Still Writing Obits

The Germans, the Chinese and Brits
Have seen manufacturing hits
But in the US
There’s been more success
Though bears are still writing obits

It is fair to say that the global economic growth rate continues to slow. We have seen weaker data as the norm, whether in manufacturing, housing or agriculture; we have seen a never-ending stream of central bankers expressing concern over this slowing growth and promising to respond appropriately; and we continue to see equity markets trade to new highs. Something seems amiss.

Yesterday was a perfect example of this phenomenon with an ISM print of 51.7, its fourth consecutive decline and the weakest reading since October 2016. In fairness, it was better than consensus estimates of 51.0, and the US was the only major economy to show continued expansion in the sector, but the trend is foreboding. The new orders component was exceptionally weak, and highlights those concerns going forward. And yet, equity prices traded to new highs yesterday afternoon, before ceding some ground into the close.

There has been a pretty complete disconnect between the fundamentals of stock valuation (at least the theories we learned in finance class about discounted future cash flows) and the actual price of stocks. And this is a global phenomenon, not merely a US outlier.

Of course, the missing link in this puzzle is central bank activities. Markets have become entirely dependent on central bank largesse to justify their valuations. Central bankers, after a decade of ZIRP and NIRP led to a huge increase in the financialization of the global economy, are now beholden to markets when they make decisions. This was made plain in January, when the Fed pivoted after equity markets plummeted following their last rate increase. They literally could not stand the pressure for even two weeks before reversing course.

So, the question becomes, will equity markets now dictate every central bank action going forward? While rhetorical, it is not hard to believe that the answer is yes. Despite all the current conversation regarding an uncomfortably low inflation rate as the driver for policy ease, it is abundantly clear that the only data point on which every central bank focuses, is their domestic stock market. I fear this is a situation that will result in extremely negative outcomes at some point in the future. However, there is no way to determine, ex ante, when those negative outcomes will manifest themselves. That is why bulls are happy, they buy every dip and have been rewarded, and why bears are miserable, because despite their certainty they are correct, thus far the central banks have been able to delay the pain.

In the end, though, the story on global growth remains one of a slowdown throughout the world. For all their largesse to date, central banks have not yet been able to reverse that trend.

With that out of the way, let’s see what those central bank activities have wrought in the FX markets. The first thing to note was that the dollar actually had an impressive day yesterday, rallying 0.7% vs. the euro and 0.5% vs. the pound after the ISM data. Given the better than expected print, market participants decided that the Fed may not be as aggressive cutting rates after all, and so the key recent driver of dollar weakness was reevaluated. Of course, one day’s reaction does not a trend make, and this morning, the dollar is backing off yesterday’s rally slightly.

Last night the RBA cut rates another 25bps, to a record low of 1.00%, and left the door open for further rate cuts in the future. Aussie, however, is higher by 0.4% this morning on a classic, sell the rumor, buy the news reaction. In the end, Australia remains entirely dependent on growth in China and as that economy slows, which is clearly happening, it will weigh on the Australian economy. While Australia managed to avoid ZIRP in the wake of the financial crisis, this time around I think it is inevitable, and we will see AUD resume its multiyear weakening trend.

Weighing on the pound further this morning were two data points, the Construction PMI at 43.1, its weakest in more than ten years, as well as the ongoing malaise in housing prices in the UK. Brexit continues to garner headlines locally, although it has not been front page news elsewhere in the world because of all the other concerns like trade, OPEC, North Korea, and in the US, the beginnings of the presidential campaigns.

But there is a very interesting change ongoing in the Brexit discussion. Throughout the process, the EU has appeared to have the upper hand in the negotiations, forcing their views on outgoing PM May. But with all signs pointing to a new PM, Boris Johnson, who has made clear he will leave with or without a deal, suddenly Ireland is finding itself under extreme pressure. A recent report by the central bank there indicated that a hard Brexit could result in a 4.0% decline in Irish GDP! That is HUGE. At the same time, the EU will require Ireland to uphold the border controls that are involved in the new separate relationship. This means they will need to perform any inspections necessary as well as arrange to collect tariffs to be charged. And the UK has made it clear that they will not contribute a penny to that process. Suddenly, Ireland is in a bad situation. In fact, it is entirely realistic that the EU needs to step in to delay the impact and cave to an interim deal that has nothing to do with PM May’s deal. At least that is the case if they want to maintain the integrity of their borders, something which has been given short shrift until now. My point is that there is still plenty of Brexit mischief ahead, and the pound is going to continue to react to all of it. In the end, I continue to believe that a hard Brexit will result in a weaker pound, but I am not so sure it will be as weak as I had previously believed. Maybe 1.20-1.25 is the right price.

In the US today there is no data to be released although we do hear from NY Fed president Williams and Cleveland Fed President Mester this morning. If the Fed is serious about staying on hold at the end of this month, rather than cutting the 25bps that the market has already priced, they better start to speak more aggressively about that fact. Otherwise, they are going to find themselves in a situation where a disappointed equity market sells off sharply, and the pressure ratchets even higher on them to respond. Food for thought as we hear from different Fed speakers during the month.

Good luck
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The Chaff from the Wheat

As markets await the report
On Payrolls they’re having to sort
The chaff from the wheat
From Threadneedle Street
As Carney, does rate hikes exhort

The gloom that had been permeating the analyst community (although certainly not the equity markets) earlier this year, seems to be lifting slightly. Recent data has shown a stabilization, at the very least, if not the beginnings of outright growth, from key regions around the world. The latest news was this morning’s surprising Eurozone inflation numbers, where CPI rose a more than expected 1.7% in April, while the core rate rose 1.2%, matching the highest level it has seen in the past two years. If this is truly a trend, then perhaps that long delayed normalization of monetary policy in the Eurozone may finally start to occur. Personally, I’m not holding my breath. Interestingly, the FX market has responded by selling the euro with the single currency down 0.2% this morning and 1.0% since Wednesday’s close. I guess that market doesn’t see the case for higher Eurozone rates yet.

In the meantime, the market continues to consider BOE Governor Carney’s comments in the wake of yesterday’s meeting, where he tried to convince one and all that the tendency for UK rates will be higher once Brexit is finalized (and assuming a smooth transition). And perhaps, if there truly is a global recovery trend and policy normalization becomes a reality elsewhere, that will be the case. But here, too, the market does not seem to believe him as evidenced by the pound’s ongoing weakness (-0.3% and back below 1.30) and the fact that interest rate futures continue to price in virtually no chance of rate hikes in the UK before 2021.

While we are discussing the pound, there is one other thing that continues to confuse me, the very fact that it is still trading either side of 1.30. If you believe the narrative, the UK cannot leave the EU without a deal, so there is no chance of a hard Brexit. After all, isn’t that what Parliament voted for? In addition, according to the OECD, the pound at 1.30 is undervalued by 12% or so. Combining these two themes, no chance of a hard Brexit and a massively undervalued pound, with the fact that the Fed has seemingly turned dovish would lead one to believe that the pound should be trading closer to 1.40 than 1.30. And yet, here we are. My take is that the market is not yet convinced that a hard Brexit is off the table or else the pound would be much higher. And frankly, in this case, I agree. It is still not clear to me that a hard Brexit is off the table which means that any true resolution to the situation should result in a sharp rally in the pound.

Pivoting to the rest of the FX market, the dollar is stronger pretty much across the board this morning, and this is after a solid performance yesterday. US data yesterday showed a significant jump in Nonfarm Productivity (+3.6%) along with a decline in Unit Labor Costs (-0.9%), thus implying that corporate activity was quite robust and the growth picture in the US enhanced. We also continue to see US earnings data that is generally beating (quite low) expectations and helping to underpin the equity market’s recent gains. Granted the past two days have seen modest declines, but overall, stocks remain much higher on the year. In the end, it continues to appear that despite all the angst over trade, and current US policies regarding energy, climate and everything else, the US remains a very attractive place to invest and dollars continue to be in demand.

Regarding this morning’s data, not only do we see the payroll report, but also the ISM Non-manufacturing number comes at 10:00.

Nonfarm Payrolls 185K
Private Payrolls 180K
Manufacturing Payrolls 10K
Unemployment Rate 3.8%
Participation Rate 62.9%
Average Hourly Earnings 0.3% (3.3% Y/Y)
Average Weekly Hours 34.5
ISM Non-Manufacturing 57.0

One cannot help but be impressed with the labor market in the US, where for the last 102 months, the average NFP number has been 200K. It certainly doesn’t appear that this trend is going to change today. In fact, after Wednesday’s blowout ADP number, the whisper is for something north of 200K. However, Wednesday’s ISM Manufacturing number was disappointingly weak, so there will be a great deal of scrutiny on today’s non-manufacturing view.

Adding to the mix, starting at 10:15 we will hear from a total of five Fed speakers (Evans, Clarida, Williams, Bowman, Bullard) before we go to bed. While Bullard’s speech is after the markets close, the other four will get to recount their personal views on the economy and future policy path with markets still open. However, given that we just heard from Chairman Powell at his press conference, and that the vote to leave rates was unanimous, it seems unlikely we will learn too much new information from these talks.

Summing up, heading into the payroll report the dollar is firm and shows no signs of retreating. My take is a good number will support the buck, while a weak one will get people thinking about that insurance rate cut again, and likely undermine its recent strength. My money is on a better number today, something like 230K, and a continuation of the last two days of dollar strength.

Good luck and good weekend
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