“Words like violence, Break the silence"
- Depeche Mode, Enjoy the Silence
Last week we discussed what we saw (and continue to see) as the significant ‘potential energy’ of the US equity market as the coming Labor Day bank holiday signifies the return of investors from any Summer breaks they may have taken. Further, we suggested that the current US growth dynamic has “the potential to significantly widen the policy and rate differentials in favour of the US – particularly relative to Europe” as we and the markets awaited the Jackson Hole Symposium speech from the Federal Reserve (Fed) Chair.
From my perspective the Jackson Hole Symposium speech from the Chair was perfectly in line with expectations ahead of the event. He gave a positive economic narrative, stating that the recovery from the covid crisis has been much quicker and stronger than expected. Indeed, he was clear that “substantial further progress had been met for inflation” and “clear progress had been made on employment”. Thus, it remains appropriate to start to reduce the pace of asset purchases this year – consistent with the July Federal Open Market Committee (FOMC) minutes.
Despite this economic bullishness and consistency with the July narrative, the reaction of the commentariat and markets were indicative of a more dovish evolution. From our perspective things are a little more complicated than that. The Chair was perhaps less clear on the transitory nature of inflation (“…cannot take for granted that transitory inflation will fade”), was non-committal on the taper timing and even emphasised the separation of the FOMC’s consideration of the tapering of asset purchases and rate hikes (for which there is a clear forward guidance). These points have been portrayed by many as a dovish iteration of Fed guidance. We disagree. Indeed, all these points, it could be argued, collectively form the position providing the highest likelihood of the current Chair being reaffirmed by the US President’s Administration (we expect over coming weeks). It is not clear that the Fed Chair will err so cautiously once he has been given the nod for a further four years!
There are also some clear ‘complications’ to the global growth backdrop at the moment – even if the consensus is a simple slowdown. Let’s take China for example. The recent PMI prints have raised a few eyebrows and exacerbated what seems to be the bearish consensus. However, there are three elements to the current growth wobble (i) the July covid outbreak which led to significant restrictions – especially relevant to services, (ii) the current targeted policy / structural reform / social engineering / deleveraging across a number of sectors and (iii) the decline in external demand as a function of the recent delta wave.
The duration of the drag from these factors on near term growth is debatable, but from our perspective all are transitory factors. When you add this into the global supply chain, the China activity dip likely impacts Europe through its greater reliance on Chinese demand, but it does little to dampen our medium-term glass half full view of the global economy. Indeed, in the US and globally there is also the prolonged impact of the global microchip shortage on both activity (most global auto manufacturers are being or have been impacted by shortages), and inflation (the demand for autos has had a remarkable impact on the price of used cars and rental prices).
Ultimately, while recent data has been on the weak side, it is likely that many commentators are too quick to accept this as a slowing of the recovery. Rather, what we view as more likely is that there is a transient dip in the global economic momentum as a function of the ‘Delta wave’ (and some other transient factors) and that the core growth / recovery / US outperformance theme that we have often outlined remains in train.
What is perhaps more puzzling to us is the intensity of the debate around the possibility of a European Central Bank (ECB) ‘taper’ before the Fed. From my perspective this is disingenuous or misleading. The two processes are not directly comparable. The key difference is that the Fed quantitative easing (QE) programme is open ended and therefore any curtailment of the pace of purchases has a significant impact on the expected value of total assets purchased (the stock of assets – the core stimulus factor of QE). The ECB debate is around the adjustment to the purchase pace of a pre-announced QE total envelope – announced at the start of the current programme (and extended in June and December 2020) stating that it would purchase in a flexible manner across time and jurisdiction. Any alteration of the pace of purchases in September (even if it comes alongside improved economic forecasts), is not directly comparable to a Fed taper. Indeed, the Bank of Canada, Bank of England and Reserve Bank of Australia (RBA) have already ‘tapered’ their QE programmes in a way mooted by ECB watchers for September.
In the near term, the USD risks being disadvantaged by the timing of monetary policy meetings. The ECB meets on the 9th September and along with updated, and likely upgraded growth forecasts for the current forecast period (though likely still highlighting a significant demand led inflation shortfall at the forecast horizon – tempering expectations of the removal of monetary accommodation). Indeed, the RBA meets on the 7th and may well decide to reduce the pace of its asset purchases (though recent lockdowns make this decision more finely balanced – H2 is likely more modest than the strong Q2).
While the FOMC meeting in September likely brings further significant upgrades to the Summary of Economic Projections (and in my view brings forward further rate hike expectations – or ‘dots’), the meeting is not until the 22nd. This may mean that the popular narrative may remain biased towards the EUR (and the EUR complex) relative to the USD for a short time longer. Ultimately though we view this as transitory. The US economic recovery, long term potential growth and r* are significantly above that of the eurozone and we expect that to ultimately be beneficial to the USD. EURUSD may be in a window of reprieve from the downtrend, but we ultimately expect persistent USD outperformance to dominate.
Lastly, given our views that the current ebb in global economic activity is likely a function of a number of transient factors, we continue to see US-led equities as the biggest beneficiary of the return of a more pronounced growth trajectory – even if this sees further steepening of the US yield curve.
In the very short-term EUR bulls may well ‘enjoy the silence’ ahead of the FOMC, but like many current factors, we see this as transitory.
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