Weekly Strategy Report - J.P. Morgan investor insights

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GIM Solutions-GMAG –
Weekly Strategy Report
23rd March 2015
 FOMC meeting – outpatient
 The UK’s pre-election budget
masks longer-term structural
problems
 Chart of the week: Spot the
odd one out – Monetary
conditions in Australia,
Canada and New Zealand
This document is produced by the Global
Strategy Team within GIM Solutions-GMAG.
For further information please contact:
Editor: Patrik Schöwitz
 patrik.h.schowitz@jpmorgan.com
Michael Albrecht
John Bilton
Michael Hood
Beth Li
Jonathan Lowe
Benjamin Mandel
FOMC meeting – outpatient. At last week’s Federal Open Market Committee
(FOMC) meeting, the Federal Reserve (Fed) removed the word “patient” from the
statement it uses to indicate when it will start normalising monetary policy. This
decision was widely expected. In addition, the Fed lowered its forecasts for growth,
inflation and unemployment for the 2015/17 period. The set of forecasts, known as
the “dots”, imply a softer profile for the rise in U.S. interest rates, with a median Fed
funds rate of 0.625% at the end of 2015 rising to 1.875% in 2016 and 3.125% in
2017. The market is pricing in rates of 0.4%, 1.2% and 1.7% respectively. Yet
within these averages, there is a wide variation regarding the direction of interest
rates among FOMC members. In contrast, the range of estimates around
economic growth and inflation projections are much smaller!
At Fed chairwoman Janet Yellen’s press conference, she was clear that any
decision to raise interest rates would be a function of “reasonable confidence” in
the Fed’s inflation outlook. In other words, the Fed would need reasonable
confidence that the rate of core inflation would move back to the 2% target over the
medium term. She cited four factors to inform a sense of reasonable confidence: a
further reduction in labour market slack; realised inflation; wage growth; and
(rising) inflation expectations. With renewed emphasis on the dots, it is clear that
monetary policy has become data dependent once more.
Yet “reasonable confidence” is also an elegant way of keeping your options open.
To give it more room for manoeuvre, the Fed reduced its estimate for the
equilibrium mid rate of unemployment from 5.35% to 5.1%, implying there is more
slack in the U.S. labour market than previously thought. This compares to a current
jobless rate of 5.5%, below the average of the last 20 years of 6% and the lowest
reading since June 2008. While the labour market is arguably tight, and unit labour
costs have started to accelerate, it is worth observing that these are lagging
indicators of activity. The other reasons for keeping its options open is that the
current quarter has been very weak, perhaps more than suggested by very cold
weather and the West Coast port strike. Indeed, the Atlanta Fed’s latest “nowcast”
estimates that first-quarter 2015 real GDP growth is tracking at only 0.3% saar.
David Shairp
Despite changing little, the impact on markets was significant last week, with
equities rising strongly, bond yields falling and the dollar weakening. Indeed, one of
the largest reactions was in the FX market, where the European currencies rallied
strongly, with the euro having an intraday trading range of 4.4% (the second
largest in the lifetime of the single currency) while sterling was equally volatile,
recording an outside day reversal, seen by some as a technical signal of trend
exhaustion and a possible change in direction.
Chart of the Week
Spot the odd one out–monetary conditions in Australia, Canada and NZ
Our COTW shows our proprietary
monetary
conditions
indicators
for
Australia, Canada and New Zealand.
These indicators comprise five monetary
variables that track the stance of
monetary policy and show that while
conditions are neutral in Australia and
Canada, they are restrictive in New
Zealand. Any weakness on the growth
front could lead to NZ policy easing and a
weakening of the exchange rate.
Sources: J.P. Morgan, DataStream, JPMAM GIM SolutionsGMAG, monthly data to February 2015
Standard deviations
2.0
NZ
Australia
Canada
Easy
1.5
1.0
0.5
0.0
-0.5
-1.0
Tight
-1.5
2007
2008
2009
1
2010
2011
2012
2013
2014
2015
FOR INSTITUTIONAL/WHOLESALE OR PROFESSIONAL CLIENT USE ONLY | NOT FOR RETAIL DISTRIBUTION
GIM Solutions-GMAG
Weekly Strategy Report
Miscellaneous Musings



The recent solar eclipse has led
some to question whether it portends
seismic shifts in markets and
economies. The ancients treated
solar eclipses as formative events,
as omens of an impending miracle,
the wrath of God, or the doom of a
ruling dynasty. Solar eclipses in
ancient times are said to have
heralded the crucifixion of Christ and
the birth of Mohammed.
More recently, the solar eclipse in
1999 precluded a period where stock
market valuations became more
extreme prior to their topping out in
early 2000. One does not have to
believe in mystic forces to note that
current valuations are looking
stretched, even if they may not be
portending a dynastic end to the
post-crisis world.
Real bond yields have trended
negative over the past four years,
with 10-year yields in the UK, France
and Germany ranging from -1.0 to 1.1%. Japan also has negative real
yields at -0.66% while the U.S. 10year TIPS yield is a meagre +0.16%.
While falling real yield levels reflect
the distortive impact of central bank
quantitative easing on markets, they
have also helped to re-rate equity
markets beyond historical ranges of
fair value. But, if the TIPS market is
a signal of underlying growth
potential (as it has traditionally
been), then it suggests that trend
growth prospects remain sombre.
A move to data dependency, combined with the shift from stable to gradually rising
rates, suggests scope for greater market volatility. This seems particularly likely to
hold true at the short end of the yield curve, where the sensitivity of 2-year yields to
economic data surprises was unusually muted between 2012 and 2014. Indeed,
uncertainty about the Fed seems apt to persist for a while, beyond the (ultimately)
minor issue of the timing of the first rate hike, as the debate shifts first toward the
pace of tightening and then to the terminal funds rate and the size of the balance
sheet, questions that have yet to receive a full airing in market discussions.
The UK’s pre-election budget masks longer-term structural problems. The UK
government delivered its last Budget prior to the general election on 7 May.
Usually, pre-election Budgets in the UK have been an institutional form of bribery,
to incentivise the electorate to vote in favour of the incumbent government.
However, Chancellor of the Exchequer George Osborne’s room for manoeuvre
was constrained by fiscal reality and his Liberal Democrat coalition partners.
Instead, a broadly neutral budget was delivered, though it was laced with some
modest electoral goodies in the form of savings tax relief for older votes and
incentives for first time home buyers. The headline arithmetic had the UK budget
moving back into balance by the 2019/20 financial year, with expenditure falling as
a percentage of GDP to 2000 levels.
Despite the relatively upbeat tone of the Budget, the UK faces sizeable structural
challenges over the next five years. As has been noted, the UK faces a productivity
problem, where average output per head lags that of France by a fifth. This has
probably been the single biggest reason as to why UK living standards have been
slow to recover after the crisis.
Some of these challenges are obscured by the official forecasts. Lurking in the
projections made by the Office for Budget Responsibility was a rise in household
gross debt, which is projected to rise from a current level of 146% of household
income to 171% by the end of 2019—above the pre crisis peak of 169% in 2008.
This suggests that household debt will grow at around 7% per annum and outstrip
nominal GDP growth by approx 3% p.a. Assuming that most of this growth in debt
will be bank financed (with a considerable chunk being mortgages), bank credit is
likely to grow much faster than forecast by bank analysts or by the banks’ own
capital positions. If this forecast is achieved, it could bring further pressure on the
current account – and potentially the currency – given a current shortfall of 6% of
GDP. Alternatively, if household releveraging undershoots this forecast, then the
growth outlook – and the UK’s fiscal profile – will deteriorate.
All this sits uneasily with the looming general election, which promises to be
inconclusive. At present, it appears to be a contest between the unacceptable and
the unelectable, with no clear winner in sight given present polling trends. A period
of uncertainty therefore awaits until a new coalition is formed. History suggests that
a combination of deteriorating external fundamentals coupled with political risk
tends to take a toll on sterling, which looks overvalued on a real effective basis. So,
the next 50 days of campaigning threatens to be volatile and could be bruising for
UK assets.
David Shairp
All data sourced from JPMAM, Bloomberg, and Datastream, unless stated otherwise.
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