Paper cuts

Henry Adams

Chief Product Officer
Thursday, Jun, 27, 2024
3mins

Death by a thousand cuts seems apt at this juncture. Not to be overly dramatic, but we are certainly starting to see signs of both rising tensions and fatigue in various pockets of several economies, placing additional pressure on what remains, which seems almost too tranquil. In some instances, cuts are actually looking more like tears. As always, we’ll be popping the hood on what is raising eyebrows here.

Macro

It is undeniable that we have entered a new phase of the monetary cycle. Growth is predicted to slow over the course of 2025 according to, among others, Fitch, who have just downgraded their outlook for global growth despite relief coming from an expected easing of financial conditions far and wide. The Swiss National Bank unexpectedly acted just last week, reducing their benchmark rate by 0.25% as their battle with inflation has gone well. No doubt though, thoughts from those members calling for this move also had an eye on the strength of their currency.

The higher-for-longer mantra is slowly coming to an end, with signs of pain being experienced from Fed policy impacting some far-flung regions and banks. Norinchukin, known as the Japanese farmer’s bank, reported losses in the tens of billions of US dollars on holdings of US government and agency paper, having bought vast amounts at the beginning of the year when the projected path of interest rates was deeply inverted. Losing money is not great; worse is the stepping in of the regulator urging executives to cut foreign bond exposures.

Risk

Stocks continue to do rather well with almost all major indices sitting in the green as we get to the end of the first half of 2024. Many are even into double-digit gains. How though, is worth pondering for a moment. For much of the developed world the anticipation of cheaper money is helping. Looking more closely at the top performer thus far, being the NASDAQ, and the story is somewhat more nuanced. According to Goldman Sachs, 35% percent of the 16.5% gain (year to date) has come from just one stock, Nvidia.

Mind the gap though as over $400 billion has been wiped off this stock in just one week! Broaden this out to just a handful more of those high-performing tech firms (which includes the likes of Microsoft and Apple), and a whopping 60% of the aforementioned gain is driven exclusively by these folks.

A turn in sentiment and/or revenue if the AI-everything boom fizzles out could see sharp reversals, particularly if employment remains high and wage inflation (a good proxy for services inflation) remains hard to knock back in line, thus further reducing the odds of cheaper money sooner. Hard though to see rates continuing to support growth up here, which is becoming increasingly important to policymakers almost everywhere. Clear evidence of this can be seen in the “hawkish” cut from the ECB. More on that later.

Credit

The price to borrow benchmarked against the risk-free rate has begun to tick higher. The tight spreads seen earlier in the year becoming a more distant memory. In part, enthusiasm for buying longer-dated debt is also fizzling out, a la Norinchukin, hoping for more immediate gains. Hedges (downside protection) up here are not particularly expensive, but also not free. Generally the financial world is a better place when those running money for others think about risk-adjusted return and the price to cut and run if needed.

One interesting dynamic seen in France following the snap election and associated uncertainty has, at least from a pricing perspective, been the emergence of a new additional “risk-off” trade. Whilst French Government debt and domestic banks have had to pay a premium to borrow since, corporates are managing to fund themselves very efficiently on a relative basis. Diversification is real!

On the retail side of life, Apple has had a rather short-lived experiment in buy-now-pay-never -later. After launching just last year, performance has been horrible. Bad debts as a percentage of borrowing, at just shy of 6%, sit at double the rate banks are currently enduring (and have buffered for!). My suggestion would be to stick to what you are good at. Despite popular belief, the business of banking is not for everyone. Nor should it be.

EUR

The first cut, widely advertised, came to fruition as expected. The question remains though, whether the European Central Bank talked themselves into a corner being less able to be data-dependent but risking reputation were they to disappoint and hold. The easing comes as services inflation, much like elsewhere, is proving to be hard to curtail. After many years of stagnant wages, apparently we all like getting paid more and become accustomed to such generosity quickly! On the flipside, manufacturing has slowed and in some instances dramatically.

Policy is always a balancing act, always more challenging at points where one may need to pivot. Or not. Since our last musings, the next gift of cheaper money has been pushed out to October. Additional challenges include the periphery effectively already breaking rules designed to curtail borrowing as a percentage of economic output. Thus far this has been successfully swept under the carpet. With greater political uncertainty and heightened sovereignty this may well rear its head sooner than many anticipate. Meaning any move is likely to be outsized.

GBP

Improved consumer sentiment and consumption coming in higher have contradicted expectations of economic contraction. Both are naturally helpful for growth, with even the Bank of England revising forecasts up following a stronger than expected start to the year. A less exciting snap election in the UK (versus France), with policies remaining pretty boring, is good for business and foreign investment.

The potential though for the Conservatives to become entirely irrelevant after this would be bad for democracy. We have seen in prior votes how a party can be entirely wiped out. Having moved from three main parties just over a decade ago, it would be bad for democracy and proper opposition and accountability if we effectively end up with a one-party state. All I can say to this is, please go and vote! Abstinence here is not a good thing.

For now at least, the Bank is also commenting on the current political climate and change in leadership, seeing no risk or change to their view of cuts coming and, to some, signalling as early as the next meeting on August 1, with the market pricing a 70% chance of just that. Come the end of the year, it is predicted that rates will be 0.50% lower than today.

The best news of late was the most recent inflation print, with CPI (the consumer price index, basically cost of goods we typically buy) coming in on target at 2%! Amazing stuff. Sadly, much like elsewhere it’s those terrible wage hikes impacting services that is making monetary policy hard here too. Last but not least, is debt to GDP in the UK at its highest levels since the swinging Sixties. Whilst that may have been a great decade, what followed with the winter of discontent and pain felt far and wide, would be good to avoid repeating. The next government would do well from knowing our history…

USD

According to some at the Federal Reserve, we have reached an inflection point in the labour market. Worth paying attention to, this remains an important metric for policy that should not be ignored. Demand in this consumer-driven economy would naturally be affected by such a shift, and potentially the only way to see inflation get back to that arbitrary 2% target.

We have often commented on the potential impact of eeking out the last incremental drop to two. Is it really worth it? Growth is still holding up well though, but at what cost? Before the year is out we are likely to see the debt ceiling debacle return and according to anecdotal evidence, being chatter from some of the biggest buyers of US treasury bills, positions are already being managed down, particularly around what are expected to be key dates that this would cause pain from late payment.

Additional clues will come later this week from a key metric for rate setting, being PCE (personal consumption expenses) data, an important inflation gauge capturing both goods and services inflation, and the Fed’s preferred measure. The consumer price index has softened, all eyes remain on data to come. Speculation as it stands is for a first cut of 0.25% in November. Sounds like great timing with a looming election and potential volatility which may not be priced in.

So what?

Well, cuts, if not already here, are certainly coming. Yet to be seen is what impact small increments might have on the economy and sentiment. Whether we also see a reversal in fortunes in the fight against inflation remains to be seen. What is certain is that the status quo of higher for longer is coming to an end. The markets have also repriced higher what any terminal rate might look like. Never a dull moment…stay tuned for the latest and greatest moves over the coming months!


*TreasurySpring’s blogs and commentaries are provided for general information purposes only, and do not constitute legal, investment or other advice.

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