positions of late, and although it is certainly not impossible, we think it is less likely that the Dollar breaks out with fast money accounts already so long the Dollar. We also think that Trump remains in a fairly combative mood, and that any breakout in the short term would likely lead to a tweet storm from the commander in chief.
So, our favoured path for the weeks ahead is more of the same; i.e. sideways type price action before a breakout in the Autumn.
We continue to focus on the Dollar because of its importance for both the global economy and financial markets. We have said before that a too strong Dollar is painful for most, and yet at the same time, a too weak Dollar would hurt as well. Or put another way, the World works well in periods when the Dollar is flat to slightly weaker, which is what we see in the immediate future.
So, if we are right, then we should all be able to head off to the beach and not worry too much about markets. However, as we are looking for more Dollar strength later in the year, we may have to adjust our thinking in September/October.
What if we are wrong? Well, if Trump gets his way and the Dollar weakens from here, we think this would be bullish of risk assets. The flip side is that if the Dollar breaks out almost immediately, then we would expect financial markets to begin wobbling a bit. And so we are watching the bond markets closely, where there are tentative signs that US yields (and perhaps yields everywhere) are attempting to move higher. If these tentative signs develop into a full blown move higher in global yields, with the US in the lead position, then the risk is that the Dollar will move higher quicker than we envisage.
So, as we head off to the beach ourselves, we will be keeping an eye on the Dollar more than we would like as a litmus test for what the global financial markets may be doing.
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Living in the UK and working in the financial sector, it feels like it's all Brexit and Trump at the moment, interspersed with some economic data and a bit of central bank action. Although the headlines are attention grabbing, the reality is that markets are still kind of going nowhere (which we pointed out a couple of weeks ago), with the US ahead of Europe and emerging markets lagging over the last few months. Our attention is focused on whether markets are about to break higher in the short term, and we also continue to spend a lot of time looking at leading indicators for both the economic and market cycle. It all feels a bit choppy to be honest.
Chart 1 below plots the MSCI World in US Dollars. We would describe what we see as an index that is still in a general uptrend, with price above the 200 day moving average which is still rising. That said, the index is up only 1.7% year to date (positive but hardly a rampant bull market) and appears to be capped by resistance created since the volatility driven sell-off in Jan/Feb. A move above resistance would be viewed as bullish.
Chart 1 - MSCI World Index Price Only
Nearly all the heavy lifting is being done by the US equity market, which is up 4.8% year to date as measured by the S&P 500. Excluding the US, the MSCI World Index (see chart 2 below) is down 4.3% year to date. We see quite a different picture here, with price having broken support created post the volatility driven sell-off in June and trading below its own 200 day moving average which is beginning to rollover. If equity market performance were the sole indicator, we would have to say that Trump is winning.
Chart 2 - MSCI World Index excluding the US
Can this out-performance really be down to Donald Trump's policy mix? Next week we will see the Q2 GDP report which is likely to show the fastest growth since 2014 and we can only imagine how this will be spun by the White House. With Trump also criticising the Fed, talking down the Dollar and vague talk of more tax cuts to come, Trump is clearly going all out for growth to show the electorate that he is making America great again.
All of this makes for great headlines and occasional political drama, but the main question is whether the Powell Fed will ignore Trump and continue to raise rates and allow the balance sheet to shrink and whether China/Xi stand up to Trump's tariffs potentially leading to a broader trade war. Frankly, we think Trump’s economic plans are mis-guided and any short-term victories on the growth front will be followed by broader problems; but those concerns may get drowned out by Trump's cheerleaders in the short-term.
What also grabbed the headlines on Friday was the appearance of the Chinese National Economic team in support for markets over there. As concerns have increased over a potential slowdown, the intervention on Friday supported equity prices and strengthened the Yuan just a few hours before Trump called for a weaker US Dollar
We can quite easily envisage markets breaking out on the combination of Chinese support/stimulus and a softer Dollar. As shown in chart 1, there is a clear zone above which global equity prices would clearly be back in bullish mode.
However, if the Chinese support is seen to only be plugging holes in the dyke, the Federal Reserve remain resolute in tightening policy and the Dollar rally continues, then markets will struggle to break out and may even slip back to the bottom of the range seen in recent months.
For our part, we will try and ignore the intra-day market gyrations caused by Trump headlines, and wait patiently for signs that markets are breaking out (the US may already have done so as measured by the S&P 500). And whilst we wait patiently, we continue to look at leading economic and market indicators. For example, data for Building Permits (a component of the US leading economic index) and housing starts were released last week, with both some way below expected.
It may be too early to say that the housing market is rolling over, but it is not really adding to economic growth at the moment, is obviously interest rate sensitive and also correlates well with future unemployment rates (see chart 3 below).
Chart 3 - US Housing starts and the unemployment rate lagged by 12 months
Our big picture view continues to be that the US economic cycle is mature and that the Fed risks creating a policy error if they tighten too far. So, the potential interference from the White House bears close watching along with leading economic indicators and signs of deterioration in the more speculative parts of the financial system. Of course, Trump is trying to extend the economic and market cycle for as long as possible, and we need to be attentive to any signs that he is having some success. Markets may be quiet at the moment, but this is a very interesting time in the larger cyclical picture.
To view a PDF copy of this report, click here.
In the last couple of months, we have regularly highlighted the underperformance of emerging market assets, and their frailty in a strong Dollar environment. A couple of weeks ago, we said we thought that the Dollar was likely to pause or correct some of the post April rally, and suggested that risk assets should hold their own if our Dollar view prove correct. Since that time, EM assets have tried to improve although we would characterise the improvement as modest and a good part of the technical damage incurred in Q2 remains in place (a potential dead cat bounce if you will).
Our concern in Q2 was that emerging market concerns could spill over into developed markets and the global economy. So far, this has not been the case although it may still be too early to sound the all clear. Chart 1 below plots Korean exports alongside the US Manufacturing PMI. The correlation is reasonably clear although the recent softening in Korean exports (flat year on year now) is in contrast to the US manufacturing PMI near multi-year highs. Do Korean exports rise or does the US manufacturing PMI decline in the next couple of quarters; or a bit of both?
Chart 1 - Korean exports year on year and the US Manufacturing PMI
As noted above, a strong Dollar is not a great environment for either emerging markets or global growth. Chart 2 below (courtesy of Nordea) plots OECD industrial production and emerging markets currencies (advanced by 5 months). Will the recent Dollar strength lead to a slowdown in OECD industrial production in the second half of the year?
Chart 2 - OECD Industrial Production with EM FX Index advanced 5 months
Even as business confidence in the US manufacturing sector remains near multi-decade highs, the global situation does not seem as robust. Although we talk about the impact from emerging markets, what is happening in THE biggest emerging market: China?
Since the Global Financial Crisis, China has emerged as the marginal consumer of industrial metals and many other commodities. In recent weeks, prices for industrial metals have collapsed, perhaps hinting that something is not quite right in China. It would also appear that they were very happy for the Yuan to weaken against the Dollar (in fairness, more catch up with weakness in other currencies rather than China leading the weakness) during a period of significant underperformance of Chinese equities and sharp falls in benchmark interest rates.
Chart 3 - Global Manufacturing PMI versus industrial metals (courtesy of Nordea)
So, this is what needs to be watched in our opinion. We know that emerging markets were under strain in the first half of this year, and this has shown through in global indicators. To date, the US appears to be an island of tranquil economic nirvana (the economic equivalent of stable genius?). To be clear, we are not calling for imminent recession; in fact, we struggle to envisage economic contraction starting within the next 12 months. However, the risks are not trivial that leading indicators of US economic growth begin to soften in the second half of the year. Going back to the US Manufacturing PMI, what we can see in chart four below is that the index leads US growth by about 6 months.
Chart 4 - US Manufacturing PMI and year on year GDP Growth lagged by 6 months
The US manufacturing index is but one leading economic indicator, but correlates well with changes in the index of US leading economic indicators, as shown in chart 5 below.
Chart 5 - US Manufacturing PMI Index and the Index of US economic leading indicators
We are also intrigued by how relaxed the US Federal Reserve seems to be over the emerging market concerns. The Fed raised rates at their recent meeting, indicated they would continue to raise rates gradually (i.e. likely twice more this year) and will continue to let their balance sheet decline by another $270 billion in the second half of 2018. We have been arguing for months that the Fed risk entering the zone of a policy error in the quarters ahead. To be fair to the Fed, with inflation above target, and likely to remain so in the next year or so, their room for manoeuvre is limited.
So, here is the main risk. The emerging market wobbles seen in the first half of the year are not contained despite the improvement in risk assets in the last couple of weeks. If these emerging market strains spill-over into the global economy in the second half of the year, then we suspect that even the US will not be immune.
We will be watching closely for signs that leading economic indicators are rolling over. And the reason for this is not that we are trying to predict the onset of recession but because history tells us that leading indicators and the financial markets both deteriorate before the onset of recession as the Fed raise rates - or as we have said many times, each Fed tightening cycle since WWII has ended in either US recession and/or a financial event in the US or abroad. Broadly speaking, financial markets and leading economic indicators are close to being coincident.
Chart 6 - S&P 500 with Fed Funds rate and Index of US Leading economic indicators
So, although markets seem very quiet and rangebound even before we get into the Summer holiday period, we need to continue to watch carefully for signs of continuing problems in emerging markets, and whether they are beginning to spill-over into developed markets and the US. And if we do see signs that this is happening, what will be the reaction at the Fed?
We would love to be able to hit the auto pilot button for the next couple of months, but something tells us that we had better keep one eye on the global macro landscape.
To view a PDF copy of this report, click here.
Last week felt very quiet to us; perhaps not surprisingly so with 4th July celebrations in the US, the sporting calendar in the UK and Europe and people thinking about heading off to the beach as the UK enjoys its best summer weather in decades. So, we will keep this week's commentary brief.
In the aftermath of the volatility led correction in early February, financial markets have mostly gone sideways, as seen in the chart below of the MSCI World Equity Index. US equity markets have performed a little better and emerging markets a little worse with European markets almost unchanged on the year to date. The experience has also been a little different depending on your home currency too, with non-Dollar investors feeling slightly better than those that measure performance in Dollars. But overall, we best characterise the last 5 months or so as rangebound.
Chart 1 - MSCI World Equity Index (price only)
However, it is not right when we say that nothing has happened. There have been shifts in both fiscal and monetary policies, headline grabbing political issues and changes to trade policies to name a few. And of course, everyday there are thousands of transactions in markets between willing buyers and sellers that result in a change of ownership. So, to put this another way, despite all of the changes seen both in markets and the real world, equity prices have been very steady.
The same kind of sideways, rangebound market can also be seen in the US bond market (European yields have generally been a bit softer with prices higher) as can be seen in chart 2 below. Despite continued gradual rate rises from the Fed, fiscal stimulus and higher inflation the US bond market has been remarkably steady.
Chart 2 - US 10-year generic government bond yield
So, what's our point here? Well, markets don't go sideways forever; at some point the boundaries of the recent ranges will be broken and price will embark on new trends. It may also be sensible to accept that we cannot predict with certainty which way these markets will break, and so we need to be patient for the market to tip its hand.
In support for the bullish camp, we would say that markets have been resilient despite the brewing trade conflict and tightening by the Federal Reserve. With economic growth still moving forward nicely, even accelerating modestly in the US, corporate earnings have continued to grow. And in particular, we would point out that both business and consumer confidence remain very much in the positive ledger, especially in the US.
In this cycle, it has paid to be bullish so long as markets either believe that the risks are acceptable compared to the risk-free rate (mostly zero in recent years), or are capable of ignoring bad news, or that central banks will rapidly head off any trouble with new stimulus. Looking at the charts above, it seems obvious, but unless price breaks below the recent lows in equity markets (yield highs in bond markets), why on earth should investors be worried?
We suggested last weekend that if the Dollar could ease off a bit from recent gains, then the likelihood was that risk assets could nudge higher. Broadly speaking, so far so good with that call, and we stick with it. We also noted last week that the tone in markets over the Summer is one of subdued activity, and that outcome would fit very much within our rangebound analysis above, with equity markets perhaps trading to the top end of the now quite well-defined range.
So, a little bit bland from us here at this short-term juncture, although we have no doubt that there will be plenty of talking points in the months ahead. Markets are seemingly happy to stand still even as things change around them, and now continues to seem like a time to do less and watch more.
To view a PDF copy of this report, click here.
Back on 22nd April, we said that we thought the US Dollar was on the cusp of an important move, and that it was time to sit up and pay attention (see that report here). Since that time, the Dollar has risen by the best part of 5% in just over two months, not a bad move in FX markets. We now think that this move is getting a little tired and we would not be surprised if the Dollar experienced a period of softness ahead. Given the weakness in emerging market assets as the recent Dollar rally progressed, we think that risk assets generally will enjoy a period of Dollar weakness. What we are not entirely certain about is how big a correction the Dollar may endure here (if any at all) and therefore how big a bounce to expect in risk assets.
Chart 1 below plots the US Dollar index on a daily basis. What we see here is that from late April and through May, price advanced steadily with only shallow corrections. Since the end of May, price is basically flat and price action is much more choppy. The recent highs in the last week or two were not confirmed by momentum (green histogram) and stochastics (lower panel) are beginning to roll over. This type of price action is indicative of a period of consolidation ahead, in our opinion.
Chart 1 - Daily US Dollar chart with 21 day moving average
If we step back and look at the weekly chart, there is some resistance in the 95+ area that has so far held the recent advance. As we said above, we are not sure exactly what path any consolidation may take for the Dollar, if one were to occur, but our working roadmap is that this is just a consolidation in a larger uptrend. Perhaps a consolidation will be orderly and find support in the 92 area, before the Dollar bull market resumes. Of course, a lot will depend on what path the major central banks will take in the meantime.
On this point, we expect the Fed to maintain the current trajectory of gradual rate rises (we'll go with two more this year) and quantitative tightening, which increases from $30 billion per month in Q2 to $40 billion in Q3 and $50 billion in Q4. Every other central bank wants to be more dovish than the Fed, and nobody wants a strong currency. Perversely, nobody wants the Dollar to be too strong either (including president Trump), and so policy makers face a bit of a dilemma at the moment, given the cracks emerging in some corners of the global markets after only a modest move in the Dollar.
Chart 2 - Weekly US Dollar index with 21 week moving average
When we look at positioning of the speculative crowd, we see that they have finally jumped on the bullish Dollar story. With markets seemingly trying to hurt the most people most of the time, will this recent surge into Dollars prove to be a tactical error, or is this just the start of a larger trend of Dollar buying? As we have noted, our roadmap for the Dollar is consolidation followed by further advance, so for long term players, we think it's buy the dip for now.
In terms of crowded trades, despite US yields moving lower and signs of global wobbles, speculative accounts have barely reduced their record short position in the 5 and 10 year part of the curve. So, as we sit here thinking about what would cause the Dollar to soften a little in the short term, we don't think it will be global central banks suddenly becoming more hawkish than the Fed. It is more likely that either the Fed backtracks a bit, Trump verbally intervenes or economic data soften a bit. If any of these things happen, we think that US yields could move a bit lower as speculative accounts close out their short positions.
So, how do we play this upcoming Dollar consolidation in the markets? Well, we will stick with our larger multi-month topping process for now. If we are right about both the US Dollar softening and US yields drifting lower, then we think equities can rally a bit. But, we still think it's a matter of selling rallies rather buying dips in this asset class. We will hold our high quality US bonds for now, and although we would expect credit spreads to tighten a little bit, we are just not that interested in owning these assets longer term as the spread is just too tight from an historical perspective, especially given the maturity of the economic cycle.
We would be cautious about actually selling the Dollar here other than for a very tactical trade. In fact, it would need a complete reversal from the Fed to a dovish path for us to think about selling the Dollar longer term.
So, the message this week is that we may see a reversal of the trend apparent in some markets in recent weeks, but we don't think this is necessarily a strong reversal; more of a consolidation. There are times in markets when it is right to press your trade ideas and times when doing nothing is the right thing to do. Boring as this may seem, we think that we may be moving into a summer lull in markets. When we discussed this potential internally last week, there was definitely some push back. Given the ephemeral nature of liquidity in markets today, it is certainly possible that something happens in the weeks ahead to shatter the calm in markets that we think we see coming, and price volatility could pick up quite substantially. As such, we all need to remain alert, especially if our multi-month topping process is correct.
So, to wrap up this week, we have been of the view that the Dollar has been taking the role of the pied piper in recent weeks, and therefore a consolidation for the Dollar should help risk assets. But we are not advocating a big shift to risk on at all. Any rally in risk assets should prove relatively muted and should be used to raise defensive positions for those that have not yet done so and are worried about a potential multi-month top in markets.
To view a PDF copy of this report, click here.
In the last few weeks, we have mentioned the concept of the totality of monetary policy. Everyone focuses on interest rates, but monetary policy is more than that. We need to look also at money supply, the yield curve as well as rates, the Fed's balance sheet and the direction of the US Dollar to get an overall sense of monetary conditions. A number of commentators will make the point that with US rates at only 2%, how can there possibly be bad times ahead; surely rates would have to reach 5% or more for something nasty to happen? Perhaps they are right, but if we accept the argument that we need to look at the totality of monetary policy, along with current conditions, then the situation has to be more nuanced that "ah, rates are too low for a recession to occur".
Chart 1 below is from the excellent Lacy Hunt of Hoisington Investment Management. His thesis (and we are massively simplifying this) is that M2 money supply growth has decelerated into 17 of the last 21 recessions (since 1900) and that the totality of monetary policy can explain the four occasions when money supply did not decelerate into recessions.
Chart 1 - M2 Money Stock Annual % change
In chart 2 below, we plot the Fed Funds rate and the US yield curve alongside the year over year per cent change in M2 and stock prices (shaded areas = recessions). What we are trying to show here is a more complete look at monetary policy than purely interest rates, which of course remain at a low nominal reading of 2%. This shows that prior combinations of Fed tightening, as shown by Fed rate rises, decelerating money supply growth and a flattening of the yield curve are a powerful force and apparent prior to recent recessions.
Where are we today? Well, the Fed will continue to raise rates until something changes (most likely something untoward in the financial markets in our opinion) M2 money supply growth is decelerating noticeably and the yield curve continues to flatten. We are of the view that these monetary levers need to tighten further prior to a recession, and that we will likely see the yield curve flatten well before such an event.
Chart 2 - The Totality of Monetary Policy
Because of its global reserve status, changes in US policy are felt at home and abroad. Global markets are also influenced by changes in the US current account (a mechanism by which the US supplies Dollars to the rest of the World thereby helping growth) and the level of the Dollar. So, with the current account about half the level it was pre 2008 crisis, and the Dollar up 7% from the recent low, headwinds for the global economy and more especially emerging markets are becoming apparent.
We think that the Dollar could be an important factor for global markets in the weeks ahead. Any further Dollar gains could easily tip markets over towards bear market territory, or a decline in the Dollar will help markets bounce from here. It is important, because as we show in chart 3 below, the MSCI World ex. US is testing a level of support that has been created over the last eight months, and it is trading below its own 40 week moving average. A break of this support could easily lead to further losses.
Chart 3 - MSCI World Index ex. US with 40 week moving average (green)
For months, we have been talking of a multi-month topping process, and this is what it looks like on a chart of a broad based index. Our preference at the current time is that this support will hold and that the Dollar could soften in the weeks ahead. We are therefore looking for the topping process to continue a little longer, and for central banks to tighten policy further (obviously led by the Fed) and for economic growth to remain reasonable. But the risks do seem to be growing and investors need to remain alert.
In the weeks ahead, we will continue to look at the current conditions of the economy, and how policy could affect growth in future quarters. As we tried to point out last week, the economy will only start to deteriorate after the turn in leading indicators and financial markets. We should certainly not confuse economic analysis with market analysis as waiting for an obvious deterioration in the economy will most likely mean that investors have overstayed their welcome. That said, we think the combination of both a financial and economic downturn will be comparable to 2008, and so understanding both is extremely important.
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