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.