Overview
Financial markets remain extraordinarily choppy and have continued to sour.
While it would be premature to promise that valuations have reached their
extremes, the opportunities are arguably growing for contrarian investors. We
discuss currency moves and their implications below.
This week’s note also tackles the myriad economic challenges confronting
the U.K., the new sensitivity of the bond market to fiscal matters, important
developments with regard to the conflict in Ukraine, some thoughts on
China’s upcoming National Congress, a mix of economic thoughts --
including the implications of recent hurricanes -- and a review of key
geopolitical risks.
Monthly economic webcast
Our latest monthly economic webcast is now available, entitled “Recession nears / inflation worries falling.”
Dollar strength
Some of the most notable recent swings in financial markets have occurred in
the currency space. The pound, euro and yen have been particularly weak.
However, the story is as much about remarkable U.S. dollar strength as
weakness on the other side of the pairing (see next chart).
U.S. dollar has strengthened against currencies of most developed countries
Incidentally, while Canadians perceive their own currency to be weak given the
nearly exclusive focus on its pairing with the greenback, it has actually been
quite strong relative to most developed-world peers.
U.S. dollar strength is the result of several things. Of greatest importance,
during a time of concerns about the global economy and heightened risk
aversion, the superior safety and liquidity of the U.S. dollar makes it highly
attractive, drawing in capital and strengthening the currency.
Another important dollar driver is the relatively more hawkish U.S. Federal
Reserve. Not only does the Fed have a higher policy rate than the currency
laggards, but its latest policy announcement revealed plans to tighten
significantly further from here – potentially to nearly a 5% fed funds
rate. This, in turn, is pressuring some of the laggards to raise their own
policy rates by more than previously envisioned.
Lastly, the U.S. economy has been relatively more resilient so far. We still
expect economic weakness for the U.S., but the deceleration to this point has
been milder. The nadir there is likely to be less extreme than in the Eurozone
or U.K.
Under normal circumstances, a big foreign exchange move like the 16%
appreciation of the U.S. dollar versus the euro over the past year –
carrying it past parity with the euro – would elicit considerable
hand-wringing on U.S. shores about deteriorating competitiveness. But that has
not been the focus. The U.S. is mostly thankful that its currency strength
helps to dampen imported inflation and that investors are not fleeing its
markets as problematically as in some jurisdictions.
In turn, talk of a coordinated international effort to weaken the dollar
– as was implemented in September 1985 in the Plaza Accord – seems
unlikely at present despite the desire of the weaker countries for a solution.
The difference was that in 1985 the U.S. also disliked the strength of its
currency. That same attitude is not visible today.
Another important difference from 1985 is that many of the countries with the
weakest currencies arguably need this softness. For the Eurozone and U.K.,
this currency weakness – and the competitive boost it affords –
helps to offset the competitiveness shock the countries have suffered as their
energy costs have soared. For a manufacturer in Germany paying eight times
more for electricity than it did before the pandemic, a sharply lower currency
is critical to continue competing on the international stage.
This isn’t to say that countries love the full extent to which their
currencies have weakened, nor the speed at which the move has occurred. Case
in point, the Bank of Japan recently intervened to defend its currency. The
yen had fallen by significantly more than other major currencies, in large
part due to the unwillingness of the Bank of Japan to raise rates given its
desire to change the inflation mentality in Japan. The implicit floor on the
yen appears to be holding. China has also intervened to defend the yuan, while
the U.K. has just cancelled part of the fiscal package that was drawing the
ire of investors (discussed below).
Looking a little further down the road, if one envisions fading risk aversion
in 2023 and a return to economic growth by the second half of 2023, it
seems reasonable to expect some reversal of dollar strength. The temporary
factors at work in the currency market today provide a further reason why a
formal accord to alter currency valuations may not be necessary.
Pound problems
The weakness in the British pound has been particularly extraordinary. The
currency recently hit a record low versus the dollar.
The rationale for this weakness includes the aforementioned forces –
risk aversion, a relatively hawkish Fed, relative U.S. economic resilience,
deteriorating competitiveness in Europe – plus a mix of made-in-the-U.K.
complications.
The U.K. was arguably living beyond its means for years, as evidenced by a
significant current account deficit that indicates spending was substantially
outpacing production. This competitiveness was further damaged by Brexit,
which erected barriers and sowed regulatory chaos. With natural gas prices
soaring, the U.K. is now reliant on huge flows of foreign capital to remain
operational (see next chart). When investors become skittish, these flows
become more grudging, weakening the currency.
U.K. current account deficit yawns wider
The country then went through a period of rapid political change, with a new
monarch and prime minister arriving within days of one another. New Prime
Minister Truss and her finance minister Kwarteng recently proposed large tax
cuts. Financial markets took this extremely poorly, with the pound collapsing
and U.K. yields surging. In the span of a week, the British 10-year yield rose
from 3.29% to 4.60%, while the pound tumbled from 1.14 to as low as 1.03.
These markets have since partially unwound those moves as the Bank of England
first intervened with emergency temporary bond purchases. More recently, the
British government cancelled a portion of the planned tax cuts.
Why was the reaction so negative? Under normal circumstances, financial
markets might have celebrated tax cuts that looked to increase the
competitiveness of U.K. businesses through lower corporate income and dividend
tax rates. Some reasons for the response include:
-
The proposed legislation was arguably the straw that broke the camel’s
back, in that fiscal stimulus further spurs inflation at a time that the
British economy is already suffering from high inflation. The Bank of
England has to raise interest rates even more in its effort to cool the
economy. Markets shifted from an expected peak policy rate of 4.72% two
weeks ago to a huge 5.98% last week. Markets now price a giant 1.25ppt rate
increase for the November meeting alone. However, calls for an emergency
intermeeting rate hike have dulled somewhat.
-
The fiscal stimulus arguably had the wrong focus, cutting taxes
disproportionately for the wealthy at a time of suffering for those with
lower incomes. The announcement gave off a whiff of amateurism in the way it
wasn’t professionally costed first.
-
Certain British financial actors – pension funds most prominently
– proved unprepared for the sudden leap in bond yields given the
amount of leverage they were carrying. This triggered giant margin calls,
forcing liquidation attempts at a time when the market was not particularly
receptive to such efforts. This was a prime motivation for the Bank of
England’s temporary bond purchases. More broadly, it reflects poorly
on British regulators that they allowed this pension sector vulnerability to
form. The British mortgage market has also been profoundly affected as
mortgage rates soar and some banks have proven reluctant to lend into such a
volatile rate environment. The British housing market is now likely to
follow a materially more negative trajectory in the coming quarters.
-
Despite the fact that the Bank of England has tentatively managed to calm
markets, the U.K. has a surprisingly small quantity of currency reserves
with which to defend sterling against depreciating pressures. The U.K. is
thus particularly attractive for speculators to bet against.
-
As previously discussed, the U.K. current account deficit was already large
before this proposal, having increased significantly on the back of natural
gas subsidies just a few weeks before. The new tax cuts will add to the
deficit, exacerbating the situation. The U.K. gross public debt-to-GDP ratio
breached 100% in recent weeks – a symbolic threshold and an
undesirably high level.
-
Currency weakness gets passed powerfully on to British inflation, with a
multiplier of 0.2 to 0.3. This would suggest an extra percentage point or
two of inflation just from recent currency weakness.
Rising fiscal sensitivity
For over a decade, sovereign debt markets have been mostly dismissive of
concerns about mounting public debt loads. Countries could run substantial and
lasting fiscal deficits without being punished via significantly higher
yields. There were a few exceptions – prominently involving peripheral
European sovereign borrowers – but they constituted the exception.
Two main factors largely explain that period of fiscal indifference:
-
Borrowing costs were so low that countries (and everyone else) could borrow
a lot more than before without experiencing particularly burdensome
debt-servicing costs. There were still limits on what countries could
afford, but the limits had suddenly leapt well beyond actual debt levels.
-
Central banks delivered repeated rounds of quantitative easing over the past
13 years, buying many trillions of dollars’ worth of bonds in the
process. This constituted a large new source of demand that created a
shortage of bonds for other investors. For significant stretches of time,
central banks were absorbing more than the entire net supply of new debt.
It goes without saying that both of these forces are now in significant
reversal. Borrowing costs are soaring. Quantitative easing is being unwound
even as fiscal deficits remain fairly large. That means the supply and demand
of public debt is again becoming a relevant determinant of bond yields.
A long-standing rule of thumb is that a 1 percentage point increase in the
public debt-to-GDP ratio should map onto a 3–5 basis point increase in a
country’s 10-year yield. That rule worked loosely before the global
financial crisis, failed utterly during the post-financial crisis era when
deficits and debt simply didn’t matter, and could be starting to
re-assert itself as borrowing costs rise again.
In fact, U.K. yields actually rose by more than the rule would suggest in
response to the proposed fiscal package. This raises the possibility of a
higher-than-normal fiscal sensitivity, albeit in the context of an especially
troubled U.K. economic picture.
This newly rediscovered fiscal sensitivity could prove relevant elsewhere,
before too long. As economies weaken and threaten to tumble into recession,
governments will be sorely tempted to deliver additional fiscal stimulus.
Indeed, one of our central theses is that we are operating in an era of
larger-than-normal governments. Some may be punished in the bond market for
the decision.
Ukraine war
The Ukraine war continues to evolve in important ways. The net implications
are ambiguous.
On the one hand, Ukraine continues to make significant geographic gains. The
country managed to reclaim another chunk of territory in recent days, having
celebrated a large advance last month.
On the other hand, Russia is responding by escalating. It is calling up
potentially hundreds of thousands of new troops and preventing military-aged
men from leaving the country. It has made repeated nuclear threats and held a
sham referendum in an attempt to cement its legitimacy over the Ukrainian
territory it occupies. This provides a convenient context for Russia to
further escalate the conflict when Ukraine seeks to reclaim what Russian now
deems to be its own territory.
One might argue that the war has shifted from a predictable stalemate to an
unpredictable war, and possibly even to an unpredictable end-game. It could go
very well indeed if Ukraine continues to make large gains versus Russian
bluster. It could go extremely badly if Russia were to cut off the rest of its
oil and gas supplies or, in an extreme scenario, if Russia deployed a tactical
nuclear weapon.
As an aside, and at the risk of delving too far down an unlikely path, while
tactical nuclear weapons inflict considerably less damage than larger
strategic nuclear weapons, the nuclear bombs dropped on Japan to end World War
II were roughly on the same scale as modern-day tactical nuclear weapons.
Thus, they are not to be trifled with both with regard to their initial
destructive force and the radiation they unleash, let alone the risk of
tit-for-tat nuclear escalation.
From an economic standpoint, none of this changes the view that sanctions on
Russia will persist. In fact, they are more likely to intensify than they are
to ease in the coming quarters. The natural gas situation in Europe is getting
worse as pipelines are now not only being slowed, but outright sabotaged. The
supply of oil remains highly uncertain with the risk that Russia materially
clips its exports in early December.
Europe likely has enough natural gas to get through this winter –
presuming some conservation in the realm of the 15% year-on-year decline
Germany has already managed and assuming the winter is not especially cold.
However, that still leaves the region in precarious shape for the subsequent
winter, as inventory levels will be quite low and capacity to rebuild them
will be limited over the summer of 2023.
China’s National Congress
The National Congress of the Communist Party of China begins on October 16. It
has the potential to be consequential not just for China but for the world.
Of greatest significance, and despite rumours of some discontent within the
Communist Party, President Xi is likely to be re-appointed for an
unprecedented third five-year term. The government eliminated the two-term
limit in 2018.
Xi has strengthened his hold on the government over the past decade, and as
such can be expected to use his next term to further his desire for more
control over the Chinese population, for a more assertive China versus the
rest of the world, and for a further pivot back from private institutions
toward public institutions. Entrepreneurs, private-sector businesses and
market forces have all been diminished in recent years. None of these
ambitions seem ideal for Chinese economic growth, which has already
decelerated significantly over the past five years.
China’s zero-tolerance COVID-19 policy is unlikely to be materially
altered until the spring. Significant COVID-19 waves tend to happen over the
winter, and the country will want to prevent unnecessary transmission during
Chinese New Year travel and festivities. If those restrictions then ease in
the second quarter of next year, that would provide an important if temporary
tailwind for the Chinese economy.
The Chinese property market may also be in focus. Close watchers of China
doubt that significant changes will emerge from the National Congress –
at least in the form of large-scale support. The government continues to
emphasize that “housing is for living not for speculation.”
Nevertheless, housing is one of the key sectors in play, and some further
effort to stabilize it is possible.
From a more general economic perspective, China could reintroduce a growth
target, possibly in the realm of +5.5% per year. This is less than the country
previously achieved, but considerably more than is likely in 2022. Key
ongoing economic themes should include:
-
enhancing the country’s “common prosperity” (code for
reducing inequality)
- upgrading manufacturing
-
achieving greater supply chain security in the context of food, energy and
semiconductors
- continuing de-carbonization efforts.
Economic developments
Hurricane effects
Hurricanes Fiona and Ian have inflicted considerable damage in the Caribbean
and along the Atlantic seaboard.
Preliminary estimates are that Hurricane Fiona caused between C$300M and $700M
of insured losses in Canada. Estimates for Hurricane Ian in the U.S. are in
the realm of $40B to $70B.
In addition to the tragic loss of life and property, there will inevitably be
an effect on the economic numbers for late September and October. Between
power outages, property damage and tens of thousands of displaced people, some
businesses have simply not been able to operate at their normal clip. Florida
GDP could be 6 percentage points lower in the third quarter, with U.S.-wide
GDP up to 0.3ppt below normal.
Of course, natural disaster-driven economic losses are usually fully reclaimed
in subsequent quarters. Perversely, areas hit by hurricanes tend to have
stronger economic activity over subsequent years as reconstruction occurs. The
timing could be particularly opportune for construction workers given the
sagging performance of the U.S. housing market.
Economic data
A significantly negative global signal came from the latest FedEx earnings
report, which announced a recent decline in global volumes, both
internationally and in the U.S. In principle, FedEx should be a useful proxy
for economic activity.
The Institute for Supply Management (ISM) Manufacturing Index descended from
52.8 to 50.9 in September. That’s just a hair above the threshold
between growth and decline for the sector (see next chart). Providing a hint
of things to come, the new orders component fell from 51.3 to 47.1, and the
employment component dropped from 54.2 to 48.7.
U.S. manufacturing activities deteriorating
Forecasts for U.S. Q3 GDP data continue to decelerate. The St. Louis
Fed’s GDP nowcast has fallen to +0.55% annualized growth. The Atlanta
Fed’s nowcast has slipped to +0.3%. Meanwhile, the Blue Chip consensus
growth forecast for the third quarter has actually slipped into slightly
negative territory.
All of that said, it is hardly the case that every economic signal is weak.
The U.S. remains among the more resilient economies, with jobless claims
recently reversing its earlier deterioration (see next chart).
U.S. initial jobless claims improve again
Strangely, and in contrast to deteriorating growth forecasts, the OECD’s
weekly economic tracker for the U.S. has actually been accelerating recently
(see next chart).
Organization for Economic Co-operation and Development (OECD) Weekly Tracker
of GDP growth, U.S.
The main conclusion is that while some economic data is weakening, it is not
yet universal and a full-fledged recession is not yet upon us.
Housing pass-through
The housing market tends to be the most adversely affected part of the economy
when interest rates rise. The direct effect of this has been well documented
for the U.S., including sharply lower housing market sentiment, lower housing
resales, a tentative decline in housing starts and a slight drop in building
permits (see next chart). So far, residential construction employment and home
prices have not yet been significantly affected, though they should eventually
be. All should soften further over the coming quarters.
U.S. housing metrics reveal burgeoning weakness
Housing weakness, in turn, is starting to bleed into adjacent industries such
as furniture manufacturing and furniture sales (see next chart).
Housing weakness translating into lower furniture sales and employment
Labour market distortions
We have regularly mused about why the labour market is so tight today.
Prominent explanations include:
-
The ferocity of the aggregate economic rebound over the past few years, to
the point that many things in the economy are overheating, including the
labour market.
-
A shift in sector preferences with regard to the desires of consumers and
the supply of workers, each at odds with the other.
-
Significant early retirement during the pandemic (several million people in
the U.S.).
-
Younger workers also dropping out of the labour force to a significant
extent (a few million people in the U.S.).
We have generally ascribed the altered behavior of these final two groups to
shifting family priorities, the fear of getting sick, and surplus wealth built
over the first two years of the pandemic. At that time, financial market and
housing valuations both soared and households were saving more than normal.
But there is another plausible answer for the reduced supply of workers: many
people may still be sick. We refer not to those who happen to have a weeklong
bout of COVID-19 at any particular moment, but instead to long COVID: having
persistent symptoms for months or even indefinitely. There have been two
recent efforts to approximate the effect this has on the U.S. labour force:
-
The Brookings Institution estimates a startling 3 million full-time
equivalent workers are out of the labour force due to long COVID. That would
significantly account for the shortfall in the labour force participation
rate.
-
Conversely, a recent study from academics at Stanford and MIT figure
“just” 500,000 people are missing from the labour force due to
long COVID. That falls well short of explaining the entirety of the labour
force gap, but still represents a significant number of people.
A further and unrelated labour market distortion of a more temporary nature is
that more people have been taking vacations than over the prior few years.
This plausibly requires more backfilling by businesses and thus temporarily
exacerbates the tightness of the labour market. Approximately 4.8 million
workers took vacation or personal days during the reference week in June
versus 3.7 million the year before. However, it is unclear if more people are
vacationing versus the pre-pandemic norm due to accumulated vacation days,
which is the real question.
Geopolitical risks
Geopolitical risks rarely feel low: one can always drum up a few things to
fret over. But they genuinely appear to be particularly elevated right now.
This is partially a structural comment: we now inhabit a multipolar era
– one in which there are multiple sheriffs in town, all vying for
influence.
But there also rather specific near- and medium-term risks.
One begins, naturally, with the potential for a significant escalation of the
war in Ukraine. Russia is threatening nuclear attacks in a manner that nuclear
powers simply haven’t done before. As the country runs out of other
options to save its dignity, the risk of a nuclear strike is not zero.
Another highly consequential but relatively low probability risk –
albeit, as with Russia, a risk that is rising – is that China invades
Taiwan. This could trigger a war between the U.S. and China, with cascading
economic consequences that would dwarf the effect of Russian sanctions. We
intend to write more about this in the coming weeks.
Iran represents another point of risk. The country is literally on the cusp of
developing nuclear weapons, and it is an open question whether the U.S. or
Israel might try to stop this acquisition via force. Efforts to secure another
deal with the U.S. have stalled. It’s possible that Iran is delaying as
it puts the finishing touches on its nuclear program. Iran’s influence
has grown considerably over the years, now permeating not just Syria and
Lebanon but also significant parts of Iraq and Syria. Fascinatingly, this has
made for odd bedfellows as Saudi Arabia, the United Arab Emirates, Egypt and
Israel find themselves tentatively united in opposition to Iran. The Middle
East matters enormously to the global economy given that OPEC nations still
produce about 40% of the world’s oil.
U.S. polarization is another obvious geopolitical risk. By some measures, this
polarization is even greater than it was during the Civil War (see next
chart). So far, that polarization has had surprisingly little effect on the
U.S. economy. However, one worries that it eventually could, be it through
more extreme (and thus arguably worse) public policy, from declining trust
(both among businesses and people), due to a rising risk premium inserted into
U.S. borrowing costs, or even via a coup. The upcoming U.S. midterms
don’t appear set to upset the apple cart, but the 2024 election could.
U.S. Congress partisan polarization intensifies
Political issues are not confined to the U.S. A number of European countries
have recently shifted quite far right on the spectrum, including Italy and
Sweden. To the extent skepticism about the European Union is a feature of some
of these groups, there could yet be existential complications at the
super-sovereign level for Europe.
The list of geopolitical risks runs on and on. Will there be significant
unrest after the Brazilian election? Might Russia’s empire-building
aspirations eventually include a bigger chunk of the Arctic, of consequence to
Canadians? Could skirmishes between China and India – the world’s
two most populated nations – eventually degenerate into a full-fledged
war? Might emerging-market countries turn on the developed world, demanding
massive reparations for the damage done by climate change?
Few of these are likely to manifest in the near term, and it is generally not
advisable to invest primarily on the basis of geopolitical risks. But, every
once in a while, such risks end up mattering quite a lot – as in the
lead-up to Russia’s invasion of Ukraine.
-With contributions from Vivien Lee, Vanessa Adams and Aaron Ma
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