The Weekly Update

Last week Greek 2 year bonds touched yields of 9.5% on the back of a disenchanting report from the IMF which has revived a dispute between the IMF and EU creditors. Europe and markets generally have continued to assume that the IMF would eventually join the third bailout programme for Greece which for the last three years has fallen solely to the European Stability Mechanism (ESM). The IMF was meant to have decided on their participation by end 2016 but continue to abstain whilst arguing for a 1.5% primary surplus – rather than an “unrealistic” 3.5% target by 2018 as demanded by the European Commission – which would necessitate significant debt relief from other Eurozone countries.

With €7bn of debt due in just 5 months another bailout will need to be reached before then and this latest spat clearly makes this more difficult; bear in mind just how little consensus has been reached in the past 2 years of negotiations. German officials have warned that without the IMF the entire rescue programme would be axed. With government debts already at 180% of GDP the IMF forecast that this debt load would turn “explosive” after 2022.

Those disputing IMF’s concerns say they have yet to fully factor the most recent improvements in the Greek economy which have been notable on the back of increased tax revenue and expectations that the economy will grow above 2% this year for the first time in a decade; that is of course after real output dropping by over a quarter since the crisis and having ebbed at this nadir for past 2 years. Greece is of course already 8 years on, so many hope it is about time for some recovery. But just because its economy has stopped shrinking does not give proper cause to believe it is assured a long term trend of growth. There are few promising opportunities on the horizon for Greece in the face of unemployment, depressed domestic spending, global secular stagnation and little in terms of policy in the pipeline that would be a boost.

One of the issues again being discussed is the risk of redenomination of Greek debts is the case of a Grexit and reinstated drachma. This of course would no longer be the preferred option for Greece itself (perhaps regaining monetary sovereignty in order to inflate debts away would have been the best option back in 2010 but that opportunity was missed). As numerous as the concerns are for Greece this is perhaps less of a concern for Greek international debt which mostly follows English law. So if the European Project does fall apart at least those holding Greek debt would get whatever funds they can recover back in euros. We of course remain averse to almost all European government debt either for lack of value or excessive and under-priced risk. A decade ago when Greece was still A1 rated and could borrow at 1% for 2 year and 4% for 10 year debt we were warning of their excessive Net Foreign Debts. Following adoption of the euro Greek debts ballooned – lured by markets wrongly associating the various euro denominated government debts.

We prefer to hold a positions such as the US company, Southern Copper Corporation across our global bond fund products. Headquartered in Phoenix Arizona with mining activity predominantly undertaken in Peru and Chile the US dollar denominated 7.5% 2035 issue has performed extremely well and is one of the few bonds currently trading above the Trump election sell-off back in early November. This bond has rallied nine points since the election and continues to offer attractive risk-adjusted value. Currently trading at a spread of around 300bps off of US Treasuries, this BBB/BBB+ rated bond remains about 4.3 credit notches cheap against its RVM fair value spread of 145bps and equates to an expected return and yield of 22.3% should it move to fair value. Of course the 5.6% yield is a welcome addition to any portfolio.

We continually search for rotation candidates across our portfolios as some names move faster than others, or indeed individual companies/Government issuers are affected by their own characteristics such as further supply or news affecting profits. However, it is challenging to find a candidate to rotate into from our Southern Copper holding which still offers so much on a risk/reward basis currently.

The Weekly Update

Friday’s January non-farm payroll release showed 227,000 jobs added which was above expectations, although the unemployment rate edged higher to 4.8% from December’s reading of 4.7%. Importantly, average hourly earnings grew 2.5% yoy, down from the previous month’s figure of 2.9% yoy, and below expectations of 2.8% yoy.

The Fed’s December projection is for 3 hikes in 2017 and 2 in 2018 but considerable uncertainty remains in terms of how much tightening will be required given a lack of policy detail from the Trump Administration. The January Fed meeting statement made no policy change with a somewhat dovish stance emphasising a gradual data dependent approach to tightening. Given the asymmetric risks that tightening too aggressively brings, and a lack of policy detail from the Trump administration, it comes as little surprise the Fed is exerting some caution. Thus, the Fed futures are discounting a 69.5% probability of a hike at the June meeting.

The US economy grew 1.9% in 2016 based on the latest Q4 data keeping the economy set in the ~2% trend that has been the case since 2010. So far, we see little evidence to convince us that growth can sustainably be boosted back above the 3% level as the structural trends of poor demographics, secular stagnation and elevated global debt levels remain firmly entrenched. It will be interesting to see how the US debt ceiling negotiations progress in March as an indication of scope for a more expansionary fiscal policy. Even if there is a boost from Trump’s stimulus and tax cuts that is not more than offset by a more protectionist trade policy the effects are unlikely to impact until 2018. A stronger dollar would remain a drag on both growth and inflation.

We expect that the Fed will remain ahead of the curve in the process to normalise rates and the yield curve is likely to flatten. US Treasuries have already factored in a significant amount of policy tightening with the 10 year yield having backed up 110 basis points from the July 2016 low of 1.36% to ~2.46%. Against such an uncertain global backdrop a portfolio of high quality bonds from creditors, particularly those offering positive yields, remains one of the most attractive places to be positioned.

One thing you can say about Trump is, unlike many politicians globally, he has followed through with some of his main campaign promises, albeit some more recent actions deemed controversial by many. We suspect the broadly dovish Fed members will act on a wait-and-see basis, as there has been little to no guidance from the Trump administration with respect to fiscal policy deployment and the consequent effects on US growth.

Our base case is that the dollar remains strong, boosted by higher growth expectations and carry traders attracted by higher US short rates. However, with Trump adopting controversial policies (read ‘muslim ban’), this may damage the allure of the US dollar as a reserve currency. Valiollah Seif, the governor of the Central Bank of Iran last week stated that preparations are underway to ditch the dollar ‘as its currency of choice in its financial and foreign exchange reports’, effective March 21. At this stage the alternative is unclear, although Seif did discuss the option of ‘selecting a basket of currencies or choosing the currency that plays the biggest part in foreign trade’; this suggests the euro could play a major role.

But how about the renminbi…? Iran’s top export destination is China, at ~USD 25bn, compared with its next biggest, India at USD 10.3bn. Back in 2012, China started buying crude from Iran using renminbi, and Iran in turn used the revenue to access Chinese goods and services; so not a completely leftfield proposition. Whatever the government decides, March 21 is less than 7 weeks away, so revenues of ~41bn of the country's largest and most vital export, oil, are likely to come under pressure. We do not and have never invested in Iran.

As President Trump continues to settle into the role, with confusion and sackings domestically, one of the international situations which we still have no information on is the policy regarding the Russian sanctions. Trump has spoken to President Putin but according to reports the sanctions were not discussed.

It strikes us that it would not be in Mr. Putin’s best interests to rush to have sanctions lifted as this would cause a further rally in the rouble; which has been a key weapon in Russia’s armoury to survive the fall in the price of crude over the last few years. Indeed between June 2014 and its peak in January 2016 the rouble fell 141% against the US dollar moving from a price of around 34 USD/RUB to 82. This is somewhat in line with the fall in crude as measured by Brent which fell from a price of $112 per barrel (pb) to $28.55pb, 75%, over the same period. Since January 2016 oil has recovered somewhat, now trading at around $55pb and the rouble has also rallied 27% to trade around 60 USD/RUB.

The big devaluation in the rouble, although not popular domestically as it pushed inflation up, was essential and a well-managed policy to cope with the loss of oil income. Broadly, with Russian production costs, wages etc. all in roubles the fall in oil was offset within the Russian balance sheet by the currency weakness. This policy worked extremely well and just a few weeks ago the Russian Central Bank announced they would once again be building up foreign reserves by buying around $1bn in currencies per month. This is due to the Finance Ministry estimating that it will receive about RUB1tn ($16.7bn) in additional revenue this year with oil averaging $50pb.

Key to this of course is the value of the rouble; a strong currency could derail the process of recovery for Russia. Central to the central bank’s battle to manage the value of the rouble is Elvira Nabiullina, the bank’s governor since 2013. Nabiullina has orchestrated policy over the last few difficult years and has worked within Mr Putin’s government since he came to power in 2000, back then she was a deputy economy minister before becoming minister in 2007 and a key member of the Putin government.

As regular readers will know we still hold Russian quasi-sovereign debt in our portfolios, in hard currencies (currently USD and GBP) and have always looked at Russia as a viable investment opportunity due to the strong balance sheet of the country; with a four star rating under our Net Foreign Asset scoring system. From our point of view an easing in sanctions would likely be followed by upgrades from Standard and Poor’s and Moody’s who have Russia as sub-investment grade and would benefit our holdings almost immediately. However, if Ms Nabiullina and her colleagues at the CBR continue to add foreign reserves by managing the rouble's value, we feel the agencies will be forced at some time to reappraise Russia’s situation, even with a continuation of sanctions.

The Weekly Update

Last week, President Trump withdrew the US from the Trans-Pacific Partnership (TPP) which had taken the Obama government two years to negotiate. The TPP included 11 other nations in a free trade agreement linking countries that account for approximately 40% of global GDP. Trump, during his campaign, claimed the current TPP and NAFTA agreements were unfair to American industry, adding that workers appear to have opened the door for China to take a major role in trade within the region.

Senator John McCain of Arizona said the US withdrawal ‘will create an opening for China to rewrite the economic rules of the road at the expense of American workers’. Next month in Japan the trade deal being promoted by China, The Regional Comprehensive Economic Partnership (RCEP) which includes 16 nations has its next round of talks and includes Japan, South Korea, Australia, New Zealand and India.

Former US trade representative for China affairs said ‘It’s a giant gift to the Chinese because they can now pitch themselves as the driver of trade liberalization.’ Chinese President Xi Jinping has already started to position China to take advantage and had anticipated Trump’s move on trade. Just last week in Davos at the World Economic Forum he described trade protectionism as ‘locking oneself in a dark room’. Xi has made trade a cornerstone of his presidency endeavouring to expand trade ties with neighbours and has put in place a massive infrastructure project opening up old trading routes to the Middle East and Europe. In fact the first direct train from China to the UK arrived in London last week, re-opening the old (2,000 year old) Silk Road route; which was previously used to carry goods between Asia and Europe. After a 7,500 mile, 18-day journey the Chinese freight train delivered  ~GBP 4m worth of clothing and other goods to Barking, East London.

Not only does it look as if China will benefit from the US withdrawal from the TPP, China will also benefit from the long awaited inclusion of China in the major bond indices. Bloomberg/ Barclays Fixed Income Indices last week announced new parallel global indices that include China RMB denominated securities.

Take two influential indices: MSCI Emerging Market Index in stocks and the Bloomberg Barclays Global Aggregate Bond Index for bonds, each comprising nearly 25 countries. Both are typical to the universe of indices and as such are systematically underweight in China. For although China dominates the EM space (with the second largest stock and third largest bond market in the world) its capital mobility restrictions, quotas and transparency hinder it from being included on a level proportional to its economic significance.

As we have previously compared: ‘China‘s GDP is over 7x larger than South Korea’s which currently accounts for over 15% of the MSCI EM Index’. Currently at 26.8% China’s weighting in the MSCI EM index could rise to 27.8% with a partial inclusion which was postponed last June. This may still be on the cards for this year but China’s recent increase in capital controls make it less likely. Further into the future it has the potential to reach over 40% will full inclusion of China A-Shares (alongside already included China and China overseas shares) should the quota systems and capital mobility restrictions ever be fully abolished. With around $1.5tn benchmarked to the MSCI EM Index and plenty more active and passive money influenced by this and similar indices this transitional trend could bump up international investment to both China’s stock and bond markets.

But whereas equity investors will have to wait a few more months for the MSCI decision, the Bloomberg Barclays Indices (which have become increasingly popular since acquired by Bloomberg in December 2015) have decided to create a parallel ‘Global Aggregate Index + China’ which would include onshore Chinese government bonds whilst keeping their Global Aggregate Index unchanged. This allows investors to decide to follow either or both going forward.

Such ‘transition indices’ should be seen as a positive step for the Chinese government who continue to suggest further key reforms are imminent. It also represents an opportunity for international investors who currently only hold around 2% of both the mainland stock market and onshore interbank bond market according to the Financial Times. Should other major index providers follow suit (JP Morgan, MSCI and Citigroup expected to make announcements in the next few months) investors should consider their allocation to China in general and make the necessary adjustments before passive investments are forced to follow any potential index adjustment. Even if China doesn’t make the cut this year its disproportional economic magnitude suggests that Chinese stocks, bonds and currency should eventually but inevitably constitute a greater proportion of international portfolios.

The Weekly Update

UK PM Theresa May’s Brexit speech and Donald Trump’s inauguration were the main features last week although China grabbed some attention, with 2016 growth releases surprising on the upside.

The week started with Donald Trump stating he will look to offer the UK a fair trade deal once he is officially in office. Although the UK is unable to sign up to any trade deals until it is formally out of the EU, it can look to get the paperwork in place. Theresa May will be meeting with Trump and his advisors this week to further discuss US-UK trade deals; where it is expected that tariffs cuts are due to be discussed and the doors open on either border for ‘free movement’.

Markets braced themselves on Tuesday morning ahead of what was so far the most important speech of UK PM Theresa May’s career, where she shed some light on the the highly anticipated Brexit strategy. The main takeaway from May’s speech is: the UK is to leave the single market, but Britain would seek an ‘associate membership’ of the customs union and ’a new equal partnership -- between an independent, self-governing, global Britain and our friends and allies in the EU’. On immigration, May stated control over Britain’s borders was a priority, adding that the nation will continue to welcome ‘the brightest and best to study and work in Britain’, however there will be control over numbers from the EU. It is still too early to tell how the UK economy will be affected by a ‘clean Brexit’ as negotiations will commence once the Parliamentary vote is cast. The IMF upgraded the UK’s economic growth forecasts to 1.5% for 2017, pencilling in a downgrade to 2018 growth expectations to 1.4%; the caveat of possible trade barriers and other unknown Brexit effects could see these forecasts revised somewhat however.

Elsewhere, on Tuesday, for the first time ever a Chinese president took centre stage at the World Economic Forum in Davos. This gathering was starkly different from previous summits, as the two biggest events of 2017 (so far), i.e. Brexit and the incoming of the possibly less trade-friendly US administration, are against everything that Davos - the global problem-solving think-tank - stands for. High up on Xi Jinping’s agenda was economic globalisation and free trade. Xi Jinping also echoed what Chinese policy makers have reiterated time and time again, that it is not their wish to devalue the renminbi to make exports more competitive. But their intention is to manage the redback against the recently expanded CFETS currency basket; of which the dollar is a large component. Non-manufacturing activities make up over half China’s GDP, so why, after all the country has done to reform its economy to more sustainable, consumer-led growth, would it wish for a weak currency; a rhetorical question. The offshore renminbi is  2.43% higher against the dollar and over 2.14% versus sterling so far this year.

A data heavy week confirmed economic stabilisation in China. The Q4’16 GDP release surprised on the upside, at 6.8%yoy, while 2016 GDP was 6.7%; comfortably within the official target. Meanwhile December’s industrial production reading was in-line with expectations, while retail sales beat consensus calls for 10.4%, at 10.9%. We expect policymakers will continue to aim for growth ‘around 6.5%’ for 2017, they have become increasingly aware of better quality and sustainable growth; with a higher tolerance to slower growth. Expectations are that they remain proactive in terms of fiscal expansion, however monetary support could be tightened as the country looks to contain financial risk.

The Weekly Update

A better week across credit markets saw the yield on the 10-year US Treasury fall a couple basis points to 2.397%. Hard/soft Brexit chatter continued to dominate headlines which saw sterling fall a further 0.85% whilst the FTSE 100 Index climbed to new all-time highs by the end of the week. Donald Trump and his relentless Tweeting also grabbed some attention, and markets appeared taken aback after his press conference on Wednesday; where there was very little clarity on future policy.

Meanwhile, Steven Mnuchin, Mr Trump's choice for US Treasury secretary is looking to achieve US GDP between 3% and 4% over the coming period, a big change from the around 2% per annum we have seen since 2009, of course we await details of how this will be achieved. We do have Mr Trump’s election promises of infrastructure spending, tax cuts and incentives for American companies to bring offshore funds back home. However, we also expect trade friction and of course immigration issues, which may result in tighter policies on entering the US, and of course a number of undocumented residents being ejected. The difficulty is, in order to achieve this level of growth there needs to be a huge rise in productivity and indeed a big jump in the US workforce, without these elements GDP cannot accelerate. On the surface the immigration policy appears to be in the opposite direction of what the economy requires.

Indeed US demographics are not very good. As mentioned the economy has grown about 2% a year since 2009 while the population has only grown by 0.76% per year, down from 0.93% in the decade to 2008 and the situation is on a downward sloping trend. So productivity challenges since the end of the global financial crisis have been hit by the headwind of demographics moving in the opposite direction. The US will also see fewer domestic consumers buying goods, which equates to less price pressure, leading to a decline in investment in aging plants and equipment - ultimately witnessing falling productivity; the opposite of Mr Mnuchin’s forecast.

Another big story last week, was the Central Bank of the Republic of Turkey’s supposed ‘intervention’ in stemming the lira’s collapse.  Despite the lira plummeting over 5.3% so far this year to new lows against the dollar (in addition to the 17.2% collapse last year), the ‘behind-the-curve’ central bank has yet to intervene on a meaningful scale, most probably out of fear. The CBT last week highlighted its concerns over the lira’s slide, and added ~USD 1.5bn of FX liquidity, and cut reserve requirement ratios across the board by 50bps. The central bank’s willingness to act against the fx mismatch saw the currency briefly fall from record highs, but we are not sure this ‘small token’ will be enough to stem further deprecation. A more substantial policy response is required via a rate hike or through further intervention, although reserves are quickly depleting.

Turkey's long-term rating was downgraded to junk in 2016 by both Moody’s and S&P last year, while Fitch maintained its investment grade BBB- rating, with a negative outlook. Having been classed an EM gem since before the financial crisis, investors appear to be falling out of bed with Turkey; a country which we have never been keen to invest in, mostly due to it’s low 2 star net foreign asset ranking, but also because we had previously seen very little relative value in the country. We would rather invest in similarly rated Russian holdings, where we view the fundamentals as being much stronger. State-owned Pemex 6.625% 2035, is also a compelling holding, offering just under 6 credit notches of protection against unforeseen events, while Turkey quasi-sovereign issues, on average, trade only 3-4 notches cheap, with a high likelihood of further downgrades.

The Weekly Update

With Trump likely to boost government spending, there will be even more attention than usual on the strength of the US economy. Despite the recent optimism, the reality is that real GDP in major economies has been declining steadily over the past 40 years, with ageing populations being a major factor. Friday’s December non-farm payroll release showed 156,000 jobs added which compares to 271,000 for the same month of 2015 and 292,000 the year before. The lower-than-expected reading was sufficient to nudge the unemployment rate higher to 4.7% from November’s reading of 4.6% and the participation rate was unchanged at 62.7%. Even if Trump’s policies do succeed in boosting growth in the short run, which seems quite likely, the underlying backdrop of ageing populations in the major economies will prove to be a significant headwind.

The other thing to watch will be global trade. Whether the actual impact of a Trump Presidency on global trade will turn out to be as negative as the campaign’s protectionist rhetoric remains unclear save that even under a better case scenario Trump is clearly looking to renegotiate the status quo. While NAFTA (with Canada and Mexico) is one agreement that he has been particularly vitriolic about, describing it as ‘probably the worst trade deal ever agreed to’, any country running a large bilateral surplus with the US could well find themselves in the firing line.

The US Treasury already releases a Semi-Annual Report to Congress on the Foreign Exchange Policies of Major Trading Partners of the US as part of a view of the exchange rate and externally-oriented policies of its major trading partners. In the October report Germany, China, Japan, Korea, Taiwan and Switzerland are all on a monitoring list having at least 2 of the following 3 traits: a material bilateral trade surplus with the US, a material current account or exhibiting persistent one sided foreign-exchange intervention. That said, under that review period none of the named countries exhibited all 3 traits or were considered currency manipulators. Nevertheless, this list of countries may find themselves more heavily scrutinised under a Trump administration.

China’s trading relationship with the US seems an obvious target with the Trump campaign voicing concern about currency manipulation. China’s decision to broaden the basket of currencies in its trade weighted index at the tail end of last year, from 13 to 24 currencies, means that the basket is now more representative of China’s trading partners as the previous basket excluded South Korea, which is China’s 4th largest trading partner. Although the timing of this move is probably unrelated to Trump’s victory, the stability or otherwise of the renminbi against the basket will be closely watched and provides a much better measure of whether the currency is being allowed to depreciate. In fact, since the middle of last year the renminbi has been broadly stable to stronger against the basket.

Nevertheless, holders of renminbi did lose 2.23% last year if they measured their performance in US dollars, although holders of euros would have lost 3.85% and sterling holders would have lost 16.3%. Whether you would have been better off holding renminbi last year depends on your starting position and 2017 will be no different.

The Weekly Update

Happy New Year to everyone and let’s hope 2017 is a prosperous year for everyone.

December was a very busy month for us with the launch of two new UCITS funds; the Stratton Street NFA Global Bond Fund launched on 30th November and the Stratton Street Next Generation Global Bond Fund launched on 16th December. With our Renminbi Bond Fund strategy, we now have three Luxembourg UCITS vehicles to complement our Guernsey PCC funds.

Looking forward, 2017 is going to be an interesting year. Against a backdrop of ageing populations in the “developed world”, voters are likely to continue to hope for a return to “the old days” even though there is very little prospect of that happening. Consequently, political change in the major economies is likely to continue with populist parties getting an increasingly large share of the votes. But whatever party is in power, one cannot escape the reality that economies cannot gain competitiveness by continuing to do things the same way things have always been done. There are plenty of difficult ways to gain competitiveness; through significant investment or by slashing wages, but the easiest one is to devalue your currency.

Which raises the question as whether Trump’s fiscal policies will achieve their goals. The short term impact is likely to be an increase in the budget and current account deficits and with the FOMC likely to tighten more quickly than might have otherwise been the case, the dollar is quite likely to rally further. But that is unlikely to make the US more competitive, quite the reverse. So don’t be at all surprised to see the US Treasury market flatten as investors look through the short term growth boost and start to factor in the combination of a stronger dollar and higher short rates on the longer term outlook for the US economy.

Which is why, after coming up with the Next Generation Global Bond Fund a couple of years ago, we were so keen to launch the fund at the end of last year. The flip side of a stronger dollar will be weaker exchange rates elsewhere. Somewhat perversely, Trump’s policies will help some of the emerging economies as they gain competitiveness if the dollar does indeed strengthen as we currently expect. Weakening currencies are bad news for indebted nations however, as their unhedged dollar liabilities rise as a proportion of GDP, but for the creditor nations, this will help their longer term prospects. In due course it will also present opportunities in some emerging currencies, although that may be a story for later in 2017 or maybe even into 2018. We shall see.

Markets are certainly interesting and anomalies remain numerous but for the time being at least, we still have a bias towards long-dated high grade bonds of the creditor nations.

The Weekly Update

This is the last weekly of 2016, so we wish you well for the holidays and look forward to catching up with you again 2017.

2017 is going to be an interesting year with plenty of things to think about. Trump’s fiscal policies are the obvious talking point as is the strength of the dollar. But is the US economy strong enough to handle two or three rates hikes? Will the housing market start to stall now that mortgage costs have risen significantly in recent months? What about the effect of ageing populations dragging down growth and inflation, the opposite of what many people think will happen to global growth next year? These are the topics we will be discussing in next year’s weeklies.

Last week the FOMC decided to raise the fed funds rate to 0.75% and have pencilled in an extra rate hike in 2017. The media would have us believe that the faster pace of normalising the policy rate to its long term norm now estimated at about 3% reflects both a stronger US economy and expectations of outsized fiscal stimulus under a Trump presidency. An upward revision to Q4 GDP also tends to have some carry-forward into the Q1 level of GDP in the staff’s forecast exercise, thereby explaining the small 2017 revision. That leaves the tiny revision to 2019, which is hardly worth mentioning. At 1.9% that forecast remains at or below the US long term potential growth of about 2%, which in itself is at the high end of the staff’s latest estimate of 1.5% to 2%.

By contrast, the ‘dot plot’ of FOMC participants’ assessment of the appropriate monetary policy has captured the headlines. While it is true that the average level of the policy rate in December calls for three rate hikes of 25 basis points in 2017, instead of the two hikes envisioned at the September meeting, the new outlook still remains less aggressive than what participants envisioned in June, and in the interim most participants seem to have signed on to the latest staff research showing strong evidence that demographics can explain all of the decline in the long term neutral rate of interest rate to less than 1% in real terms (3% in nominal terms if inflation is stable at its target of 2%). A few members remain outliers in calling for the fed funds rate to rise to 3.5% to 4% but that dissenting view is increasingly out of sync with the majority.

If Congress does approve an outsized fiscal package, the staff forecast will be revised upward commensurately with the inescapable consequence of having to raise the inflation forecast for 2018 and beyond. In short, upward surprises in either economic growth or in the nation’s fiscal policy setting are likely to translate into a more aggressive Fed. The December FOMC decision is not yet the clarion call for higher rates at a faster pace, but it is a red flag for things to come if politicians think fiscal policy is a free lunch.

Turning to the topic of aging populations, a couple of recent papers from the IMF have detailed the palpable problem of aging populations and specifically aging workforces across Europe and Japan; highlighting the current and expected accelerating impact these will have on productivity and economic growth. Whereas an increase in the dependency ratio is an obvious drag to economic growth - the effects of an aging workforce itself is not obviously a hindrance to productivity. For an older workforce may make up for in experience what they may have lost in vigour and entrepreneurialism associated with youth; particularly in technologically advanced economies where the considered elderly may easily be just as effective in many fields of employment. Studies of this effect on advanced economies are scarce and ones accounting for the further potential advance of technology are fewer but these two papers, “The Impact of Demographics on Productivity and Inflation in Japan” and “The Impact of Workforce Aging on European Productivity” go some way to showing that these ‘headwinds can have a non-trivial impact on total factor productivity (TFP) and deflationary pressures.’

The age distribution of the workforce in Europe has shifted upwards over the past few decades but will accelerate in the years ahead to the extent that it ‘could reduce TFP growth by an average of 0.2 percentage points every year over the next two decades’. ‘But in countries where aging will be most pronounced—Greece, Hungary, Ireland, Italy, Portugal, Slovakia, Slovenia, and Spain—annual total factor productivity growth could be reduced by as much as 0.6 percentage points.’ Japan faces the same problem along with an overall declining population and few major economies are exempt from the predicament. Across the 24 European countries projected by 2030 all except Luxembourg will have between 15-25% of the workforce aged 55-64.

Countries that have already ridden the demographic growth boom and failed to invest those gains preparing for when these population pyramids become top heavy will face an increasingly uphill battle. Those with already unsustainable net foreign debts will have shrinking productivity with which to service these hefty debts whilst spending on increasing welfare costs. This problem is only exacerbated every time such necessary global deleveraging is pushed down the road and it will remain a long term risk to global growth and inflation prospects well beyond the next few election cycles and perhaps well into all of our retirements (or geriatric careers). We continue to believe that high quality investment grade debt from net foreign creditor regions represents a sensible investment in the face of such growth headwinds.

Changing demographics provided the idea for the Next Generation Global Bond Fund which we launched as a Guernsey based fund back in July. This fund is proving very popular with a UCITS version of this fund being launched today.

Wishing you a prosperous 2017.

The Weekly Update

The Italian Prime Minister Matteo Renzi has formally announced his resignation after losing the referendum on constitutional reform, potentially tipping the Italian economy into political turmoil. As well as submitting his resignation to Italy’s President Sergio Mattarella, Renzi also insisted he would not be available to lead a caretaker government and over the weekend Paolo Gentiloni, the former Foreign Minister, was appointed Prime Minister. Although many expected Renzi to lose the referendum, the size of the loss will surprise some commentators. With over 33 million Italians voting, more than two-thirds of those eligible, nearly 60% voted against a change to Italy’s constitution. In a speech after the vote, Renzi said ‘My experience in government ends here … I did all I could to bring this to victory’ adding  ‘If you fight for an idea, you cannot lose.’ The vote is the latest blow to establishment politics in favour of populist and anti-immigrant parties, following on from the Brexit vote and Trump's surprise victory. The biggest objection to the reforms was that it would have given the ruling party more power at a time when there was little faith in politics. On the back of the result the euro touched a 20 month low against the dollar (1.0506).

Elsewhere, some good news for Mexico last week as they successfully auctioned off eight deep water oil and gas blocks in the Gulf of Mexico as an ongoing policy to open up the country’s energy industry. Companies such as China Offshore Oil Corporation (CNOOC), Australia’s BHP Billiton, France's Total, Norway’s Statoil, Malaysia’s Petronas, BP and a number of US companies were all successful bidders with a number of joint ventures established.

Mexico’s relieved energy minister Pedro Joaquin Coldwell said, ‘This underlines Mexico is very competitive in the oil and gas sector’ adding, ‘Before the current administration ends in two years’ time Mexico will likely hold three more oil auctions for shallow and deep water, as well as onshore areas’. Government expectations were reportedly that it would have been content if just four fields had been auctioned so the result that eight were successful was an obvious boost. It is thought that over the next decade the fields auctioned yesterday will add around 900,000 barrels a day to Mexican output with the auctioned fields thought to contain an estimated 8.4 billion barrels of oil.

Also good news from China, where both global and domestic demand appear to have improved as trade data releases for November materially rebounded, exceeding market expectations. Exports gained 5.9% while imports were up 13%, in renminbi terms; this was the first month of positive export growth, measured in US dollar terms since March this year. We expect exports to come under pressure if the US does go ahead to restrict imports from China, although China has a multitude of options to turn to and is currently in talks with the UK, which we expect, could be one of China's closest allies going forward. Trade between the two nations stood at just under $80bn last year.

China’s imports jumped the most in over two years off the back of a surge in copper, crude, iron ore and coal demand. The combination of a weaker currency and stronger commodity prices suggests China’s PPI will continue to push higher. Higher PPI inflation should lead to increased corporate profitability, as these two measures have historically been positively correlated. Higher and more stable inflation has aided the PBoC in shifting to a more neutral monetary policy stance.

The Weekly Update

In its first international report since Donald Trump’s unexpected presidential victory, the Organisation for Economic Cooperation and Development (OECD) said that although the exact benefits of Trump’s proposed spending and tax cuts are unclear, it does expect his proposals to boost economic growth in the US. The OECD said the likely boost would improve US growth in 2017 from 1.9% to 2.3% and in 2018 from 2.2% to 3%. As for global economic growth, they have raised the outlook from 3.2% in 2017 to 3.3% and from 3.3% to 3.6% in 2018. The forecasts are based on the US government increasing spending in 2017 and 2018 by .25% of GDP, together with a cut in the corporate tax rate along with a cut in income tax. Together the 2 cuts in tax will represent approximately 1.25% of US GDP by 2018.

OPEC agreed to their first production cut in eight years with members on paper at least agreeing to a cut of 1.2million barrels a day. Headlines such as ‘OPEC resurrection’ ‘OPEC are back’ and ‘OPEC in the driving seat’ combined with a near 10% bounce in the price of Brent, welcome the news that OPEC and Russia are working together and Saudi and Iran are in agreement. However, the agreement depends on self-compliance of all the countries involved to keep to targets and there remains problems as to how to measure production and so this agreement will be extremely difficult to police. Countries such as cash starved Venezuela and Angola would love to take advantage of higher pricing and sceptical traders doubt if Iraq and Iran will be in compliance in just a couple of months’ time.  Also the promised reductions by non-OPEC members Russia and Mexico of 500,000 barrels a day is a huge proportion of the reduction and in the case of Mexico the cut looks more like a natural decline rather than genuine production compliance.

Towards the end of the week the attention was taken up by Italy's constitution referendum and the Austrians voting for a new Prime Minister over the weekend. Italian Prime Minister Matteo Renzi’s job was on the line if he was to lose. He had already said he'd resign if the nation rejects his political reforms, which polls and bond yields predicted would happen. In Austria the EU was hoping for an  independent pro-EU Alexander Van der Bellen being able to hold off the challenge of Norbert Hofer of the anti-immigration Freedom Party.

There was press speculation that the ECB could temporarily step up purchases of BTP’s (Italian Government Bonds) should Sunday’s result cause yields to spike. The suggestion in the Reuters report was that the ECB QE programme was flexible enough to allow for a temporary increase in purchases and that undertaking such a move would not necessarily need to be ‘rubber-stamped’ by the Governing Council, which as a reminder meets formally 4 days after.

Friday’s November non-farm payroll release showed 178,000 jobs added which was in line with expectations. The prior month’s reading of 161,000 jobs added was revised down to 142,000.  The unemployment rate fell to a nine year low of 4.6% from October’s reading of 4.9% and the participation rate dropped a little to 62.7%.  Average hourly earnings was an off setting factor to an otherwise expected and rather neutral report as month on month the -0.1% saw a 2.5% year on year number from the 2.8% previous report. This data release in conjunction with recent Fed commentary makes a December rate rise almost inevitable with the market pricing in a 100 percent expectation of an increase in rates. What is more challenging to determine is what a Trump Presidency really means for growth and inflation.

The Weekly Update

Last week, five months to the day since the EU referendum, Chancellor of the Exchequer Philip Hammond delivered the first Budget of the Theresa May Government; the first Autumn Statement to the Commons in light of Brexit. In brief: GDP growth forecasts lower by 0.8% and 0.4% for 2017 and 2018; planned borrowing to increase by £122bn for the next 5 years; some slender support for renters and affordable housing; some mollifying policies for the ‘just about managing’ or JAMS increasing the ‘national living wage’ and tempering some of the Universal Credit reforms; corporate tax will be cut to 17% along with a wide range of new tax reforms; and new fiscal targets of a 2% deficit with debts falling by 2020. Markets saw inflation expectations surge higher; also sterling rallied to 1.2435 during the statement but then fell to 1.2360 before the end of the statement as US data came out.

Before today, Chancellor Hammond had already referenced the UK’s ‘eye-wateringly’ high debt levels, yet today confirmed that borrowing for the next 5 years will increase a further £122bn to fill the black hole that has become apparent since the Brexit vote and increase in debt interest costs, however it will also help to fund a £23bn new ‘national productivity investment fund’ which will incrementally fund projects from transport infrastructure to high-tech innovation.

Perhaps an interesting technical oddity we noticed is the budget no longer misleadingly accounts for pseudo sterling gains from hedged foreign currency reserves when calculating the Public Sector Net Debt (PSND). Previously it had included such gains in sterling terms on the assets whilst omitting the corresponding losses from the hedging derivatives (from sterling weakness) because of odd Eurostat guidelines; last year this accounted for around £10bn that would have never materialised in the National Accounts and could have perhaps been even more significant for the recent months following Brexit and sterling weakness.

Another take on the UK finances since the Brexit vote comes from Credit Suisse’s 2016 Global Wealth Report which estimates that UK household finances are $1.5tn worse off, equivalent to an average $33k reduction in value of accumulated assets per adult. Should Anglo policies continue to diverge alongside potential Trumpflation this in-dollar-terms write-down may just be the beginning for UK residents and investors. The report also calculates a $3.5tn rise in global wealth to $256tn but that this ‘wealth creation has merely kept pace with population growth’ for the first time since 2008. With such population growth slowing and the risks to global trade increasing, overall global growth faces strong downward/sideways pressures that regional pockets of fiscal stimulus and infrastructure spending will likely do little to offset.

With Brexit and the election of Donald Trump as US President, 2016 has been a year of political change, perhaps even revolution. Populist politics is seemingly the new zeitgeist as voters have vented their dissatisfaction with rising inequalities blamed on globalisation and more liberal policy agendas instead favouring more conservatism and protectionist approaches to areas such as immigration and potentially trade. This trend is also spreading to Continental Europe where the Italian referendum on constitutional reform is due on December 4 but could end up being a protest vote against the incumbent government and ‘economic malaise’. The ongoing primaries for the French Presidential Election next year are also sowing the seeds for a departure from the status quo with François Fillon, who comfortably won his party’s primaries on Sunday, predicted to easily win the presidency based on current polling. The clear message is that people in France are dissatisfied and frustrated with the status quo. With 283 terrorist related deaths since January 2015, an unemployment rate still around 10 percent, momentum looks to be with the candidates offering change.

Whether politicians can actually make a real difference to ageing so-called “developed” economies, is debatable. Against a backdrop of shrinking populations, growth will be very difficult to come by in many countries over the next decade or two and continual political change being a likely consequence. That is not true for all countries though with those running current account surpluses, with strong NFA positions and faster growing populations being the obvious candidates for bond investors looking for attractive alternatives.

The Weekly Update

For our weekly update, Dr Bob Gay*, our macro economist, provides his views on “A Trump Presidency”.

Donald Trump’s election victory is bringing forth a lot of speculation on the next administration’s possible economic policies and their consequences. These exercises are fraught with uncertainty in part because Trump as a candidate spoke so little about what his policies would be. A few themes are likely to remain intact now that election posturing is finished and so some thoughts are worth considering. Some of the main items on the agenda supposedly will include: renegotiating trade agreements including NAFTA, curbing immigration, health care reform (again), deregulation (notably for small businesses), repeal of Dodd-Frank, tax cuts and most significantly fiscal stimulus presumably in the context of infrastructure spending. Some of this agenda, however modified, is likely to move forward in 2016 because America has voted for ‘change’. Recall that each of the previous 8-year US presidents (Reagan, Clinton, Bush and Obama) was replaced with someone who was diametrically different in some sense from their predecessor, so the populous expects and Congress must deliver something new.

The Trump agenda is a mixed bag of supposedly pro-growth policies for the short run that unfortunately could have very negative consequences for the economy’s long term potential, so let’s divide the discussion into two phases – the short view and the long view.

The Short View

Not surprisingly, much of the market’s initial reaction seems to focus on the short view, especially the prospects for infrastructure spending. Markets have responded by raising inflation premiums on long term bonds. Although a growing consensus of economists now believes infrastructure spending is a viable anecdote for secular stagnation, some caveats are noteworthy.

When an economy is operating close to its potential, as is the case with the US economy today, an outsized initiative on infrastructure is ill-advised. The projects rarely provide jobs for the long-term unemployed or those who lack the requisite skills for such work. Moreover, the extra stimulus is likely to cause some inflation with a lag of about one year if it pushes the economy above potential. In a world where deflation still lingers, the risk is not so much a reversion to high inflation but rather the persistence of inflation from operating the economy ‘too hot’.

Congress will likely set restrictions on what projects would qualify, typically limiting the ventures to so-called ‘shovel-ready’ initiatives under the guise that the spending would not be a permanent feature of the government’s budget. The flip side of ‘shovel-ready’ however is that little thought is given to the long-term payback from projects or to what would be high priorities in raising the nation’s potential output. Only a small portion of the ARRA funding in 2009 was devoted to ‘greenfield’ projects which were next to impossible to accomplish within the two-year window of the stimulus package. The result often that most of the money is spent on pet projects, local road projects and transfers to local governments. This approach would be antithetical to the notion of remedying secular stagnation.

Waste is the Achilles’ heel of congressional legislation and infrastructure is no exception. Consider Japan’s ambitious building program of the 1990s that did nothing to augment potential growth but did implode the government deficit that remains today.

Apart from infrastructure, a Trump presidency also is perceived as more pro-business and hence good for growth. It is not clear what the transmission mechanism is however. Deregulation or repeal of Dodd-Frank and Obamacare supposedly would remove ‘shackles’ on businesses and health care providers and would allow banks to take more risk and lend. Neither of these themes is very convincing either as a short-term stimulus or a long-term boost to potential growth. It depends on what, if anything, replaces the old regulations and how reform is carried out. Mr. Trump is not known for his attention to detail and neither is Congress and, with regulations and health care, the devil is in the detail.

The Long View

A longer view is far more uncertain. The most controversial issues – namely, protectionism on foreign trade and restrictions on immigration – also are the most detrimental to the US long term growth prospects. Indeed, free trade – as opposed to globalization of production – and immigration including undocumented migrants from Mexico have been the most important engines of growth over the past two decades. Closing the doors the flow of goods, services and workers is one of the surest ways to raise domestic prices, undermine domestic demand and stifle competition that is the lifeblood of innovation. An aging workforce already has taken a huge toll on US potential growth which the Federal Reserve staff now estimates at only 1.8%. Because a nation’s demography changes very slowly absent immigration, a closed door policy in effect would doom the US to low potential growth for decades, not just during this incoming administration. The same, of course, could be said for Europe and Japan where demographics have played a major role in limiting the growth in domestic demand over the past 20 years. And demand is by far the most potent driver of business investment; bank regulations play a minor role by comparison.

*Dr Bob Gay is a consultant with the Fixed Income team and served eight years as Senior Economist with the Board of Governors of the Federal Reserve in Washington DC.

The Weekly Update

As the world continues to recover from the ‘surprise’ outcome of the US presidential elections, US Treasury yields have backed-up with the 10 year closing on Friday at a yield of 2.15%. Although much higher than the low of 1.36% set in July, we are now back close to the levels seen at the beginning of January 2016.

Trump’s election victory is bringing forth a lot of speculation on the next administration’s possible economic policies and their consequences. These exercises are fraught with uncertainty in part because Trump as a candidate spoke so little about what his policies would be. A few themes are likely to remain intact now that election posturing is finished and so some thoughts are worth considering. Some of the main items on the agenda supposedly will include: renegotiating trade agreements including NAFTA, curbing immigration, health care reform (again), deregulation notably for small businesses, repeal of Dodd-Frank, tax cuts and most significantly fiscal stimulus presumably in the context of infrastructure spending. Some of this agenda, however modified, is likely to move forward in 2016 because America has voted for ‘change’. Recall that each of the previous 8-year US presidents (Reagan, Clinton, Bush and Obama) was replaced with someone who was diametrically different in some sense from their predecessor, so the populous expects and Congress must deliver something new.

The Trump agenda is mixed bag of supposedly pro-growth policies for the short run that unfortunately could have very negative consequences for the economy’s long term potential. Not surprisingly, much of the market’s initial reaction seems to focus on the short view, especially the prospects for infrastructure spending. Markets have responded by raising inflation premiums on long term bonds. Although a growing consensus of economists now believes infrastructure spending is a viable anecdote for secular stagnation, some caveats are noteworthy.

When an economy is operating close to its potential, as is the case with the US economy today, an outsized initiative on infrastructure is ill-advised. The projects rarely provide jobs for the long-term unemployed or those who lack the requisite skills for such work. Moreover, the extra stimulus is likely to cause some inflation with a lag of about one year if it pushes the economy above potential. In a world where deflation still lingers, the risk is not so much a reversion to high inflation but rather the persistence of inflation from operating the economy ‘too hot’.

A longer term view is necessarily far more uncertain. The most controversial issues – namely, protectionism on foreign trade and restrictions on immigration – also are the most detrimental to the US long term growth prospects. Indeed, free trade – as opposed to globalization of production – and immigration including undocumented migrants from Mexico have been the most important engines of growth over the past two decades. Closing the doors the flow of goods, services and workers is one of the surest ways to raise domestic prices, undermine domestic demand and stifle competition that is the lifeblood of innovation. An aging workforce already has taken a huge toll on US potential growth which the Federal Reserve staff now estimates at only 1.8%. Because a nation’s demography changes very slowly absent immigration, a closed door policy in effect would doom the US to low potential growth for decades, not just during this incoming administration. The same, of course, could be said for Europe and Japan where demographics have played a major role in limiting the growth in domestic demand over the past 20 years. And demand is by far the most potent driver of business investment; bank regulations play a minor role by comparison.

Although nothing will transpire overnight and the wheels of change will grind slowly, with little economic impact until the latter end of 2017 and into 2018, the potential infrastructure boost has seen industrial metals outperform with copper taking the lead; 3 month futures are up almost 18% so far this month. This will no doubt give a further boost to Southern Copper 7.5% 2035, a holding within our global portfolios. Although this bond has sold off with other bonds, we are well off the low of 88 set earlier this year, with bonds trading at 115 or a yield to maturity of 6.14%. The Baa1 rated bond continues to offer exceptional risk-adjusted expected return of ~19%, a very attractive yield and 3.6 notch credit cushion.

With so many unknowns, it is clear that markets are finding it very difficult to make a definitive call at this juncture and for this reason we expect asset classes will continue to be volatile. We therefore believe that having a suitable mix of AAA positions alongside the credit spread component is the best way to be placed currently.

The Weekly Update

With just days before the US Presidential Elections, the FOMC held off raising rates last week, at least until the next meeting on December 13-14. This now means that it will have been a whole year since the last Fed rate hike last December back when markets were pricing in 4 rate rises in 2016.

The most notable change in the statement’s language was the addition of the word ‘some’ to the ‘further evidence’ required before a data dependent hike would be warranted. We expect that a not too turbulent Clinton win and payroll data that are in line with expectations could be enough to warrant this ‘some further evidence’.

Friday’s October non-farm payroll release showed 161,000 jobs added which was below expectations of 175,000 although the unemployment rate edged lower to 4.9% from September’s reading of 5%. This follows the US Q3 GDP release which looked strong at the headline number of 2.9% but the underlying data painted a weaker picture. Inventory build was a major contributor increasing from -1.2 percent in the prior quarter to 0.6 percent in Q3. Net exports were also strong contributors giving a 0.8 percent contribution reflecting a surge in soybean exports on the back of a disappointing harvest in Argentina. Final domestic demand was subdued at 1.4 percent quarterly annualised. Business investment remained weak and below expectations growing at 1.2 percent.

We would also note that the September durable goods orders do not bode for a particularly strong Q4 either. More anecdotally, Doug Oberhelman, the Chairman and Chief Executive of the global economic bellwether Caterpillar noted ‘Economic weakness throughout much of the world persists and, as a result, most of our end markets remain challenged.’ More specifically the company noted ‘construction activity and construction equipment sales in North America during the second half of 2016 are now expected to be lower than they expected in the previous 2016 outlook’. Caterpillar has cut its 2016 profit estimate for the third time this year and sees little sign of a recovery expecting 2017 revenues to be similar to 2016.

Nevertheless, Friday’s employment data leads us to expect that the Fed will remain ahead of the curve and raise rates in December; the futures market is now implying 76 percent chance of a rate hike in December although that is based on an assumption of a Clinton election victory. But the key point is that any interest rate increases are likely to be extremely gradual; many of the forces that have been driving neutral rates to lower levels will remain entrenched anchoring interest rate expectations at the long-end of the curve where we favour positioning. We expect the yield curve will flatten from here.

High levels of uncertainty in global markets makes high quality bonds from creditors, particularly those offering positive yields, one of the most attractive places to be positioned. A good example of this would be Kuwait. Last week Al-Qabas newspaper reported that Kuwait is looking to abolish public subsidies on, for example, water, electricity and fuel by 2020. It is estimated that these subsidies along with fiscal support account for ~USD3bn, so roughly 5% of forecasted spending in the current fiscal budget. In September the government partially lifted subsidies, with some fuel prices pushed up by as much as 83%; regular gas is still at a lowly USD 0.28 per litre!

With one of the lowest fiscal and external breakeven oil prices, the Gulf State has been able to weather lower oil prices to a greater extent than some of its regional peers, like Oman and Bahrain for example. However, Kuwait has also been a lot slower at diversifying its economy away from hydrocarbons, compared with its GCC counterparts like Qatar, and thus remains one of the most oil dependant economies in the region in terms of government revenues and exports. 7 star rated Kuwait is the highest ranked country in our Net Foreign Asset (NFA) universe, ahead of Hong Kong and Qatar.

We have in the past held debt issued by the country’s quasi-sovereign issuers, however we cannot find attractive enough value currently. Last week we saw a new deal from Equate Petroleum, a petrochemical producer based in Kuwait. The company issued two tranches in a USD1.25bn deal; the 5-year tranche was issued at +195bps over Mid-swaps while the 10-year launched at MS+270bps or ~255bps over Treasuries. The deal was ~2.3x oversubscribed. Rated Baa2 by Moody’s only, we did NOT add this holding to our portfolios despite the quasi-sovereign nature and strategic importance to the Kuwaiti economy as our proprietary RVM calculated that the bond did not offer an attractive risk-adjusted expected return, nor sufficient credit notch cushion versus other regional holdings within our portfolios. Currently the bond offers an expected return of 4.7% and only 1.4 credit notches of support. By comparison, the new Saudi Government 10-year issue, rated A3, on the other hand offers in excess of 7.2% expected return and almost 4 notches of protection.

Our projections for Net Foreign Assets help us identify the countries likely to be upgraded (or downgraded) owing to current account imbalances, and our RVM allows us to recognise exceptional risk-adjusted value and credit notch cushion within our investable universe. As such, on a weighted average basis, our single A rated portfolios have in excess of 3 notches protection and offer over 3.5% in yield terms. That level of protection also affords us with plenty of opportunity for capital gains if the underlying bonds reprice closer to fair value as we would typically expect.

The Weekly Update

Whilst there is plenty of press coverage on the impact of QE on bond yields, very little attention is paid to the impact on currencies and global imbalances. Earlier this month the US Treasury released its Semi Annual Report to Congress on the Foreign Exchange Policies of Major Trading Partners of the US as part of a review of the exchange rate and externally-oriented policies of its major trading partners. Germany, China, Japan, Korea, Taiwan and Switzerland are all on a monitoring list having at least 2 of the following 3 traits: a material bilateral trade surplus with the US, a material current account or exhibiting persistent one sided foreign-exchange intervention. That said, at this juncture none of the named countries exhibited all 3 traits or were considered currency manipulators.

Germany has a sizeable current account surplus at just over 9.4 percent of GDP (1H’16) and it runs a significant bilateral surplus with the US. As the EC itself notes ‘While current account surpluses in countries with an ageing population like Germany are to be expected, and recent oil price and exchange rate developments had a favourable impact on the trade balance, the current value of the surplus appears well above what economic fundamentals would imply.’

Germany’s situation is exacerbated by the euro: combining creditor and debtor nations in a currency union can be problematic. In the case of the euro area post GFC, the highly leveraged, deficit running members notably Greece, Spain and Portugal have been forced down the route of austerity to adjust and now run current account surpluses. Germany, a strong creditor nation, has become locked into a relatively weak euro exchange rate (than had it retained the deutschmark) and is by default pursuing a mercantilist model. The IMF’s 2016 External Sector Assessment notes that the German REER is undervalued by 10-20% and using their current account regression model with standard trade elasticities it is 10-15% undervalued. For Europe: ‘On balance, staff assesses the euro area average real exchange rate in 2015 to be undervalued by 0-10%. The REER gaps are large in many member countries, ranging from an undervaluation of 10-20% in Germany to an overvaluation of 5-10% in Spain.’

The EC established the Macroeconomic Imbalances Procedure (MIP) after the crisis ‘to identify and address imbalances that hinder the smooth functioning of the economies of Member States, the economy of the EU, and may jeopardise the proper functioning of the economic and monetary union.’ The MIP uses a range of indicators including ‘a 3-year backward moving average of the current account balance as a percentage of GDP with thresholds of +6% and -4%.’ The latest review notes that the euro area current account surplus ‘is higher than the surplus implied by economic fundamentals’ with the bulk contributed by Germany and the Netherlands; the euro area current account reached 3.7 percent of GDP in 2015. Thus, one of the areas of debate has been about bringing the excessive surplus for Germany to a more sustainable level to avoid the current account surplus for the Eurozone as a whole reaching unsustainable levels. The obvious ways to try and do this involve trying to boost domestic growth through policies that encourage private investment, infrastructure investment and aim to boost wages and domestic consumption.

Adjustments do happen and perhaps given the low growth environment have become important subjects for discussion at G-7 and G-20 meetings and IMF review reports. Indeed the Trans-Pacific Partnership incorporates provisions to address unfair currency practices. Ultimately, trading relationships, economic or currency unions have to bring benefits to all to prosper. As an example, China’s current account surplus reached an excessive and unsustainable level of 10 percent of GDP in 2007 but has now adjusted back to a reasonable level in the range of 1.9-2.7 percent for 2011-2015. In the case of the euro area there has been some progress, helped by five rounds of the MIP, but really as the 2015 Five Presidents’ Report notes a deepening of the fiscal union also ultimately needs to happen with a euro area treasury and a common macroeconomic stabilisation fund for rebalancing and redistribution to be more effective.

Our Next Generation Global Bond Fund uses our projections for Net Foreign Assets to help us identify not only the countries likely to be upgraded (or downgraded) owing to current account imbalances, but also the currencies that are likely to see upward pressure over the long run. Needless to say, the euro, yen and Chinese renminbi score strongly under this type of analysis. For the past few years the US dollar has been very strong, partly as a result of being further ahead in the interest rate cycle. However, with December looking like a near certainty for a Fed rate rise, one has to wonder how many more rate hikes we will see when the global economic backdrop remains so weak. At a point that investors believe that we have reached the end of the US tightening cycle, the dollar is likely to come under significant pressure. Under those conditions, the Bank of Japan and the ECB in particular are likely to find it difficult to keep the yen and the euro from appreciating against the dollar.

The Weekly Update

The biggest news last week was the largest ever developing market bond sale, from the government of Saudi Arabia. Having heard rumours of a record breaking debt sale from the Kingdom for almost a year, it was no surprise that the USD 17.5bn deal was 3.8 times oversubscribed. The three tranches rated AA-/A1 were priced at: 5-year UST+135bps, 10-year at 165bps over and the 30-year at +210bps. We added the 10-year and 30-year issues across our portfolios as they offered the most attractive expected returns of 7.8% and 20.4% with yields of 3.4% and 4.6% respectively.

The Kingdom clearly warranted the interest, with yields typical of a Baa1 rated issue, it is AA-/A1 rated with a Net Foreign Asset rating of 7 stars and 18% of proven global oil reserves (enough for 70 years at current production rates of around 12m barrels per day). Saudi Arabia has a large and well diversified sovereign wealth fund and a 24% of GDP capex has quickly turned some non-oil domestic industries (e.g. mineral mining) into global players. Also their disproportionately large FX reserves, at $616bn, is undeniably sufficient to maintain a dollar peg and support growth as they target a balanced budget by 2020.

The Kingdom’s 5-year CDS, i.e. the cost of insuring the debt against a default, plummeted ~10% over the week, and has continued its fall today, currently at ~132, from 142.5 ahead of the new issuance. The new deal also breathed a bit of life into the emerging market credit with some our favoured holdings bouncing around 6 points; the yield on state-owned Saudi Electricity 6.05% 2043 for example fell over 37bps to a still attractive yield of 4.99%. We continue to support such bonds from the region’s highly rated sovereign and quasi-sovereign issuers, which have rallied off the back of the Saudi deal, and offer exceptional value and spread cushion.

Meanwhile, the most colourful US Presidential debate in history ended with polls indicating that Clinton is winning the race, although Trump is not willing to accept an election loss claiming the results could be ‘rigged’. The election’s proxy currency, the Mexican peso continued its appreciation last week gaining and is now one of the strongest performing currencies so far this month having gained ~4.25% against the dollar. Our positions in state-owned oil company Petroleos Mexicanos have also performed well; with the 6.625% 2035 issue rallying around 5 points so far this month. Held across our global bond portfolios this issue continues to offer a very attractive risk-adjusted return of over 24% and yield above 6%. We calculate that the bond could rally a further 21.5 points to reach a fair value spread of ~165bps, and has a sufficient 4.5 credit notch cushion.

Elsewhere, China’s latest GDP reading for Q3’16 matched market expectations at an annualised 6.7% yoy, unchanged from the previous quarter and on track to meet the government’s 6.5-7% target. The services sector once again expanded at a faster rate than the rest of the economy, contributing over 50% to growth. We expect growth momentum to continue on a steady path, with new tightening measures to control the property sector a marginal downside pressure. Other data also indicated stabilisation, with retail sales and industrial production coming in line with expectations at 10.7%yoy and 6.1%yoy, respectively. The stand out indicators were the inflation releases, where CPI beat market expectations at 1.9%yoy and PPI bounced into positive territory.

The Weekly Update

A rollercoaster week across asset markets saw the yield on benchmark 10-year US Treasury jump 8bps to 1.80%. Meanwhile, sterling extended losses against the US dollar, falling to its weakest level since the GFC. Despite recent economic data such as retail sales surprising on the upside sterling is being pounded by worries over a 'hard Brexit'. The pound closed the week 16% weaker against the dollar year-to-date and has plummeted more than 18% against the euro. In fact the currency is one of the worst performing against the greenback so far this year; worst than the Argentinian Peso, and sitting ahead of the Angolan kwanza, Nigerian naira and the Venezuelan bolivar! Former BoE governor Mervyn King last week claimed that the weaker pound is a 'welcome change' adding that the Brexit concerns are ‘over the top’. He went on to comment that during the referendum campaign, it was noted that Brexit would push inflation higher, and that house prices and sterling would fall; basically what the BoE has ‘been trying to achieve for the past three years and now … have a chance of getting it.’

The Gilt market has also taken a beating as concerns over fiscal spending and the weaker sterling increased. The combination of a weak currency, higher inflation and increased government spending (at record low borrowing levels) may put even further pressure on the Gilt market. The market’s expectations for a surge in inflation has pushed the 5-year, 5-year GBP inflation swap rate up ~24% to 2013 levels during the week; from the lows at the end of July.

As all our funds are US dollar denominated we have very little exposure to sterling currency moves. Across our portfolios we hold a couple of sterling bonds; the likes of state-owned Russian Railways 7.487% 2031 which has rallied over 28%, and Scottish Widows 5.5% 2023 has gained 6% on a total return basis year-to-date. Both bonds continue to offer attractive risk-adjusted returns of 18.2% and 12.7% with yields of 5.8% and 4.2%, respectively. Although denominated in sterling, these bonds are fully hedged so our exposure to sterling is zero.

Elsewhere, the Fed minutes show a committee mixed with a 7:3 vote not to raise rates in September, but it does appear that the voting members are moving closer to a 25bps rise when they meet in December, a move in November is unlikely due to the election; but a Trump withdrawal could open the door here as well; data dependent of course.

Helicopter money, the transfer of cash directly to consumers from central banks, in order to immediately stimulate economies has been looked at time and time again, particularly recently in Japan. The concept has been around for many years since it was first dreamed up by Nobel Laureate Milton Friedman nearly fifty years ago. ECB President Draghi described it as a 'very interesting concept' while Mark Carney called it a 'flight of fancy' and Japan's governor Kuroda has said it is prohibited by current Japanese law.

The Weekly Update

Sterling has been under renewed pressure since Theresa May said she would trigger article 50 by next March. At one point early on Friday morning, the pound traded as low as 1.1491 against the US dollar in very thin volumes before recovering to close the week at 1.2434, still a substantial decline from the prior Friday close of 1.2972. May has hinted at a “hard Brexit” with immigration controls being traded at the expense of remaining in the single market with all the short term negative consequences for the UK’s economic performance. Longer term, a weaker pound could put the UK in a competitive position to attract overseas investment, but for that to occur we will need to see a much weaker exchange rate than currently, even though sterling is trading at new 31-year lows. What is surprising is how UK investors do not seem to have taken the opportunity to invest in other currencies, particularly in Asia, to take advantage of the likely continued weakness in sterling in the months ahead.

Aside from sterling, the main focus last week was on September’s non-farm payroll data released on Friday. 156k jobs were added which was below expectations of +172k with the unemployment rate rising to 5% (versus expectations for 4.9%). For us, the key point is that US growth remains patchy and weak; the IMF cut its US growth forecast for 2016 to 1.6% from 2.2% and downgraded 2017 to 2.2%. In fact since the GFC US growth on an annual basis has been 2.5% or above in only 2 years one of which was 2015: this paled with the more buoyant decade or so pre-GFC. While indicators such as 2Q GDP have been revised up to 1.4% on a quarterly annualised basis and the September ISMs for both manufacturing and services showed improvement indicators such as the Chicago Fed National Activity Index, a broad based indicator of 85 economic variables, fell to -0.55 in August.

The IMF’s updated World Economic Outlook noted, ‘Some risks flagged in recent WEO reports have become more pronounced in recent months, including those associated with political discord and inward-looking policies, or secular stagnation in advanced economies. Other risks, such as rising financial turbulence and capital pullbacks from emerging market economies, seem to have become less prominent, but they still remain. On balance, downside risks continue to dominate.’ We would add negative demographic trends, disappointing productivity growth, rising inequality, weak business investment and high debt levels to a list of things to be concerned about.

A case in point would be Australia. In terms of rapidly increasing private debt, the IMF has singled out Australia, highlighting its increasing concerns over the country’s household debt. As regular readers know, Stratton Street’s Net Foreign Asset (NFA) calculations consider not only government debt but also corporate, and importantly, household liabilities. As such, Australia is not included in our investable universe as the country is assigned a 2 star rating; as NFL are greater than 50% of GDP.

Previously when high debt levels were of concern, world output and inflation were relatively strong, allowing debt to GDP ratios room to decline. Currently however we are faced with painfully slow global growth and benign inflation making these high debt levels, especially within the private sector appear even more concerning and unsustainable. Faced with this backdrop, central bank policy options will be highly constrained, with interest rates at very low levels for an extended period of time.

All this points to a continuation of the period of insipid growth and benign inflation, especially given the aging nature of the global population, particularly in the so-called “developed world”. Consequently, whilst we expect that the Fed will remain ahead of the curve and that any interest rate increases are likely to be extremely gradual; many of the forces that have been driving neutral rates to lower levels will remain entrenched anchoring interest rate expectations at the long-end of the curve where we favour positioning. We expect further flattening of the yield curve. High levels of uncertainty in global markets makes high quality bonds from creditors, particularly those offering positive yields, one of the most attractive places to be positioned.

The Weekly Update

Another rollercoaster week saw OPEC discuss the possibility of a production freeze. For the first time in eight years, the cartel announced that members had reached an “agreement” to marginally cut crude production, in an attempt to temper the supply glut and stabilise oil prices. Markets reacted positively to the news, despite no fundamental changes or a concrete deal; which is due to be ratified at the OPEC meeting in November. Nonetheless, Brent enjoyed a ~8% rally over the week, closing above $50pb. Concerns over European banks’ capital levels and the consequent contagion effects saw markets end the week on risk-off tone. Major asset classes remained relatively flat over the week, having rallied after the OPEC news and the Clinton 1:0 “win” against Trump after the first presidential debate.

Elsewhere, as was widely expected, rating agency Moody’s downgraded Turkey’s Baa3 long-term rating by one notch to junk Ba1, citing 'The increase in the risks related to the country’s sizeable external funding requirements' and 'the weakening in previously supportive credit fundamentals particularly growth and institutional strength' as the main drivers for the downgrade. Moody's also highlighted the country’s susceptibility to event risk as ‘high’ adding its concerns over the country’s vulnerability to political instability and geopolitical risks emanating from ‘Syria’s ongoing civil war and the crisis in Iraq.’ After the failed coup in July, Standard and Poor’s swiftly downgraded the country’s rating to BB, however Moody's said it would take time to review the situation later stating, ‘The risk of a sudden disruptive reversal on foreign capital flows, a more rapid fall in reserves and, in a worst-case scenario, a balance of payments crisis has increased”. Fitch is the only major rating agency to maintain an investment grade rating on the country; at BBB-.

Although a very popular holding amongst emerging market indices, we have never held Turkish debt, the main reason being that the country has a Stratton Street NFA score of only 2 stars; thus not within our investable universe. Also using our Relative Value Model, we calculate that the benchmark government curve is already pricing in a number of downgrades and is therefore trading fairly close to fair value, with the most attractive point of the curve at 5-years. The 5.625% 2026 offers a small 2.5% expected return and only 1.5 notches of credit cushion; we would much rather invest in 7 star, Aa2/AA rated sovereign paper like Qatar 9.75% 2030s which offers an expected return of around 11%, and has 5.5 notches of protection.

On Saturday, October 1, the Chinese renminbi was included in the IMF’s Special Drawing Rights (SDR) basket as a reserve currency. We expect the PBoC will look to maintain currency stability, with little flow expected this week as the country celebrates Golden Week. Last week’s data releases showed China’s PMI data was stable in September; both the official and Caixin manufacturing readings remained in expansionary territory, while the non-manufacturing print improved to 53.7.

This week, market focus will likely remain on the European banking crisis, especially after the hard line the German government has taken with regard to strictly no bailouts.  Elsewhere there will be a number of Fed members due to speak, and some focus on UK PM May’s Conservative Party conference, after her comments over the weekend regarding triggering Article 50 in Q1 ‘17. At the end of the week we have the all important US non-farm payroll reading; consensus is for an additional 170k jobs and for unemployment to stick at 4.9%.

The Weekly Update

Last week started with asset markets on tenterhooks; awaiting monetary policy announcements from the BoJ and Fed. As we had expected the BoJ moved to steepen the JGB curve, by launching 'QQE with Yield Curve Control', or Quantitative and Qualitative Monetary Easing with 10-year yield cap at 0%, and the Fed maintained the status quo; leaving a hike in December on the table.

The BoJ’s shift in policy creates a lot more flexibility without actually doing much to immediately push inflation higher. The central bank seems to have quietly dropped the unrealistic 2 year timeframe for reaching its 2% inflation target, forward guiding that an inflation overshoot will be tolerated, broad yield curve targeting rather than allocated QE amounts and maturities and the further possibility of increasingly negative key rates. The BoJ do still have some tricks up their sleeve though the latest comments suggest that they, like the rest of the world, still regard ‘helicopter money’ as unviable. However, there is still the possibility they are already preparing to pull out a fourth arrow, at the very least promoting wage increases to be based on future inflation expectations rather than the preceding year’s measure. After all with full-time wages remaining flat for over two decades many feel it is long overdue. We don’t see Japan’s economy sinking yet but there are clearly still a lot of holes to patch up.

Elsewhere, the Fed 'struggled mightily with trying to understand one another’s point of view' said Fed Chair Yellen, adding however that 'most participants do expect that one increase...will be appropriate this year' and that the issue is about timing rather than hiking. Having risen to 61.2% on Thursday, market odds for a hike in December ended the week around the same level, at 55.4%. The Fed’s median forward guidance was revised to two rate rises, from three for 2017.

US employment appears robust and August’s inflation numbers surprised on the upside, although retail sales did retreat. So some might say that the case for a 25bp hike has strengthened, but it appears that as much as the Fed may wish to tighten it is concerned with the eventual global market turmoil; as markets continue to cling onto central bank mutterings and have thrown fundamentals out the window. We have seen demonstrations of this all month as Fed speakers have opined differing views and asset markets have swung. We also have the market's overreaction since the Fed announcement yesterday; the S&P bounced over 1% into the close, the dollar and US Treasury yields fell and gold witnessed its strongest rally in a fortnight. The FOMC committee continues to indicate a 'gradual' path to tightening and this is exactly what they are doing, surely 25bps of tightening a year IS gradual.

Risk-on sentiment immediately picked up after the FOMC unchanged policy announcement and most assets classes enjoyed a bounce over the week. The yield on the 10-year UST fell 7bps over the week and the VIX (volatility Index) plunged 20%. Holdings across our portfolios benefited from the risk-on sentiment, especially at the long-end of the spectrum. Qatar sovereign 6.4% 2040s bounced 3.5 points just short of all-time highs. The issue continues to offer very attractive risk-adjusted return including  yield of ~17% with a comfortable 4 notch credit cushion, according to our proprietary Relative Value Model the bond could still rally another 20 points to reach fair value.

This week, market focus will turn to the US presidential debate; where Clinton and Trump are due go head-to-head in what might be the most tuned into TV broadcast in history; ~100m viewers. This is where we’ll get a real indication of where public opinion lies. The OPEC meeting, which begins today in Algiers, will also be watched closely. There have been rumors that Saudi Arabia has offered to freeze production at January levels, with Iraq stating the meeting could end with steps to tackle the supply glut; should be interesting to see what Iran’s stance is… we will not be holding our breath.