28.07.17

Snapshots is wondering if the (very tight) air force flight suit that Emmanuel Macron wore this week is a sign that Europe has its mojo back. Indeed centre-left candidate Martin Shulz’s campaign slogan for the upcoming German elections is MEGA, which stands for “Make Europe Great Again”!

Central Bank Shuffle

Despite the recent fall in inflation prints we believe the focus of the major central banks is still on policy normalisation.  The broad direction of travel is the same for the FED, the BoE, the BoC and the PBoC.  This is quite possibly being coordinated to prevent destabilising FX moves.

We describe this as a very slow shuffle by the key central banks to exit stage left.  It seems that only the BoJ remains in the middle of the stage in a spinning pirouette.

To reiterate we are not advocating much higher rates unless wages suddenly pick up.  We just think that we are changing from a world of abnormally low rates to one with low rates, and the Fed’s recent comments are illustrative of the new focus on asset prices and policy normalisation:

“Broad U.S. equity price indexes increased over the intermeeting period, and some measures of valuations, such as price-to-earnings ratios, rose further above historical norms.”

According to Capital Economics, at a global level net asset purchases by central banks are likely to decline to zero by the middle of 2018.  This is a big change to the economy that we have got accustomed to, and it reminds us of a saying by the former Quantum fund manager Stanley Druckenmiller: “focus on the central banks and focus on the movement of liquidity…it’s liquidity that moves markets.” This is why we remain cautious on parts of the liquid fixed income markets.

Volatility

The unusually low level of market volatility is again raising eyebrows.  A number of market commentators are worried about strategies that target specific levels of risk and algos, which drive pricing in large parts of the equity market, whose inputs include recent volatility.

We think this is an equity story.  Mark-to-market leverage is creeping back into the credit market through structures like zero recovery CLNs and synthetic CDOs, but we do not think it is extreme.  Also, we believe that the use of algos in the credit markets is limited to assisting human traders as opposed to replacing them.

An excellent question was asked by the folks at Maples Fund Services which was “Will equities or credit lead the next downturn?”. The last financial crisis was obviously led by credit.  However, given the prevalence of volatility strategies and algos in the equity market there is an argument that equities could lead the next one. The important caveat is that if this did occur it would, in our view, be a “price” led sell-off that would result in a new clearing level being found and would not necessarily mean an increase in default rates if the capital markets stayed open during this price interruption.

By Asif Godall
Deputy CIO