Macro:

The question of Euro existentialism is rising once again with Greece negotiating with the EU and IMF over its bailout program and with the French elections becoming more uncertain. Few people believe Le Pen has a chance at winning the second round, but the consequences of such a low probability event are serious since a National Front victory could lead the way to the same in the summer legislative elections which could make a Euro referendum a reality. In truth the exit of a Euro member would be intractable but reason has never stopped other similarly intractable endeavours. The collateral damage would be substantial.

India’s demonetization has been confusing and we believe that we, together with most other investors, have been reading it incorrectly. The initial reaction and the current consensus is that the demonetization results in an immediate shrinkage of the money supply. This is trivially true of narrow money, but the reverse is true for broad money. By forcing money out of the physical realm and into bank accounts, the RBI has transferred narrow money from a system with a reserve ratio of 100% to the fractional reserve system. The first clues of this dynamic was the flood of capital into the bond market and the clumsy reaction of the RBI to increase required reserves lest the influx of cash was immediately multiplied through the system. We see the demonetization as highly reflationary in the longer term and that the RBI was right to shift from accommodative to neutral and to maintain its FY2018 GDP forecasts at an optimistic 7.4% (despite cutting FY2017 from 7.1% to 6.9%.

Positive for Indian equities and bonds.

Bonds:

QE has been going on a long time and it hasn’t had no effect. The effect has been mistargeted, but even an imprecise tool like QE is bound to have some effect, and it has. Inflation is turning around and central banks will not be able to ignore this. Last week, the RBI, largely expected to cut rates, decided to hold fire. The PBOC, while not an explicit QE operator had for the past year been operating de facto QE via open market operations and targeted repo. This year, it raised rates, not on its main lending rate, but on repo rates. On current economic data, the ECB will lose its justification for maintaining let alone accelerating QE. Unless a major political event such as a National Front victory in France threatens the integrity of the Euro, or Greece actually defaults, QE will likely fade away at the end of the year. This would then leave the BoJ the last of the money printers, yet even in Japan, economic data indicate recovery, and a change of stance at the BoJ may not be too far away. The time of ultra low rates is passing or has passed.

In the short term we are giving loans a rest. We are not selling but we are not adding either. The fear of rising interest rates has driven the retail investor into the arms of loan ETFs at a rate of a billion a week and loan prices at the liquid performing end are pushing past par, not an ideal situation. However, with default rates falling back to just over 1.5%, the fundamental credit dynamics are still good. Pricing isn’t.

European bank capital is still a theme for us. Apart from the fundamental value, the attractive yields, the low trigger risk, the increased clarity around coupon risk, if Trump materially rolls back Dodd-Frank, the ECB will have to acquiesce to European banks’ call to rebalance the regulatory burdens to restore competitiveness.

FX:

The strength of the USD in the last 3 years began with commodity weakness, the by-product of a manufacturing recession, itself the result of a trade war. At the same time the Fed had announced a tapering of QE. Underlying this was an economy that was squarely in recovery. These factors have not changed. The near term factors which may carry the USD even higher include a trade policy that may further shift a trade balance which was already in recovery. The USD is likely to remain strong for the foreseeable future.

Arguments to the contrary include that Europe hasn’t yet weaned itself off QE and when it does, the EUR should recover. Also, the EUR may be held back by the significant breakup risk introduced by the series of elections this year. And the European economies are now growing faster than the US’s, although this could prove short lived. Then there is Japan, also in the earliest stages of a second wind recovery, also with a still accommodative central bank, where a change of fortunes and policy could buoy the JPY. And finally there is the commodity recovery, the result of global manufacturing exiting recession, which could put pressure on USD. These are compelling reasons for a more cautious assessment of the USD’s prospects. However, these are discrete events which would introduce intermediate and intermittent periods of USD weakness.

If as we expect, the US continues to advance its insularity, and this is something that began well before Trump even campaigned on that ticket, then the supply of USD should decrease relative to its demand.

Commodities:

It wasn’t all China. When China’s economy faltered in 2015, its reaction was to shore up the economy, even as it pursued reforms elsewhere. One channel for quick reflation is infrastructure and construction and this explained the strong recovery in industrial metals (and cement) in 2016. But 2016 was a recovery for manufacturing worldwide, not just in China. We think that manufacturing has significantly or fully adjusted to the new trade reality, and has thus exited recession and that this has also pulled industrial commodities out of recession. This is positive for global metals and mining producers, despite their stellar run in 2016.

Gold has had a good first 6 weeks of 2017 and looks set to continue rising. Political risk is rising globally and inflation is rising. The threat to gold is that whenever there is a liquid alternative, that is a store of value and which is positively correlated to inflation, then capital could easily leak into the alternative. We think this is less likely now and that gold is having its day.

Our view on oil stands. The advancement of the Aramco IPO is a milestone confirming our conviction. We think oil will remain supported and could rise further.

Week ahead:

Feb 13

  • European inflation data
  • Eurozone GDP
  • India CPI

 

Feb 14

  • China CPI
  • Japan IP
  • Germany GDP
  • US PPI
  • Spain inflation

 

Feb 15

  • Taiwan GDP
  • US CPI, retail sales
  • UK average earnings, claimant count, ILO unemployment
  • US Empire State, cap utilization, industrial production

 

Feb 16

  • US building permits, housing starts, Philly Fed

 

Feb 17

  • HKMA interest rates
  • UK retail sales
  • Singapore NODX