Reflation Trade Is Back

A much softer than expected US January jobs report didn’t prevent US equities from closing higher at the end of last week as the reflation trade kicked back in.  One of the biggest driving forces for markets was the growing prospects that much of President Biden’s $1.9 trillion fiscal stimulus plan will be passed, albeit via a process of reconciliation, which allows Democrats to circumvent the need to gain the support of at least 10 republicans. This contrasts with prior expectations that the final stimulus was going to be less than $1 trillion. 

Pushing stimulus through this way highlights Biden’s urgency to inject more spending into the economy but could come at the cost of hurting bipartisan policy efforts. The impact of expectations of increased fiscal stimulus is particularly apparent in the US rates market, with US Treasuries selling off and bear steepening of the curve.  Although higher US Treasury yields failed to give support to the US dollar (USD) there is still scope for a short covering rally, which could still help give the USD relief.     

At the beginning of the year the US jobs market took a hit from renewed lockdowns and surge in COVID cases; US January non-farm payrolls increased 49k, and December was revised to -227k from -140k while more positively the unemployment rate fell to 6.3% from 6.7% though this was flattered by a drop in the participation rate as less people were looking for work.  According to the payrolls report there are still 9.9 million more unemployed compared to pre-COVID levels.  As such, the weak jobs data added more support to Biden’s fiscal stimulus proposals.   

This week focus will likely turn more to President Trump’s impeachment trial in the Senate than economic data.  Key data/events this week include China’s credit and monetary aggregates (9-15 Feb), central bank decisions in Sweden (Wed), Philippines, Mexico (Thu) and Russia (Fri).  Among these the consensus is for only Mexico to cut its policy rate. Also in focus are inflation readings in China (Wed), US (Wed) and India (Fri).  UK GDP (Fri) and US Michigan sentiment (Fri) will also garner attention. 

The return of the reflation trade, rally in risk assets and decline in cross-asset volatility bodes well for emerging markets (EM) assets.  However, there are definitely various cross currents impacting asset markets at present especially with US Treasury yields rising, which could potentially support the USD and pressure EM local bond rates markets.  EM assets were clearly favoured towards the end of last year, and while the positive story has not dissipated, EM assets may take a pause for breath before pushing higher again.  

In Asia, the Chinese-new-year holidays this week may dampen activity while China’s PBoC also appears to be limiting liquidity injections around the holidays, which could limit some of the gains in Chinese and impact China linked assets.  Chinese authorities have re-focussed attention on preventing an excessive build-up of leverage and credit metrics have peaked as a result.  As such, they may be less keen to inject a lot of liquidity into markets at present. 

Sell On Fact

It was a case of buy on rumour, sell on fact at the end of last week, with US equities falling the most in over a week on Friday in the wake of the much anticipated but largely priced in announcement of President-elect Biden’s $1.9 trillion fiscal plan.  While the amount of stimulus is significant the reality is that it will be difficult to pass through Congress even though Democrats will have control of Congress and the Presidency. Something in the region of $1 trillion fiscal stimulus could end up being the price tag that is eventually passed in Congress given Republican opposition to some of the measures in the stimulus plan.  This would likely be followed by a possible $2trn+ plan for infrastrucutre/green spending.

Note that a 60-vote supermajority will be required to pass the fiscal legislation in the Senate, meaning that several Republicans will need to support the bill given the 50/50 Senate split.  Hence, a likely lower than $1.9trn eventual stimulus bill will be what is eventually passed. However, Democrats can pass the spending bill via “reconciliation”, but they would have to remove unrelated measures such as the proposed increase in the minimum wage, which they will unlikely want to do. 

Treasuries and the US dollar (USD) benefited from a worsening in risk sentiment at the end of last week.  USD positioning is at extremely low level, suggesting scope for some short covering. The VIX equity volatility index ticked higher and continues to remain well above its pre-COVID lows.  Given that many key equity gauges were in overbought territory according to their relative strength index (RSIs) some pullback/consolidation could be on the cards though the glut of global liquidity suggests that there is still plenty of money ready to buy on dips.  Yesterday US markets were closed due to the Martin Luther King Holiday, but Canadian and European stocks ended higher and futures point to gains today. 

US data isn’t helping sentiment, with yet more evidence that the economy was under pressure at the end of 2020.  Retail sales fell for a third consecutive month, the New York Empire manufacturing index fell for a fourth consecutive month in January. Lastly, University of Michigan consumer sentiment fell modestly early January.  Market direction today will likely come from the release of China’s December data dump as well as Q4 GDP.  In contrast to weakening US data Chinese data yesterday highlighted that solid recovery was sustained into year end, with GDP beating expectations, rising by 6.5% y/y in Q4 2020.  

The rest of this week is a heavy one for central bank decisions, with China, Malaysia, Canada (Wed), Indonesia, Eurozone, Turkey, South Africa, Brazil (Thu) and Japan (Fri) on tap.  In terms of policy action Malaysia is likely to cut, Turkey will likely tighten but the rest will likely be on hold.   The main event of the week is Joe Biden’s inauguration as 46th President of the US on Wednesday, and attendant risks of renewed unrest.  US Q4 earnings releases will also be in focus in the days ahead, with earnings releases ramping up over coming days.

Asia In Demand

Equity markets managed to shake off Covid concerns at the end of last week despite virus cases in the US reaching a record high and Europe battling a full-blown second wave; S&P 500 and Russell 2000 hit record highs.  Asian equities started the week building on this positive momentum.  Helping markets was the news that advisors to President-elect Joe Biden have said they oppose a nationwide US lockdown despite the sharp rise in virus cases.  This will help allay fears that the US economy will weaken sharply over the next few months amid severe lockdowns and before a vaccine can be distributed.

Vaccine enthusiasm will likely play against Covid escalation in the days and weeks ahead. In the near-term slim chances of a sizeable US fiscal stimulus taken together with a more rapid increase in global Covid infections highlight clear risks to risk assets, and this may be enough to put roadblocks in place at a time when various equity indices are reaching key technical levels.  Conversely, it is too early to write the US dollar off in the short term even if the medium-term trend is likely to be downwards. 

Asia remains favoured within emerging markets, as the virus has come under control across most of the region.  News of the signing of the Regional Comprehensive Economic Partnership (RCEP) trade deal by 15 countries in the region after 8 years of negotiations, but without the US and India, provides another boost to regional economic and market prospects.  The deal is less extensive than the Trans-Pacific Partnership (TPP) as it removes around 90% of tariffs rather than 100% under TPP.  Nonetheless, it is estimated that the deal could boost the global economy by close to $200bn by 2030.  Although the deal still has to be ratified by a number of countries it is a step closer to a unified trade block like the EU.   

Additionally, Chinese data today ought to be supportive for regional assets even amid the threat of further sanctions by President Trump’s administration in the weeks ahead. China’s October activity data including industrial production fixed assets investment, property investment and the jobless rate were on balance positive, showing that China’s economic recovery is gathering steam.  The data will likely provide further support to China’s markets including China’s currency, though it effectively seals the case for no further easing by China’s central bank, PBoC, while giving the rest of Asia more fuel to rally. 

Over the rest of the week emerging markets central banks will garner most attention, with a plethora of policy rate decisions on tap.  Hungary (Tue), Thailand (Wed), Philippines (Thu), South Africa (Thu), and China (Fri) are set to keep policy rates on hold while Indonesia (Thu) is likely to cut by 25bps and Turkey is expected to hike its policy rate by 475bp hike (Thu).   Turkey in particular will be a focus in this respect given the replacement of central bank governor and the more than 10% rally in the Turkish lira last week.

Looking At Central Banks For Direction

This week feels as though its one where markets have gone into limbo waiting for developments on the trade war front, and for direction from central bankers.  So far there has been no indication that a date or even location has been set to finalise details of a Phase 1 deal between the US and China.  While officials on both sides suggest that progress is being made, markets are left wondering if a deal will even be signed this side of the new year.  Despite such uncertainty there does not seem to be too much angst in markets yet, and if anything, risk assets including equities look rather resilient.

Central bankers and central bank minutes will garner plenty of attention over coming days.   Overall it looks as though major central banks led by the Fed are moving into a wait and see mode and this means less direction from these central banks to markets over the next few weeks and likely into year end.

Fed FOMC minutes this week will give more information on the Fed’s thinking when it eased policy in October, and markets will be looking for clues as to what will make them ease again.  In his recent Congressional testimony Fed Chair Powell highlighted that he sees little need to ease policy at the December meeting, strongly suggesting no more easing from the Fed this year.

Reserve Bank of Australia minutes overnight highlighted that the Bank will also now wait to assess past monetary easing measures before cutting rates again while still holding the door open to further cuts if necessary.  While the RBA noted that a case could have been made for easing this month, it doesn’t appear that they are in a rush to move again, with easing now becoming more likely next year than in December.

Another central bank in focus is the ECB, with ECB President Lagarde delivering the keynote address at the European Banking Congress in Frankfurt.  This will be an opportunity for markets to see whether her views are in line with previous ECB President Draghi and also to see how she reacts to criticism of the ECB’s decision from outside and within the governing council, to ease policy further at the September meeting, when it cut the deposit rate to -0.5% and restarted asset purchases.

Another central bank in focus over coming days includes the PBoC in China.  The PBoC cuts its 7-day reverse repo rate by 5bps this week, the first decline in this rate since 2015 in an attempt to lower funding cots to banks.  While the move is small the direction of travel is clearly for lower rates and this is likely to be echoed in the release of the new Loan Prime Rate tomorrow, which could also reveal a small 5bps reduction.  China is likely to maintain this path of incremental easing in the weeks ahead.

All Eyes On US/China Trade Talks

A major focus for markets next weeks is the US/China trade talks in Washington.  After the US reportedly turned down an offer of preparatory talks this week talks will begin on Monday, with China’s Vice Commerce Minister, Vice Finance Minister and central bank, PBoC governor.

It is unclear who on the US side they will meet, but the idea is to prepare the ground for the heavy weight talks between US Trade Representative Lighthizer, US Treasury Secretary Mnuchin and China’s top economic official Liu He, from Jan 30 to 31.

Both sides need a win on trade and markets are pinning their hopes on some form of a deal. The reality is that they are still very far apart on a number of issues.  As highlighted by US commerce secretary Ross, a trade deal is “miles and miles” away.

The easier issues on the table are increased purchases of US goods by China, something that China has already said they will do, in order to help reduce the record Chinese trade surplus with the US.  The tougher issues are more structural, including forced technology transfers, state subsidies, discrimination against foreign companies, regulations on intellectual property etc.

Not only is the US determined to gain China’s agreement on the above issues, but is also looking to find ways to ensure compliance monitoring.  However, China does not believe that foreign companies are transferring technology to Chinese companies, while they have already offered measures to increase access to foreign investors.  Overall, this means there is little room for negotiation.

In any case with just over a month left before the March 1 deadline that President Trump has set before he imposes increased tariffs of 25% on around half of Chinese exports to the US, there is little time to thrash out a deal on the key structural issues that would likely satisfy the US administration.

The likelihood is that negotiations will not be completed, especially on structural issues, leaving markets very little to be excited about.  While both sides may leave the talks, claiming a degree of progress, this will not be sufficient to allay concerns.  Risk assets will look vulnerable against this background.

 

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