This time last year we were on the brink of an unpredicted and unpredictable UK General Election and unexpectedly loud tightening noises from UK and US central banks. Still markets remained mostly becalmed.
Given how 2018 is panning out, I’ll be amazed if this summer passes without drama. Investors are getting to grips with so many new realities: some good, some bad and some they just can’t call. It’s been a while they had to seriously consider trade wars and cold wars. Unfamiliar risks with asymmetric outcomes are difficult to trade.
So more volatility ahead, but where and what to watch? Over the next few weeks I’m going to pick my top ten areas, starting this week with: oil prices, US inflation, emerging market debt, BBB debt and the World Cup.
The oil price
During most of 2016 and 2017, oil traded between US$45 and US$55 a barrel – another becalmed market. But, in late 2017, prices broke out of this band as OPEC production cuts and rising demand took effect. In recent weeks, prices have spiked further towards US$80/barrel as Middle-East tensions and Venezuela’s plight worsened – with the rise sparking new debate. Is this a blip or a new band? Are we heading to or beyond US$100?
Without wanting to duck the issue, it’s a tough call. Previous forecasting playbooks have been torn up – not so much by alternative sources, but by the impact of US shale. The US is set to become a net oil & gas exporter by 2022, according to the IEA. OPEC has indicated that it could increase supply – which has led to prices dipping back. But it’s balancing its members’ revenue needs – and those of its ally Russia – and its market muscle has diminished.
So where does this leave oil prices? Trading in a higher band for now with the potential for greater volatility given the high number of wild cards. A period of steady trading within a higher band would be good news for producers and the oilfield services sector – although it may take a while for the OFS sector to feel that recovery.
Rising oil prices = higher inflation = faster rate rises? Not directly. The Federal Reserve tracks core inflation – at 2.1% in April – and this week a greater tolerance of minor inflation overshoots due to growing external concerns, e.g. trade. Or, at least, that’s investors’ interpretation, with expectations for a 0.25% June rate rise (as reflected in Fed Funds futures) falling from 96.7% on Tuesday from 82.9% on Wednesday. Expectations that the US would see three interest rate rises in 2018 dropped from 86.7% to 76.6%.
US interest rates will probably rise in June – but the path is a little less certain. Inflation might be subdued now, but a rising oil price and tightening labour market might force the Fed’s hand. The same uncertainly applies in the UK, where inflation dipped to 2.4% in April and interest rate expectations have dipped in the last few weeks. The difference between US and German bond yields has also moved to its widest level since 1990. It seems that investors still expect US growth and interest rates lead the way, sustaining the attractiveness of US debt – and dollars.
But will the US government stand by and let the dollar strengthen? Recent history suggests not. The upshot being that we can expect greater volatility in currency markets and beyond given now much activity rests on low interest rates. Removing this pillar was always going to be tricky – more so outside the US than within.
Emerging market debt
JPMorgan’s benchmark emerging market government debt index – which tracks local currency debt – gained c.35% in the year to January 2018 before wobbling then diving in more recent weeks.
If this was just a currency issue, the money might have just flowed into EM dollar debt – but it hasn’t. This suggests that the perceived risk in emerging markets has increased beyond dollar risk and beyond the high profile troubles of recent weeks. Is growth seems becoming more of an issue? Capital Economics suggests EM growth may have slipped as low as 4% at the start of 2018. But is there a new playbook to consider here too? As Bhanu Baweja of UBS recently noted in The Financial Times, the composition of capex in the developed world…
“is shifting slowly away from industrial equipment, business hardware and transportation towards shale production, intellectual property, services and tech products. An increasing amount of the value added in these investment goods is produced within advanced economies…….the true emerging markets, with lower per capita incomes and strong demographics may have to work that much harder to redefine their competitive advantage in a world that may need less of what they make.”
This week we’ve seen a few issues at around this grade stutter – ostensibly because of investor caution triggered by emerging market/Italian wobbles. A blip in a week of mostly smooth issues or a sign that more nervous investors are pushing back after years of what feels like ever loosening conditions?
It’s too early to say, but the stakes are high. This is a large group of borrowers vulnerable to downturn, given that their position at the edge of investment grade, and whose next refinancing won’t be as favourable. According to figures reported in The Financial Times, the BBB market now accounts for 48% of the US investment-grade market (ICE BofAML Indices). Leverage amongst triple B-rated issuers increased from about 2.5x in 2015 to just below 3x in 2017, according to Citigroup.
On the other hand, there’s a long way until the refinancing peak – now well into the 2020s – and growth is improving in most economies. An area to watch this summer if markets wobble, but also to keep weather eye on longer term.
The World Cup
A disappointing clutch surveys has fuelled concerns that the UK’s Q1 GDP slowdown to 0.1% growth wasn’t just weather related – if at all. ONS is skeptical. The Q2 GDP numbers released in late July should show some post-snow bounce, but the picture that’s emerging is of an economy lacking momentum and catalysts.
Lower inflation could boost consumer spending power, but higher oil prices will limit price falls and consumer confidence is still subdued. Firm Brexit progress would be a welcome fillip to business and consumer confidence – as might World Cup success for England – in England…maybe less so elsewhere….
The jury is out on how much exactly the World Cup boosts overall consumption. Previous years suggest that for every BBQ, there are fewer people on the high-street. Although, it will be interesting to see if the digital era creates new dynamics? Will online be the winner? Will England? The economic impact question may be moot given recent history and UBS’ analysis that ranks England fourth overall, but likely to lose to Brazil before the semi-final…
Maybe best to just focus on watching and enjoying the football…