Macro Drivers

Macro memes are likely to eclipse the high-frequency economic data in the coming days.  The preliminary PMIs are among the first survey data for the new month, and October's are on tap next week.  The key reason that there may be downside risks in the US and Europe, especially in services, is the virus's resurgence and new restrictions.  A third of US states are reporting a record number of cases, and in Europe, from Portugal to Poland, are getting hit harder than many did earlier this year. Optimism about a near-term vaccine was blunted last week as two pharmaceutical companies halting testing due to safety concerns.  

The virus, and mounting evidence of second-time affliction, which also makes herd-immunity even in relatively small communities, like neighborhoods, more elusive, will continue to frame the macroeconomic forces and policy.  It seems that increasingly businesses are preparing for social restrictions and the need for PPE to extend well into next year.  It will restrain the economic recovery and continue to justify support from central banks and governments.  

Judging from private sector forecasts as well as the IMF's new World Economic Outlook,  the economic contraction in the US, EMU, Japan, the UK, and Canada this year are somewhat less than feared projected in June.  However, the IMF's better 2020 forecasts were essentially borrowing from 2021 activity.  Canada is the only one for which the IMF has forecast stronger growth in 2021 than it did in June (5.2% vs. 4.9%).  The IMF forecasts emerging and developing economies may shrink by 3.3% this year, a bit more than it projected in June (-3.0%), but did not fully shift into 2021 (6.0% vs. 5.9%).  The costs of growth in terms of the relaxation of social protections too early (deaths and illness) and in terms of deficits and debt are worth considering.  Deficits can be expected to be smaller next year, but the US is projected to be more than 8.5% before the next stimulus measures.  

Within the context of the worst pandemic in at least a century, four macro memes straddle economics and politics that are shaping the investment climate:  the US election, Brexit, integration of China into global markets even as trade tensions remain elevated, and the strong rally in European bonds. 

US Election:  What had looked like a close contest a few weeks ago is now turning into what many refer to as a blue wave, a Democratic Party sweep of both houses of the Congress and the White House.  There still is the risk of the uncertain aftermath of the vote due to a likely high number of paper ballots.  Given the divergence in the parties' use of paper ballots, it is possible that the machine voting shows one result, and with paper ballots, showing another. Yet, the investors seem more comfortable as the spread between the October and November VIX futures has nearly halved last week as the blue wave seemed more likely.  

Some argue that the Democratic tax and spend policies will be inflationary.  It is possible, but that argument seems to be based on suspect assumptions, like knowing the size of a deficit or debt allows one to forecast inflation. Knowing the size of 2020 deficits would not have been particularly helpful in forecast inflation or interest rates. The non-partisan Congressional Budget Office projects next year's deficit to be around 8.6% of GDP, and that is before another stimulus package.  The median forecast among economists Bloomberg surveyed sees a deficit a little below 10% of GDP.   By a few percentage points, it will likely be the largest in the G7.  Recall that in 2018 and 2019, while the mature expansion drove unemployment rates to the lowest in a generation, the US was running deficits above 4%.  It has become popular in some quarters to blame current account surplus countries for the US current account. The deficit-goosed economy may play a larger role.  Although some observers played up the 10.3% year-over-year rise in used vehicle prices, the drivers of measured inflation, especially core measures, are shelter and medical care (goods and services).  

Partisanship and personalities, and the stark differences on domestic policy, may obscure similarities on foreign policy.  Biden and the Democrats are critical of the administration's policy toward China not because it is too harsh but because they have not been effective.  A Biden administration approach may be more multilateral, but getting NATO members, for example, to boost spending and the intolerance of a NATO member (Turkey) purchase and test an anti-aircraft defense system from Russia, is likely to continue.  

The push to avoid using Chinese 5G equipment for on security grounds will persist, as will the pushback against a digital tax, which the French have indicated they will implement in the middle of December.  Policy toward Iran and Venezuela are unlikely to change substantively.  The US will likely reengage the World Trade Organization, including no longer blocking appellate judges' appointments. The US and EU may still have trade disputes (e.g., Boeing and Airbus), and Washington will remain opposed to the Nord Stream II pipeline, even if the vitriolic rhetoric is avoided.   At the same time,  Biden's "Made in America" economic program is just as much an import substitution policy as Trump's "Make America Great Again" efforts.  Economic nationalism appears to enjoy bipartisan support.  

Brexit:  This has been a nearly constant issue since the run-up to the referendum in June 2016.  The protracted divorce is nearly at hand.  The issue remains as it always has: what kind of trade relationship the estranged couple has after the separation.  A hard-exit was understood to be one in which the WTO rules replace the intimacy that has been enjoyed for nearly half a century. However, for political purposes, the 10 Downing Street likes to refer to it as the Australia-style trade deal.  This remains a distinct possibility. Reports from both sides suggest there has been little progress over the past couple of weeks since Johnson and von der Leyen spoke earlier this month.  A mini-climax was reached before the weekend as with high drama, and ostensibly due to the EU statement that did not commit it explicitly to intensifying efforts, Johnson indicated that there was no purpose of further negotiations if the EU does not change its position.  

The markets yawned as talks will still likely be held next week, and sterling managed to close slightly higher, and a little above $1.29 even after Moody's cut its sovereign rating to Aa3 (the same as Fitch's AA- and a notch below S&P).  Until the end of last week, the pattern seemed clear. Sterling was sold on news that made no-deal exit more likely.  

The reason that there has not been an agreement is that neither side is willing to compromise.  However, given the size differential and trade composition, the UK is at a distinct disadvantage, as French President Macron baldly stated.  There are considerable costs in leaving the EU even with a deal.  Custom checkpoints where there were previously none and additional rules and regulations will boost the cost of goods and services even if there is an agreement.  

While an exit is disruptive regardless, the resort to the WTO's basic rules is projected to hit growth quickly but also lower the path going forward. Simultaneously, the government is pushing a bill that would let it unwind past foreign acquisitions, especially by state-owned enterprises (obviously, China is top of mind), and the Bank of England is widely expected to ease policy next month (November 5). The contagion surge is obviously challenging on public health grounds, but it is also posing political challenges for Prime Minister.

China:  There is an emerging contradiction.  On the one hand, the US and the EU, and others have taken action against China on trade, understood broad enough to include Huawei and apps, which India appears to have been more aggressive than the US.  On the other hand, China is becoming more integrated into global capital markets. This is significant in its own right but also may have far-reaching implications.  

An important part of the Phase 1 trade deal with the US called for several specific market-opening measures. Beijing is well on its way to fulfilling these, which the mercantilists among us rarely acknowledge.  In some ways, this expedited a direction China already seemed to be moving.  Evidence is that China's bond and stock market have been included in global asset managers' benchmarks.  China's data show that foreign investors bought about $90 bln of Chinese bonds in the first eight months of this year and about $13 bln of Chinese shares.  That inflow lifted foreign holdings of China's bonds and stocks to about $420 bln and $150 bln, respectively.  

In industry surveys, reserve managers say they look to boost yuan holdings to around a 5% share.  According to the IMF's most recent COFER report, globally, it was about 2% at the end of June.  It represents a $16 bln increase in value in the first half of the year. Valuation adjustments likely played a role as bonds rallied strongly over this period, even though the yuan depreciated by about 1.5% against the dollar in H1. Central banks as a whole shift reserve allocations gradually, and in the year through June 30, the share of allocated reserves accounted for by the yuan increased.

During the first eight months of the year, Chinese investors bought almost $21 bln of Japanese bonds, the most since the Ministry of Finance (Japan) time series began in 2005.  Some speculate that this could be the PBOC diversifying away from US Treasuries.  It could be, but so far this year, and the TIC data is only through July, China has a bit more Treasuries now ($1.073 trillion) than it did at the end of last year ($1.070).  Some of the Chinese interest in Japanese T-bills may be linked to swap activity, where dollars are swapped for yen at a premium.  

Moreover, it appears that some of what may appear to be Treasury sales in a given month may be a shift to Agencies.  The dollar value of the yen in global reserves fell slightly in H1. In the past four years, 102 China-based companies had initial public offerings in the US, raising $25.5 bln, according to Dealogic.  During the previous eight years, 105 IPOs raised $41 bln, of which $25 bln was accounted for by one company (Alibaba, 2014).

Given that the yuan is closely managed, even if not direct intervention, its appreciation must mean that Beijing sees it in its interest.  However, the mercantilists distrust it because a rising yuan is supposed to be bad for exports.  The yuan's appreciation does serve a trade function when it needs to buy an agreed upon dollar-amount of US goods and if it wanted to stockpile some commodities if it fears growing global hostility.  An appreciating yuan is also consistent with its effort to integrate into the global capital markets.  It is encouraging foreign investment, and part of that requires a yuan that reflects the relatively high-interest rates and what may prove to be the fastest-growing large economy this year and next.    

Europe:  Another development that may be missed if one does not focus on it is the dramatic decline in European interest rates, especially in the periphery.  This is related to several factors.  The chief among these is the ECB's support under the Pandemic Emergency Purchase Program.  However, the purchases under the PEPP have slowed, and it cannot be simply dismissed as a summer lull.  In June, about 120 bln euro of bonds were purchase under its auspices.  Last month, it bought 70 bln euros of securities.  Japanese investors bought a record amount of Italian bonds (~$5 bln), both July and August.  Last week, Europe's peripheral yields had fallen to record lows (Italy and Greece) or near them (Spain and Portugal).  

The Greek yield is an amazing story.  In early 2016, the 10-year yield was above 11%.  It fell below 6% around the middle of 2017 and has been holding below 4% (except for a spike in March) since the Q1 19.  It approached 80 bp last week. Italy sold its first bond, a three-year tenor, with a zero-coupon, and it was over-subscribed to boot.  On the same day, it sold seven and 30-year bonds at record-low yields.  The premium the market demands of Italy over Germany was near 160 bp at the end of last year and last week it near 120 bp, the lowest since Q2 18. 

The same cannot be said of Spain.  Its premium over Germany has edged up to around 75 bp from 65 bp at the end of last year.  Italian bonds are outperforming Spanish bonds may first be a function of their higher yield starting point.  To this, one must add that Italian data has surprised on the upside.  Consider last month's composite PMI.   It rose to 50.4 (from 49.5) while Spain's fell to 44.3 from 48.4.  After the regional elections, Italy is enjoying a relative political calm period, while the tension between the regional and central government in Spain is elevated.  

The Federal Reserve announced its average inflation target approach at the end of September and has made it clear in word and deed that it does not require new measures. Like other central banks, the Fed has been encouraging the government to use fiscal policy.  The ECB expanded and extended its emergency bond-program in June, and many expect it to do so again in December.  The surge in the virus is taking place just as the recovery pace seemed to have been moderating. Additionally, a rate cut and new targeted long-term refinancing operations (loans from the ECB tied to bank lending) cannot be ruled out.  There already is record excess liquidity sloshing around the Eurosystem, and the unsecured overnight borrowing rate has fallen below the minus 50 bp deposit rate, which previously served as the floor.  

The point is that despite the Fed's adoption of the average inflation target, the market expects the ECB to move again before the end of the year in the face of materializing downside risks and deflation.  The US premium (over Germany) has been rising for five weeks.  At the end of August, the US two-year premium was below 80 bp, and last week it was above 90 bp for the first time in four months. In understanding and forecasting currency, we often emphasize short-term interest rates, but at times, the long-end does seem to exert influence.  However, the story is the same.  The US 10-year premium over Germany rose to about 135 bp last week, the most since March, and above the 200-day moving average (~131 bp) for the first time since early 2019.  

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