Marathons, hurdles, sprints and relays

The British government and European Union (EU) recently agreed on the terms and conditions of the UK’s exit from the EU in March 2019 which the British and European Parliaments are expected to vote on in late-2018.

Prime Minister Theresa May’s cabinet has completed a bruising 18 month training program and is now at the starting line of a gruelling marathon to agree on the terms and conditions of the UK’s transitional deal with the EU. There is still a non-negligible risk of the UK exiting the EU on 29th March 2019 with no deal in place and reverting to punitive WTO rules.

In any case precedent suggests that burst of speeds and stumbles will punctuate complex Brexit negotiations. Moreover, the UK’s economic backdrop remains challenging, despite the unexpected jump in retail sales in November, and CPI-inflation may be close to peaking.

We therefore expect the Bank of England to keep its policy rate on hold at 0.50% at its 8th February meeting, although the more hawkish of the nine Monetary Policy Council members may vote for a hike. In this scenario, Sterling may continue to struggle for direction.

German Chancellor Merkel’s bid to form a majority coalition government has hit multiple hurdles since federal elections 82 days ago. However, we still think that another grand alliance between her CDU-CSU and the SPD is more likely than new elections.

Such an outcome, alongside the ongoing pick-up in Eurozone economic activity, could provide the flat-lining Euro with a modest second wind which the European Central Bank would in turn likely try to moderate, in our view.

In the US, the Republican Party is in a sprint to get its comprehensive tax bill approved in the 100-seat Senate where its majority will halve to one next year. Passage of the bill could temporarily buoy a range-bound Dollar and further fuel the metronomic rise in US equities.

However, once the initial euphoria has been fully priced, greater challenges will likely lie ahead for financial markets and particularly the US Dollar. Janet Yellen, who will stand down as Federal Reserve Chairperson in January will now pass on the baton to Jerome Powell and an FOMC which could see further personnel changes in 2018.

 

British government’s Brexit training has finished but marathon has only just started

After 18 months of often bruising negotiations, the British government and EU last week finally reached an agreement in principle, on the broad terms and conditions of the UK’s exit from the EU scheduled for 29th March 2019 (the “withdrawal agreement”). In particular, Prime Minister Theresa’s minority government agreed to:

  1. A financial settlement (or “divorce bill”) which will reportedly equates to approximately £40bn (the final number and payment scheduled is yet to be finalised);
  2. The treatment of EU nationals residing in the UK and;
  3. The framework for addressing the unique circumstances in Northern Ireland.

 

4x global research marathon Fig 1

EU leaders are expected to formally approve this verbal agreement in coming days and, according to the British Parliament’s official timeline and in line with the timelines imposed by Article 50 of the Lisbon Treaty, the UK and EU will aim to finalise a draft agreement by October 2018. The British and European parliaments are then scheduled to vote on the withdrawal agreement by late 2018 or early 2019 and finally the European Council will vote (with a qualified majority required) before 29th March 2019 (see Figure 1).

The European Council had, from the start, made such an agreement in principal a pre-condition for substantive negotiations on the terms and conditions of a future trade deal between the UK and EU which are now expected to start in the New Year. The often divided and divisive British cabinet has shown a willingness and ability to compromise on key issues and both sides have praised the breaking of the deadlock.

However, the more important negotiations were always going to be over the nature of the relationship between the UK and EU beyond March 2019 given the government’s plan to take the UK out of the Single Market and Customs Union. In effect, British negotiators have worked hard to get to the start line but the marathon starts now and the clock is ticking. In practise they have about 12 months to reach an agreement – no easy feat given the complexity of negotiations which have no precedent. There is therefore still a non-negligible risk of the UK leaving the EU with no trade deal in place and reverting to potentially punitive World Trading Organization (WTO) rules.

Admittedly, the British government has given itself some breathing room by agreeing in principle to a transition deal likely to last two years. So while the UK will formally leave the EU on 29th March 2019 – two years after Prime Minister May triggered Article 50 – the final trade deal may not kick in until early 2021. This will give both sides more time to agree on the finer details of a permanent trade deal and give governments, companies and households more time to adjust to the final trading arrangements. So assuming the British government crosses the line in March 2019, it will face a two-year run to get to its ultimate end-point. Theresa May and the Conservatives will be hoping that by 2021 the issue of Brexit will have been put to rest so they can re-focus their attention on general elections scheduled for mid-2022.

 

Bank of England unlikely to hike rates in February, Sterling likely to struggle for direction

The Bank of England (BoE) will hold its next policy meeting on 8th February and also publish updated macro forecasts. Our core scenario is that it will keep rates on hold at 0.50%, although the more hawkish of the nine Monetary Policy Council (MPC) members may vote for a 25bp hike.

The majority of MPC members, including Governor Mark Carney, will likely vote for rates to remain on hold until they have evidence that:

  1. EU trade negotiations have progressed further;
  2. Already modest GDP growth did not slow in Q1 2018;
  3. The November jump in retail sales was not unwound in December-January and that household consumption picked up in Q4 2017; and
  4. Real wage growth is tempering the base-effect generated fall in CPI-inflation.

The market is currently pricing in 3bps of hikes for the February meeting (a 12% probability of a 25bp hike) and 35bp of hikes for the full-year 2018, implying that the MPC will hike once or twice next year. This seems about appropriate at this juncture as long as the MPC remains on hold in February and, in this scenario, Sterling may continue to struggle for direction.

 

Monetary Policy Council likely to be conservative in the face of stop-start Brexit negotiations

Precedent suggests that burst of speeds and stumbles will punctuate complex negotiations between the UK and EU on a new trade deal and significant progress is unlikely to have been made by the time the MPC meets on 8th February. The MPC, in its latest policy meeting statement on 14th December, emphasised that “Developments regarding the United Kingdom’s withdrawal from the European Union – and in particular the reaction of households, businesses and asset prices to them – remain the most significant influence on, and source of uncertainty about, the economic outlook”. It will arguably be difficult for the MPC to gage the pace of progress on negotiations after only a few weeks.

 

Tepid UK GDP growth curtails room and need for higher Bank of England policy rates

GDP growth only ticked up to 0.4% quarter-on-quarter in Q3 2017 despite a modest rebound in household consumption growth (see Figure 2) and UK growth is lagging growth in other G7 member states and major Eurozone economies  (see Bank of England – Trick rather than treat, 3 November 2017).

 

4x global research marathon Fig 2 and 3

At the very least, the MPC will likely want tangible evidence that GDP growth did not slow in Q4 2017 and Q1 2018, in our view, with preliminary Q1 2018 data not due for release until 27 April 2018 (see Figure 4). This is another reason why we do not expect the MPC to seriously consider a rate hike before its 10th May policy meeting.

 

UK retail sales jump – Start of a new trend or ballooning influence of Black Friday sales?

The seasonally-adjusted volume of retail sales was broadly flat between November 2016 and July 2017 but has since risen 2%, with over half of the increase (1.2%) occurring in November 2017 (see Figure 3). However, it is conceivable that Black Friday sales in late-November – which have become increasingly popular in the UK – had a larger-than-normal impact on retail sales. Put differently, consumers may have brought forward Christmas and New Year purchases more than they did in previous years which would have partly nullified the Office of National Statistics’ seasonal adjustments.

The MPC may therefore want to gage how retail sales fared in December 2017 and January 2018 before coming to the conclusion that retail sales are on a more sustained upward trajectory. It would indeed make sense in our view to compare retail sales in November 2017-January 2018 with the previous year, in the same way that the timing of the Chinese New Year renders the analysis of macro data in January and February somewhat redundant, with the January-February average more telling. UK retail sales data for January 2018 are due for release on 16th February, eight days after the MPC’s February meeting (see Figure 4).

 

Moreover, the relationship between retail sales and the broader measure of household consumption is tenuous, as depicted in Figure 5. This in our mind provides another reason for the MPC to wait for the release of Q4 2017 household consumption data on 22nd February (i.e. a fortnight after its February policy meeting) before coming to a firmer conclusion about the underlying strength of consumer demand.

 

4x global research marathon Fig 5

 

UK inflation may have peaked despite rise in global energy prices

In its latest policy meeting statement on 14th December, the MPC judged that headline CPI-inflation, which rose to 3.1% year-on-year (yoy) in November (see Figure 8) “is likely to be close to its peak” and we would concur. The 30% rise in the price of Brent crude oil since mid-year will buoy the year-on-year increase in energy prices in the UK. However, this inflationary impetus will likely be more than negated by the ongoing fall in overall imported prices as a result of Sterling base effects falling out of year-on-year calculations.

The Sterling Nominal Effective Exchange Rate (NEER) fell sharply in the wake of the June 2016 referendum but has been broadly stable since end-November 2016 (see Figure 6).

 

4x global research marathon Fig 6

This has resulted in a sharp fall in the year-on-year rate of Sterling depreciation and since September 2017 the Sterling NEER has actually appreciated in year-on-year terms, according to our estimates (see Figure 7). As has been the case in the past, this has translated into a sustained fall in the price of imported goods.

 

 

Figure 8 points to a strong historical relationship between imported priced and overall CPI-inflation. Headline CPI-inflation has yet to fall, which is likely due to rising energy prices’ inflationary stimulus, but core CPI-inflation, which strips out fuel and food prices, has been stable at 2.7% yoy since August 2017. The question for the MPC, in our view, is not whether headline CPI-inflation will start to fall – as we expect it will in the next couple of months – but how fast it will fall. We expect the MPC to want a few months worth of inflation data before coming to any firm conclusion as to the likely inflation path.
 Formation of German government necessary condition for any (modest) Euro rally

German Chancellor Angela Merkel’s bid to form a majority coalition government has hit multiple hurdles since federal elections 82 days ago which left her centre-right CDU-CSU alliance 109 seats short in the 709-seat Bundestag (see Figure 9). Coalition talks with the Freedom Democratic Party (FDP) broke down three weeks ago, with the parties unable to agree on the formation of a majority government which would also include the Green Party (see Euro impervious to Eurozone’s political pantomime, 24 November 2017).

However, another grand alliance between the CDU-CSU and the centre-left Social Democratic Party – a repeat of the 2005-2009 and 2013-2017 governments – is more likely than another set of elections. Our view is premised on recent opinion polls suggesting that in the event of new elections, which could take months to secure, the CDU-CSU, SPD and Left Party would all lose seats while the Greens, FDP and far-right Alternative for Germany (AfD) would gain seats (see Figure 10).

 

 

New elections could thus further sap Merkel’s credibility and make it even harder for the CDU-CSU to form a majority coalition on its own terms. If coalition talks once again failed, Merkel would be back to square one and would conceivably be under pressure to resign – a scenario which we flagged two years ago and now seems plausible even if still unlikely (see What to expect in 2016 – Same, same, but worst, 19 January 2016). Moreover, senior SPD members are reportedly putting pressure on the SPD’s leader, Martin Schulz to reconsider the possibility of governing alongside the CDU-CSU.

A coalition between the two heavyweights of German politics – the centre-right CDU-CSU and centre-left SPD – would enjoy a comfortable majority of 44 seats in the Bundestag and provide a degree of continuity. Moreover, there is a case to be made that if Merkel cannot form a majority coalition and opts for early elections, the SPD would be left with even fewer seats than it currently has (153). Another coalition with the SPD may thus be the least unappealing option for the normally pragmatic Chancellor, while the SPD and Schulz may have more to lose from new elections than the FDP and Greens.

 

Possibility of cooperation coalition (“KoKo”) between CDU-CSU and SPD

If this option remains off the table, the CDU-CSU and SPD could opt for a cooperation coalition (which has been abbreviated to “KoKo” in Germany) – a hybrid solution reportedly gaining traction within the SPD leadership. The SPD would support the CDU-CSU in key Bundestag votes, which would provide some policy continuity, but have the option of voting with the opposition in order to maintain the SPD’s political identity. This would not be too dissimilar to the formal “confidence-and-supply” agreement in the UK whereby the Conservative Party (which is short of a majority) seeks parliamentary support from the Northern Irish Democratic Unionist Party (DUP) on a case-by-case basis (see UK: Land of hope & glory…but mostly confusion, 7 July 2017).

Financial markets would more likely react positively to a straightforward coalition between the CDU-CSU and SDP as a cooperation coalition could see Merkel and the CDU-CSU lose key parliamentary votes and policy stall (as has been the case in the UK with Theresa May’s Conservative Party losing a key vote in the House of Commons on 13th December).

However, even such a compromise could provide the flat-lining Euro with a second, albeit more modest wind, to the extent that another set of elections would create far greater uncertainty and leave Chancellor Merkel – Europe’s longest standing leader – in a potentially very precarious position. The Euro Nominal Effective Exchange Rate (NEER) appreciated about 7.4% between mid-April (the run-up to the French presidential elections) and early August but has since been in a narrow 2% range, according to our estimates (see Figure 11).

 

Sustained pick-up in Eurozone economic activity provides template for modest Euro appreciation

Moreover, the ongoing pick-up in Eurozone economic activity provides a more fundamental basis for the Euro to appreciate and for fund managers to be comfortable in holding Euros. Put differently, a resolution to Germany’s political impasse could be the trigger which sees rising Eurozone economic growth translate into a stronger single currency. Based on flash (preliminary) data, the Eurozone manufacturing Purchasing Managers’ Index (PMI) rose to a record-high of 60.6 in December from an upwardly revised 60.1 in November (see Figure 11). The services flash PMI jumped to an 80-month high of 56.6.

The PMI composite output index (a blend of output in both manufacturing and services) hit an 82-month high in December, which based on precedent points to a further acceleration in Eurozone GDP growth from a six-and-a-half year high of 2.5% yoy in Q3. Final composite PMI data are due for release on 4 January 2018.

In Germany, Europe’s power house, the Ifo Business Climate Index hit an all-time high of 117.5 in November 2017, shadowing the Euro’s appreciation (see Figure 12). This would indicate that the benefits to German companies of rising Eurozone economic growth, as reflected in a stronger Euro, significantly outweigh any loss of export competitiveness which German companies may suffer as a result of the Euro’s appreciation.

 

 

Euro upside likely limited

However, any rally in the Euro is likely to be modest, in our view. For starters, the US Dollar, which has also been range-bound since mid-year (see Figure 13) may also get an uplift if the Republicans can secure their first major policy victory by getting their tax bill through Congress (see below). This would result in a EUR-USD cross struggling for clear direction. Moreover, the European Central Bank would likely try to moderate any Euro appreciation on the basis that Eurozone headline CPI-inflation has treaded water for the past seven months while core CPI-inflation has edged lower (see Figure 14).

 

4x global research marathon Fig 13 and 14

 

Republican Party in frantic race to pass US tax reform bill through Congress

US President Trump’s electoral promise of widespread tax cuts has arguably helped support the Dollar and fuel the US equity rally and on 13th December Republican Party representatives in Congress finally reached a deal on tax legislation which amongst other things will cut the US corporate tax rate to 21% from 35%. The Republican Party is now in a race to push the legislation through the House of Representatives and Senate, with the two houses likely to vote next week.

The Republicans have 52 seats in the 100-seat Senate, which means they can afford to lose two votes and still get the bill approved (in a 50-50 tie Republican Vice President Mike Pence has the casting vote). Republican Senator Marco Rubio declared on 14th December that he would vote against the tax bill unless the tax credit that low-income Americans can claim for their children is expanded. The tax bill could still pass without Senator Rubio’s support but the Republicans risk only just squeezing over the finish line as the original version of the tax bill was approved by only 51-49 votes with Senator Rubio’s support.

Moreover, this majority will be halved when Doug Jones, the Democratic candidate who recently won the Senate seat for Alabama, is officially appointed most likely in the New Year. The Republicans will then be left with 51 seats and a slender majority of one vote.

Approval of the tax bill, arguably President Trump’s first major legislative victory, would likely provide further support to the Dollar and the almost metronomic rise in US equities. However, once the initial euphoria has been fully priced, greater challenges will lie ahead for financial markets, particularly the US Dollar in our view. These include key personnel changes at the Federal Reserve, with Chairperson Janet Yellen handing over the baton to Jerome Powell in the new year, Federal Reserve Bank of New York President William Dudley’s planned resignation in mid-2018 and the possibility of President Trump filling the still vacant three Board of Governors seats (see Plan B, 5 December 2017).