October has lived up to its reputation as the month when crazy things happen in financial markets. We are beginning our last full week of the month with positive developments out of China, news of the Italian budget crisis, and the US jitters infecting bond and equity markets.
China is proposing changes to personal taxes that would bring a variety of deductions and allowances for households. Reliefs for mortgage interest, rent support, education allowances, a deduction for dependents, public healthcare and insurance coverage. The specifics will be announced after a period of public comment, with a target implementation date of 1 Jan 2019, just in time for the full rollout of US tariffs. This is by far the largest stimulus measure we have seen and will put money directly in the pockets of people with a high propensity for consumption spending.
Thus far, skeptics have labeled Chinese fiscal actions as half-measures, insufficient to turn the Chinese equity markets around. The important thing to note is the change of Chinese policy objectives from deleveraging to stimulus. We know the Chinese have the firepower to do it, and there is no point in waiting for the big guns to rollout before deploying to this market because when it does, there will be no time to react. So far in October, we have seen export tax refund increases, fiscal spending increases, corporate funding support, and an increase in the personal tax bracket thresholds. You can now add January’s household tax reliefs to the list.
Knockin’ On 7’s Door
As expected, China escaped the “currency manipulator” label in the US Treasury’s semi-annual report on the foreign exchange policies of major trading partners.
On 10 September, we wrote:
China made an effort to prevent the “currency manipulator” label by reintroducing its counter-cyclical factor in FX management, effectively putting a stop to further depreciation of the yuan against the US dollar.
Now that the Treasury’s report on currency manipulators is out of the way, will the PBOC loosen its control over the yuan? The USD/CNH has already broken the 6.9 line in the sand and is slowly sneaking up on the psychologically significant round number 7. With the trade war in full swing, we see the yuan at lower levels. There is no reason why the yuan should be trading at higher levels. As USD interest rates rise, yuan money markets will lose their yield advantage, and flows will pressure the yuan lower.
Month-to-date, the USD/CNH is up 0.82%, from 6.88 before the 10% tariffs came into effect. With exports at $2.4 trillion, that makes Chinese goods $19.7 billion cheaper to the rest of the world. A 10% levy on $200 billion is $20 billion. Coincidence? As economists have long known, tariffs do not work because the adjustment back to supply/demand equilibrium comes through the FX channel. Trade is not a zero-sum game, and the only effect that tariffs will have is a lower standard of living and a higher propensity for international conflict.
Moody’s lowered Italy’s rating to Baa3, which is the lowest notch in the investment grade category. This was no surprise to us, and we wrote to our clients about the risk of “a possible S&P or Moody’s downgrade of Italian credit” once the Italian budget is formally submitted to Brussels.
On 1 October, we also wrote:
We see a “junk” rating unlikely in the near future. A downgrade may present a buying opportunity for BTPs.
Moody’s changed its outlook to “stable” after the downgrade. This signals exactly what we were saying: a “junk” rating is not on Moody’s agenda anytime soon. This also means that financial institutions, including the ECB, will not be constrained by regulatory requirements from holding Italian debt. Now that the budget has been formally submitted, the showdown with Brussels will begin. Italy’s 10-year bond is already yielding 3.55%, a level comparable to BB-rated EUR-denominated corporates. With Germany’s 10-year yield sitting at 0.45%, this is shaping up to be as a nice buying opportunity for BTPs. With Brexit on the horizon, the EU is unlikely to start another fire by enforcing its budget rules on Italy.
Remember Operation Twist? It seems like so long ago that the Fed was trying to lower long-dated yields during its QE operation. The logic was that Operation Twist will lower long-term rates on all fixed-rate loans, which impacts home loans, durable goods, and business investment. Lower financing rates allowed the economy to expand more cheaply.
This was not the first time in history the Fed has targeted long-term rates. To help with the World War II financing effort in 1942, the Fed announced a price limit on long-term Treasury debt in the form of a ceiling equivalent to a 2.5% yield. The Fed’s price target on long-term debt lasted for a decade. It was not until 1951 that the operation ended, and it helped the US return to normalcy in the aftermath of WWII.
What we are now seeing in long-term Treasuries is not that unusual. Consider for a moment that the Fed’s unwinding of QE will reverse the downward pressure on long-term Treasury yields. Why should we expect an inverted yield curve at a time when inflationary pressures are becoming more visible? Higher inflationary expectations and higher interest rates go hand-in-hand.
From a portfolio allocation perspective, we do not expect bonds to provide sufficient protection from an equity downturn. This is why we have been recommending against long duration exposure. As the yield-chasing crowd discovered this October, interest rate risk can hurt your returns more than credit risk.
As many academics have argued, empirical evidence suggests a significant positive correlation between higher interest rates and higher equity market volatility. This is second-nature to most seasoned traders who have experienced markets during high-interest rate regimes. In the heyday of QE, asset liquidity quickly returned after any market turbulence. Real rates were negative, people had access to cheap funding, and even corporate issuers were borrowing money to buy back their own shares. We are now returning to a normal market where the cost of funding matters.
This earnings season will be interesting and full of contradictions. While the numbers are looking good, companies might be sufficiently spooked by market action that they set future earnings expectations lower. Uncertainty is creeping in, and the easy money has been made. Make no mistake, the US is still in a bull market, but this is the time when skill matters and returns will favor quality companies. We can help you navigate this late-cycle equity boom with defensive long exposure to non-cyclical components and with portfolio insurance strategies. Contact us to discuss options relevant to your specific situation.
The Week Ahead
The ECB meets on Thursday. Markets will watch for any change in Mario Draghi’s language for signals on the pace of monetary tightening. We expect nothing more than the usual intraday FX volatility during and after Draghi’s speech. No change is expected on the Main Refinancing Rate, Marginal Lending Facility or Deposit Facility Rate. US GDP figures will be released on Friday.
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