Takeaways: Surprise! China has lowered rates and Brussels has all-but promised more liquidity. So, that’s currency volatility back to the top of the agenda. Markets are treating these moves as good news – for now. In a few days, they could be read as an indication of the global economy’s dire straits – that’s just the kind of markets we’re in. Meanwhile, UK retail sales have thrown a spanner in the interest rate works – although we’d urge caution before leaping to conclusions. And bond liquidity is a hot topic again. Predictably, there are many camps – from the apocalyptic to the muddle through and the outcome is still tough to call. Either way, high-yield can’t take as much for granted any more – the trend is still for tighter markets here, even if they’re periodically loosened.
From Brussels (and Shanghai) with liquidity
We started last week with China’s Q3 GDP data, which arguably is our economic situation in microcosm: Worse than it was, not yet as bad as feared and just enough unanswered questions to prevent a clear narrative forming. Add in more clear as mud Fed guidance and this remains a fluid situation (as they say in 24hr news speak) with more than the usual tie-in between market sentiment and policy decisions…..
As proven by Mario Draghi’s announcement last Thursday that put a shiny gloss on just about everything – and this morning’s rate cutting news from China, which put a cherry on top. Actually Mario didn’t so much announce as hint – but such a strong hint that no-one could really miss the meaning. He said the ECB is “open to a whole menu of measures” to begin in December…..nudge, nudge, wink, wink say no more…
This virtual QE promise had an immediate impact on all things Eurozone. On Thursday afternoon,Italian two-year government debt yields fell below zero for the first time. The Euro fell 2.3% against the dollar and the FTSEurofirst 300 rose by 2.1%.
Why is Mr Draghi making such loose noises when the Eurozone economy seems firmly set in recovery mode? October’s flash Eurozone composite PMI’s reading of 54, up from 53.6 last month and well ahead of the 53.4 forecast, would seem to confirm that the Eurozone is one of the world’s brighter growth spots. Although, that accolade is really all about forward momentum – i.e. improving growth rates. Actual growth rates are still rather low and the ECB clearly still have their eyes on the impact of deflationary pressures and the impact of any global slowdown. Mr Draghi also mentioned the investment required to support the refugee integration, which may also require some fiscal flexibility.
In this context, perhaps it wasn’t surprising that the ECB prepared markets for further loosening. What was surprising – given the expected resistance amongst some members – was an explicitness that will make it very hard to pull back. To add to the surprise, we also have a 0.25% cut in Chinese lending rates and a 0.5% cut in the reserve requirement rate, which has given an immediate boost to commodity and equity markets again.
Now you’d think that markets would add ECB QE and Chinese rate cuts together and get BUY…but there is always a chance that this could go the other way and make investors wonder just how bad things are!
Everybody needs good neighbours…
As for currencies, it’s like trying to negotiate a house of mirrors. A potential delay to Fed action into December was touted as a reason why the ECB had room to take a slightly looser path. The markets seem to have entirely discounted a 2015 move from the Fed, but economists questioned by the FT are still mostly (65%) plumping for a rise this year. So, it looks like we’ll almost certainly have the ECB moving in a different direction – and maybe the totally opposite direction to their US counterparts. That could create some pretty big dollar-euro moves and capital flows.
Meanwhile, Sweden and Switzerland might not be thanking the ECB. One in every two Swiss francs is earned in the Eurozone, 60% of all Swiss exports are sold in Europe The Riksbank has cut interest rates three times already to keep the Crown’s strength in check and stave off deflation. One central bank move begets another in this region.
What about the UK? Data had been pointing to weaker Q3 GDP growth, with one exception – and it’s a pretty big one. BRC figures, released earlier this month, showed the biggest like-for-like increase in retail sales since January 2014 –barring Easter distortions. The official ONS data last week showed an astonishing 6.5% year on year increase in retail sales in September, well above August’s reading of 3.5% and the 4.8% consensus forecast.
This news helped push sterling to its highest level for a month against the dollar in anticipation of a quicker rise in UK interest rates, but this is after months of decline and expectations pushing out to almost 2017. We’d throw some more caution in here from a number of sides. In economic terms, the September figure was up against weak comparatives and distorted by a late bank holiday and the positive impact of the Rugby World Cup. The current consumer picture is very good, but not that good. For retailers, it’s also worth remembering this is a sales figure. Consumers might be spending more, but the price of goods they are buying is still falling. In addition, retailers costs are rising, from wages to the rising price of fulfilment. Moreover – as EY ITEM Club recently pointed out – we are at the peak in terms of the wages-inflation equation. From next year, the picture doesn’t look so bright and recent profit warnings have also highlighted the impact of a more sluggish housing market.
This week we release our UK profit warning paper and Capital Confidence Barometer, which will help us look a bit further under the UK’s bonnet. More on this later in the week.
To the bond markets…
Bond market liquidity has been on our minds for a while, but apparently this has now shot right up the investor agenda. According to Barclays, bond trading turnover has dropped 40% since the credit crisis, while the inventory of Treasury Bills has fallen by 20%.
Typically, opinion is divided and two camps have formed around what might be termed apocalyptic vs make-do-and-mend outlooks. The former camp believe that regulations aimed at enhancing financial market stability – as well intentioned as they are – have cut liquidity, creating new risks to stability. The less gloomy camp argues that that there still buyers clamouring for higher yields to ensure that any turmoil will be quickly subdued – as per 2013. There is always a price; it just may not be one that the seller likes – that doesn’t make it a systemic problem. In fact, it will help bring more discipline into the market. Investors will need to research investments and think about who the next buyer might be – without just relying on the “greater fool”.
Without this sounding too much of a cop-out, it’s a tough call. The likelihood is that markets will muddle through – maybe with more help from central banks – but as we’ve seen before, stress tends to expose any weak links and linkages not spotted before and we have no firm idea where the losses will ultimately hit home, which will be all important here. What we can say is that for borrowers at the margins, it is going to be tougher – although weeks like this may cause the odd substantial rush back into the class. But still, in October, US junk bond yields moved above 8% for the first time since 2012 as investors start to demand a little more for increasing risk. Defaults are up in 2015 – mainly in energy, but it’s more stress than we’ve seen for a while.