It has become clear that certain events this December would likely generate a heightened degree of volatility and could set the tone of markets as we move into 2016. Four days into the month and we are certainly seeing a few thrills and spills.
Top of the bill last week was Mario Draghi. We wrote extensively about this two weeks ago highlighting how the ECB had been extremely vocal in communicating a big increase in stimulus to the market. We explained how we thought the short Euros versus US Dollars had become an extremely crowded trade (and therefore vulnerable to a reversal higher in the Euro) and that European government bond yields were fully pricing in an aggressive easing (and so also vulnerable to price declines which means higher yields).
A lot has been written about the ECB and so we won’t rehash all of it here but, by only cutting the deposit rate by 10 basis points to minus -0.3% and only extending QE officially to March 2017 (an extra 6 months), Draghi woefully under delivered. Having been hailed as the messiah of central banking, what went wrong? We can only speculate, however it seems highly likely that the Germanic block did not support much, if any, further stimulus. This could be because even the ECB staff forecasts were broadly unchanged from the last set made in September, therefore neutralising the argument for new and aggressive stimulus.
Whatever the reasons, Draghi and his trusted lieutenants had whipped up the market into a frenzied excitement over the possibility of big bazooka sized stimulus package and they only delivered a pea shooter size package. Markets were understandably disappointed and a massive position adjustment took place in relative illiquid trading conditions. The Euro rose by about 3% against the Dollar as shown in chart 1 below, which is one of the largest daily moves since the inception of the Euro.
Chart 1 – The Euro versus the US Dollar
It was also carnage in the European bond markets with German yields higher by 13 basis points in the two year and nearly 20 basis points in the five and ten year bonds. With a huge sum of Government bonds trading with a negative yield on the assumption that the ECB would move to an even more extreme policy stance, any disappointment was bound to have been met with a sharp decline in price and so higher yields, as shown in chart 2 below.
Chart 2 – The German 10 year bond yield
Draghi did make a speech late on Friday that was seen by some as an effort to re-establish his credibility and persuade markets that he will do whatever it takes. However, we think the damage has been done. There may be no limits to policy in theory, but as we’ve seen with the Swiss National Bank in particular, there is a practical limit, and the market knows this. Nobody knows exactly where the practical limit is, and frankly central banks should not want to get near it as, by the time they reach it they will have lost any credibility they may have left when they have to abandon the policy.
Moving on, it was a big week for data in the US, with important manufacturing and services sector surveys along with the monthly employment report. The business surveys were disappointing, especially the manufacturing sector. The employment report showed another decent month for job creation in November, albeit of the low paying variety and of the part time variety.
Of immediate interest to everyone will be that the employment report will do nothing to stop the Fed from raising interest rates on 16th December. Indeed, the speech and testimony from Chair Yellen last week fully indicates that she wants to raise rates. So, in simple terms, the Fed rate hike is now fully factored in by the market. What we may hear from the Fed will be their expectations for how far and fast they may raise rates. We are very comfortable with the view that they will raise rates very slowly. In fact, they will tell us they are data dependent, and we still hold to our view that they will raise rates twice (December and again in March), and that will be it. By Q2 next year, we expect the US economy will remain soft enough for the Fed to pause in their rate rising cycle.
Employment is actually a lagging indicator as is inflation so, although these are the key indicators that the Fed have to watch to fulfil their legal mandate, they are not the indicators that will tell us what will happen to the US economy in the future. As noted above, two key business surveys released last week were disappointing. The manufacturing survey, that has been struggling for some time, fell below 50 which indicates a manufacturing recession. The services survey fell more sharply than expected, but remains well above the key 50 level.
It has to be said that neither of these surveys are perfect predictors of the future. What had been puzzling a few people of late was the disparity between the two, i.e. manufacturing struggling alongside the services sector at historically high levels. The fact that they both fell in November and the manufacturing survey is now in recession territory should be seen as a potentially worrying development. Indeed, when we compare the manufacturing survey with the year on year performance of industrial production (lagged by 6 months – see chart 3 below), we do worry that the industrial sector can slip further in the next couple of quarters. If this does happen, then economic growth could easily be sluggish enough to encourage the Fed to move the side-lines early next year.
Chart 3 – US Industrial production (year on year and lagged 6 months) versus manufacturing survey
The way we see the backdrop at the moment is that the Fed is planning a dovish hike as the US economy is at risk of slowing from an already modest pace. The ECB have probably fired off its last stimulus for the time being and badly missed market expectations. At best, markets will be stable in the months ahead as economic growth muddles through and there are no exogenous events to grapple with. At worst, the US economy (along with most of the emerging market complex) is slowing further and volatility increases.
What this means is that it will be very difficult, as it has been all year, for buy and hold investors to make any returns. It is also interesting to note another high profile hedge fund closure indicating how difficult it has been for active managers to make money. In these frustrating times, we believe that it makes sense to be flexible, avoid consensus trades and be aware of potential market dislocations that can be very painful.
Please note that RMG will be launching a UCITS compliant version of its successful FX Strategy in December. Should you wish to receive any information on the fund, please visit the website HERE.
Stewart Richardson
Chief Investment Officer, RMG Wealth Management
