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Central banks disappoint expectations

3 May 2019

Last week we wrote that stock markets faced being challenged by the decline of a number of
stimulating aspects that had been regularly named as the drivers of the 2019 recovery. The most
crucial one being central banks’ assurances that they would refrain from further monetary
tightening and might even consider renewed rate cuts.
No wonder then that the past week began with weaker trending stock markets as everyone was
waiting with bated breath for the latest policy announcements by the central banks of the US and
UK. Better-than-expected European and US economic growth (GDP) rates had already raised the
prospect that further monetary support might not be forthcoming. This was precisely what
happened. Rate-setters at both the US Federal Reserve (Fed) as well as the Bank of England
(BoE) ‘disappointed’ any remaining expectations of forthcoming rate cuts. Indeed, BoE’s Mark
Carney went as far as suggesting capital markets were mistaken in only pricing in a single 0.25%
rate hike for the next two years.
The fact that stock markets took the news in their stride and actually regained ground towards the
end of the week will have disappointed all those who had suggested the 2019 recovery was merely
a function of a return of central bank support. The remarkable aspect of the week’s dynamics from
our perspective was that the economic data was not in any way positive enough to compensate
for the loss of further central bank easing prospects.
It would seem that investor sentiment has improved so decisively since the turn of the year that
confirmatory evidence that the global economy is not slowing further is sufficient to keep investors
interested. Yes, corporate earnings growth has inched back above the 0% line, but at an annual
growth rate of 3% it is a far cry from last year’s double digit pace. Forward indicators of economic
activity in the form of PMIs are at best stabilising at low levels, and GDP growth has only recovered
to very pedestrian rates of around 2%, which we used to dismiss as stall speed.

The crucial point is that this is enough to underpin the expectation of continued economic
expansion – albeit at a once again slow speed – rather than to suggest a looming recession. Such
an environment is sufficient to allow companies to continue to grow their profitability and thereby
make money for their shareholders. This re-establishes the benign environment for risk asset
investors where the big question is not to worry about the return of capital but focus on where the
best returns on their capital will be achievable in 2019.
Here the debate continues to rage at to whether the US stock market will be able to continue to
reward its investors with significantly higher company valuations relative to their ongoing earnings
than elsewhere. In this respect it is interesting to observe that year on year earnings growth in
Europe is currently running at exactly the same rate as in the US: 3%. Perhaps the fact that over
the past weeks the US market has no longer led the rest of the western world is an indication that
market leadership is slowly changing.
To close this week’s summary with a more domestic observation, we found it very notable that our
most reliable ‘Brexit-Barometer’, the £-Sterling currency market, reacted remarkably strongly to the
poor performance of the Conservative and Labour parties in the UK’s local elections. £-Sterling
has reached its highest level against the €-Euro for a year, so it may be tempting to purchase one’s
holiday currency before currency markets change their minds about political weakness making an
imminent agreement on a Brexit deal more likely.

An early view on April PMIs

one of the more important data releases being the PMIs which gauge if things are improving or deteriorating
in terms of new orders, employment, output and various other factors.
This is distilled into a single number which oscillates around 50
(over 50 = getting better, below 50 = getting worse). As we’ve discussed in these pages
before, we are positioned for a moderate improvement in economic data relative to the gloomy
expectations which gripped the markets through the turn of the year. Chinese stimulus (via the rest
of Asia) leading to increased international demand, a pool of savings, and a fiscal tightness in
countries like Germany which could be reversed, alongside reasonable valuations — this was part
of the argument for our overweight position in European equity. PMIs give us a timely indication of
how well part of this story is playing out.
Starting with Asia: we have had reports for April for five countries’ manufacturing sectors within
Asia. Since the start of the year we have seen a notable tick-up after an initial drop (this chart
shows the PMI minus 50, e.g. 2 corresponds to a PMI of 52).

The most recent observation indicates an improved picture in Korea and Vietnam, however we
have seen small drops in China, Indonesia, and Taiwan figures after a rebound. A lack of continued
improvement may test our thesis of gradual improvement in growth through 2019, should the next
set of readings not resume the upward trend.

The question from here is whether this modest improvement in manufacturing outlook in Asia has
made it across to Europe. Below we have the European manufacturing numbers to April (which
have been in far worse shape than their services counterparts).

As is often the case with Europe, we see a bifurcation along geographic lines. At the moment
southern Europe seems to have bounced in concert with Asia, however northern Europe seems to
be stuck in the doldrums, flatlining at best.

This flat result for Europe in aggregate is actually marginally ahead of the early estimates from
“Flash” indicators but there’s no getting away from the fact that it still looks a sad picture. Clearly
European markets are somewhat discounted compared to some other regions, but should the
rebound from Asia fail to materialise on the continent at least one potential catalyst for a rerating
of the markets relative to others is in doubt.
One of the other reasons for Europe’s discount to the rest of the world is its relatively cyclical
composition: high fixed costs in many industries such as autos give them a higher operational
gearing than other regions. So we would expect a relatively small tick-up in these figures to be a
boon for asset prices in mainland Europe. We will continue to watch with interest.

The UK’s inflation conundrum

The Bank of England is one of a few global central banks that has steadfastly maintained its
message that interest rates are set to rise, slowly. This is against a backdrop of other central
banks ending their tightening bias as global growth weakened in 2018. An example of this is the
US Federal Reserve who noted in this week’s FOMC statement that core inflation is now “below
2%”, and therefore the Fed “will be patient” regarding any further interest rate moves.
For the UK, the last increase in rates was in August 2018. Since this point the central bank has
been walking a tight rope: balancing evidence of increasing inflationary pressures against the
economic threat of a no-deal Brexit. It was only in February that the Bank of England (BoE) cut its
forecasts for output growth this year in a dovish report that left the market anticipating interest rates
would remain at 0.75% until at least the end of the year. Now, the reduced threat of a no-deal

Brexit, alongside resilient economic data, continued strength in employment, and wage growth that
is underpinning consumer spending, have seen market expectations move to a 0.25% hike in rates.

On Thursday, the BoE, Monetary Policy Committee (MPC) continued its stance and signalled its
commitment “to ongoing tightening of monetary policy” but any rate rises would take place “at a
gradual pace and to a limited extent”. It also revised up its forecast for growth to 1.6% in 2020,
and 2.1% in 2021, from 1.5% and 1.9% respectively.
That said, the MPC also judged that Brexit uncertainties still had the potential to hit business
investment and that the recent rise in sterling would keep import prices under control. Alongside a
predicted fall in energy prices and following an expected fall in oil prices they anticipate that Ofgem
will reduce the cap on electricity and natural gas prices later this year.
But the MPC has also noted that wage growth has “remained strong” and that unit labour costs
have “risen to rates that were above historical averages”. In the UK, year-on-year growth in unit
wage costs have picked up to a 9 year high of 3.1% in 2018 from 1.5% in 2017.
Thursday’s report also showed that the MPC model implies that they need to raise rates by 0.90%
over the next three years taking into account the expected downward pressure from energy prices.
If this view regarding energy prices is incorrect then the tightening could be more aggressive. But
even at face value there is a disconnect between market expectations of one 0.25% hike and the
MPC model.
The conundrum for the BoE regarding inflation has been ongoing for some time as they balance
forward guidance of the risk of increasing inflationary pressures against market expectations that
these pressures remain more benign and economic momentum weak. Quantitative easing (QE)
was aimed in part to raise inflation to its target level. Despite the enormous amount of stimulus
applied, inflation has remained contained without the need for significant interest rate rises.
Historically, before QE central banks considered the trade-off between unemployment and
inflation. The view being that high unemployment would diminish employees’ expectations of wage
growth. Unemployment in the UK has now reached historically low levels, but despite this, wage
demand from workers has also remained contained. Why is still unclear, but arguments range
across globalisation, technology, demographics and weaker unions. All are likely to have played
their part.
As such, the disconnect in labour between wage growth expectations and unemployment remains;
and the disconnect between market expectations and the MPC forecasts remain. The latter is
more likely to be addressed by the risk that more aggressive interest rate hikes get priced into the
market expectations. Currently, the MPC forecasts that CPI will rise to 2.1% in two years and 2.2%
in three years – judging by the muted market reaction this week, investors remain more concerned
about Brexit than inflation risk for the UK.

The demise of LIBOR signals further loss of bank influence

In the US and the UK, the interbank lending system is declining. The associated reference rates,
in particular the London Interbank Offered Rate, are set to disappear.
Born in 1969, LIBOR came on the scene when Greek banker Minos Zombanakis, a managing
director at Manufacturers Hanover Trust in London, brokered a syndicated loan of $80 million. Ten
months after the first deal – on June 5, 1970 – “Manny-Hanny” announced a second 5-year loan
of $100 million bearing a fluctuating interest rate “based on the six-month interbank rate in London.”
These are the first records of the London interbank offered rate – LIBOR.
In 1986, the British Bankers’ Association formalised a system for the various rates’ calculations,
just a few months ahead of the “Big Bang”. LIBOR and the rise of the City went hand-in-hand.
LIBOR was a big improvement in interest-rate transparency. The publication of a set of rates
formed from the reports of competing banks allowed the markets to see how those rates varied on
a daily basis. Previously there were only the policy (unvarying) rates set by the Bank of England.
It led to much more confidence from participants that both lenders and borrowers were getting a
fair rate. This in turn enabled a new set of instruments to develop – swaps. These allowed
participants to make long-term transactions which would exchange an ongoing fixed rate for the
market-based short-term rates. Loans and floating-rate notes also became based on these rates.
According to the Financial Stability Board (2014), LIBOR rates were the basis for in excess of £200
trillion of financial instruments. So the LIBOR scandal was a big deal given that the market had
expanded because LIBOR had been deemed trustworthy.
75% of the LIBOR-based market is in US dollars (FSB 2014 again). A year ago, the US central
bank, the Federal Reserve started publishing the Secured Overnight Financing Rate (SOFR), to
replace LIBOR. The new SOFR rate represents interest rates for overnight secured borrowings,
commonly referred to as repurchase agreements (or “repos”), secured because the borrower posts
U.S. Treasury securities as collateral.
According to JP Morgan, average daily trade volumes of the SOFR index components are now
regularly in excess of $900bn, 1,800 times the average daily unsecured bank trades in underlying
USD LIBOR. Activity in SOFR futures and floating rate notes (FRNs) continues to build, facilitating
the growth of OTC swap markets.

Smaller in size, a similar process is happening in £-Sterling. SONIA (Sterling Overnight Interbank
Average) was established in April 2017 as the risk-free rate for the UK. However, it differs from
SOFR in that it is a pure interbank rate as well as unsecured.
Risk seminars and conferences throughout the financial centres constantly focus on this changing
environment.
The first area of attention is: How will outstanding contracts and financial instruments be
successfully translated without creating huge amounts of risk? Most people believe that a fair
translation of valuation between SOFR and USD-LIBOR is possible, but until it is, there is a
commonly agreed basis for transferring contracts. There is a large potential for problems if the
LIBOR system is destabilised before that point. This heightens liquidity appetite – or rather reduces
risk appetite. If the holder of a previously highly liquid LIBOR-based note thinks it may get locked
up in a legal rut, that holder has a big incentive to get rid of it quickly.
So the second focus is about access to cash on an ongoing basis, amid signs that depositors and
investors have increasingly fickle risk appetites.
The vast pre-eminence of the US-dollar market makes the secured nature of SOFR more notable.
We think there is a clear sign that the business of finance is moving away from banks. Unsecured
lending requires that the lending counterparties are extremely creditworthy, of a size and stability
that means liquidity is constantly available. Balance sheet is everything. The need to have
collateral at the heart of liquidity suggests that participants no longer believe that banks are
creditworthy enough.
The holders of collateral are the asset managers. Most assets are not government bonds, but
asset managers are still in a more favourable position than the banks. Essentially they have a
competitive advantage over the banks. They have the capital to lend and now the access to
liquidity. Banks must continue to be intermediaries rather than the primary risk-takers.
Meanwhile, recent bouts of illiquidity in markets have been blamed on “shortage of off-shore USdollars”,
with Asian borrowers unable to find lending counterparties.
Even after the financial crisis, their share of profit has remained high. Perhaps the change, the narrowing of the interbank
markets and the demise of LIBOR is signalling the end of a 50-year era of bank dominance in credit markets and beyond.