Market Bulletin - Tonal range
Janet Yellen launched the reversal of QE in the US, Angela Merkel won a fourth election victory, and Theresa May laid out her Brexit vision in Florence.
“It is up to leaders to set the tone,” said the prime minister in her landmark speech on Brexit in Florence last Friday.
The comment came at the end of a week in which the variety of tones among global leaders had been strongly apparent. Donald Trump delivered a thundering address at the United Nations, in which the US president called Kim Jong-un a “madman who doesn’t mind starving or killing his people” and threatened to “totally destroy” North Korea. The baiting continued, as Kim Jong-un appeared on North Korean television to say that Trump’s speech at the UN had “the sound of a dog barking”.
As far as markets were concerned, the most important speech came in the middle of the week. After a two-day meeting of the Federal Reserve’s Federal Open Market Committee, Janet Yellen announced that the bank would not be raising rates – so far, so humdrum – but proceeded to set a date on when it would begin to unwind quantitative easing (QE): next month.
As perorations go, it was forgettable; the phrase “balance sheet normalisation” doesn’t set the pulse racing, but neither is it meant to. Moreover, the intention had been well signposted to markets, leading to a relatively muted response. Yet the detail is enormously significant. As of October, the Fed will reduce its bond repurchase programme by $10 billion a month. In January 2018, the reduction will rise to $20 billion a month – it will be $30 billion from April, $40 billion from July, and $50 billion from next October. If the Fed proceeds as planned, it will effectively remove $2.1 trillion from the market over the next four years – roughly the size of the Brazilian economy. Moreover, no bank has yet tried to unwind QE. Few do understatement like Janet Yellen. Yet market participants remain convinced progress will be slow.
The S&P 500 found a new record high midweek, but ended the period unchanged; in part due to weakness in the IT, telecoms and consumer goods sectors. However, jobless claims fell significantly to 259,000 – far below the 310,000 expected by economists.
Politically, however, the most important news of the week came at the weekend, as Angela Merkel secured a fourth term as German chancellor. Like Yellen, Merkel is known for her cautious words and restrained manner. But her rule has thus far overlapped with the terms of three US presidents, four UK prime ministers and four French presidents. Despite a major decision to allow in almost a million migrants in 2015, her victory was comfortable.
Yet the horse-trading has barely begun. Merkel will need to form a broad coalition after her traditional partners, the SPD, suffered their worst ever result and said they would go into opposition. Alternative für Deutschland (AfD), the anti-immigrant and eurosceptic party, became the first major right-wing party in the Bundestag since the Nazis. Since she has ruled out any association with AfD, Ms Merkel is left only with the option of a three-way deal with the Greens and the Free Democrats, a liberal pro-business party. Her victory has left her weaker – it was her party’s worst result since 1945.
Yet she will be buoyed by positive economic and financial developments across much of the EU, news of which continued last week. Standard & Poor’s restored an investment grade rating to Portugal’s debt for the first time since the financial crisis – the country’s 10-year sovereign bonds ended last week with a yield of less than 2.5%.
Meanwhile, in France, Emmanuel Macron successfully pushed through his labour reform package, which was widely seen as a central element in his bid to improve France’s competitiveness and job creation rate. Macron eschewed the low-key approach, inviting the cameras into the Élysée Palace to record his signature of the bill. Reforms include giving employers more flexibility to negotiate pay and conditions with workers, and reducing the cost of firing staff. The Eurofirst 300 rose 0.7% over the course of the week – European stocks are enjoying a particularly strong year.
European leaders ended the week with increased reasons for hope over Brexit negotiations too. After a difficult few months of negotiations, and in the wake of an act of apparent subversion by her foreign minister (in the form of an article in a national newspaper), the UK prime minister delivered an emollient and optimistic Brexit speech in Florence last Friday. She opened with references to Florence’s Renaissance and trading past – its openness to the world – and used it to set the tone for her address. The prime minister offered the beginnings of clarity where it had been lacking, and laid out the UK’s terms of engagement in far greater detail than ever before. She also struck a very different tone from the defiant prime minister who intoned on Brexit at Lancaster House in January.
But the specifics were perhaps more important. She said that the UK would seek a two-year transition period for its EU exit. She pledged to pay into the EU budget until the current term ended in 2020. She also stipulated that Britain would participate in some elements of the EU after the formal exit (such as science and security). She said that neither the European Court of Justice nor the UK courts should resolve disputes, but that an alternative would be needed. She offered an unconditional commitment to maintaining European security. And she suggested that the EU–UK relationship needed a new solution, arguing that Norway and Canada would not be appropriate models.
Some groups complained that her touted transition period was too short, while Nigel Farage criticised her claim that “we don’t seek unfair competitive advantage”. Yet much of the reaction was positive – Michel Barnier said the speech had been “constructive”.
The FTSE 100 was buoyed by the speech and finished the week up 1.3%, but the pound slipped after the address to under $1.35. In fact, the FTSE 100 has only moved within a range of 6% so far this year, its narrowest range since 1984 – the year of the index’s creation. A similar story appears to be playing out for UK government bonds, which have this year traded in their narrowest range since 1965 – despite all the political goings-on, investors seemed relatively unmoved. Moody’s took the opportunity to cut the UK’s credit rating still further on Friday afternoon. The ratings agency argued that the UK’s finances and its forthcoming EU exit lay behind the decision, but later said that the decision has been made prior to the speech – and that the speech hadn’t changed its view.
Cost of cash
Fresh reasons for confidence in the UK outlook were supplied last week, despite poor construction data, as the latest Treasury figures showed that government borrowing fell faster than expected in August due to increased VAT receipts and a fall in state spending. Economists now project that borrowing for 2017/18 could be £10 billion less than projected.
Yet some liabilities are worsening. The public sector pensions bill has risen 30% over the past year to above £1.8 trillion; not far off the annual output of the entire economy. The upsurge follows a drop in bond yields since the EU referendum, a drop that has raised the cost of future pensions.
Personal balance sheets also tell a grim story, and MPs last week urged the government to set up an independent public inquiry into the £200 billion of debt amassed by UK households, which has reached the same level as shortly before the global financial crisis.
The news came just a day after Mark Carney, governor of the Bank of England, warned that a sharp fall in migrant workers coming to the UK due to Brexit could push up short-term inflation. Borrowers and savers alike should heed his call. The impact of rising inflation is already hitting those with cash savings hard – if a further spike is possible, the impact will only increase.
Data from the Bank of England shows that savers have moved £504 million from Cash ISAs so far this year, while around £13 billion has been deposited into easy access accounts, as savers opt to keep their cash accessible in the hope that an interest rate rise will boost fixed rate returns. But that flexibility comes at a cost. Moneyfacts data shows that the average no-notice Cash ISA rate was 0.38% in August, against an inflation rate of 2.9%. That takes real returns (annualised) to around -2.5%.
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