Brevan Howard market commentary for the month ended January 31, 2016. See 2015 letter to investors here.
Brevan Howard Market Commentary – US
The economy delivered mixed messages at the start of the year. The labor market continues to impress. The unemployment rate fell to 4.9%, job gains were respectable, and wages increased at a brisk pace. Real GDP growth appears to have steadied after having posted a lacklustre performance in the second half of last year. Meanwhile, all aspects of inflation are underperforming. Headline inflation promises to fall in the coming months as consumer energy prices decline and core inflation will be lower for longer, primarily because the appreciation in the exchange value of the US dollar will put additional downward pressure on import prices. The presumably transitory shocks to inflation cannot be taken for granted in light of the deterioration in market-based measures of inflation compensation and in surveys of consumers. In particular, consumers’ longer-term inflation expectations moved down to historic lows in the two most widely followed surveys conducted by the University of Michigan and the Federal Reserve Bank of New York.
To complicate matters further, developments in financial markets are buffeting the forecast for growth going forward. The sizable drop in energy prices and interest rates (US 10-Year Treasury) looks to be a net positive for growth in the next year. However, in 2017, the building negative impact from the appreciation of the US dollar and wider credit spreads should lead to a larger net subtraction from growth. However, in light of such extreme movements in financial conditions, any forecast has to be more uncertain than usual.
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A confusing macroeconomic backdrop and volatility in financial markets have inspired a cottage industry of econometric models designed to predict the chances of a recession. The odds vary widely depending on what the user inputs into the models. On the one hand, a solid labour market and extraordinarily accommodative monetary policy suggest the odds of recession over the next year are below average. On the other hand, falling profit margins, wider credit spreads, and significant headwinds from the external sector suggest the odds of recession are elevated. The US economy has successfully navigated a number of similarly negative shocks during the expansion and probably will do so this time. However, there’s little margin for error given the economy’s slow growth and the inability of monetary or fiscal policy to offset further downside surprises.
Brevan Howard – EMU
In January, both EMU activity and sentiment indicators posted marked declines, while worries about China, European banks and global risk-off sentiment lead to a sharp sell-off of risky assets, which accelerated in the first weeks of February. The EMU Composite Purchasing Managers Index (“PMI”) fell from 54.3 to 53.6, back to September 2015 levels. The German IFO survey was no exception, with business expectations losing around 2 points, to 102.4, the lowest level in five months. Most importantly, Q4 2015 EMU GDP reported a modest 0.27% q/q, continuing the gradual, but relentless moderation from the 0.54% local peak recorded in Q1. The outcome would have been worse had it not been for the public spending in Germany in connection with the huge wave of refugees. The only relatively good news stemmed from the labour market, as due to a very low rate of growth of potential output, the unemployment rate continued its gradual fall, to 10.4% in December from 10.5% a month earlier. So far the adjustment in the labour market has been too slow to have any impact on wage growth, which continues instead to slow down to record low levels. On the consumer price front, Harmonised Index of Consumer Prices (“HICP”) inflation increased modestly in January from 0.2% y/y to 0.4% y/y. Despite a strong base effect these values are way below the December European Central Bank (“ECB”) staff projections. Meanwhile, market-based measures of inflation expectations continued the downward movement initiated in the aftermath of the ECB December policy decision, hitting all-time lows. Both money and credit slowed down; as a result, the credit impulse, instrumental as a driver of the EMU recovery, deteriorated further. In light of the current weak inflation readings, rising EUR, lower oil prices and worsening growth picture, the ECB adopted a more dovish tone than expected at its January monetary policy meeting. The introductory statement noted that in light of increasing downside risks and weak inflation dynamics, the Governing Council would “review and possibly reconsider” the monetary policy stance at the next meeting in early March, when the new staff macroeconomic projections will be available. In addition, Draghi highlighted that the January ECB statement wording had been unanimous in the Council, hinting that the ECB President could be more successful than in December in forming a consensus for further bold policy action at the March meeting. However, given the loss of credibility due to poor communication at the December meeting, the market snubbed these indications, as displayed by an even sharper acceleration of the drop in inflation expectations.
Brevan Howard – UK
The UK economy continues to grow at a moderate pace, shaped by resilient private domestic demand within the setting of an “unforgiving global environment”. Services output (typically indicative of domestic activity) grew solidly, expanding 0.6% q/q in Q4. In contrast, manufacturing output failed to grow in Q4 giving evidence to the recent bout of modest global growth. On the whole, GDP grew a moderate 0.5% q/q in Q4 2015, roughly in line with the pace of growth experienced in both Q2 and Q3 of 2015. Looking forward, the first business surveys of 2016 suggest that economic activity should continue to grow at a similar pace in Q1. The trade-weighted exchange rate has depreciated 9% since the peak in July 2015 (although it’s still 8% higher than the lows in 2013). This should provide some support for exports; however it will take time for the full effects to feed through. The consumer retail sector continues to perform well. Although growth in retail sales volumes has moderated from a very high pace, it remains robust, supported by multi-year high levels of consumer confidence and rising real incomes. Mortgage lending continues to grow at a smart pace (3.4%), faster than recent history but still far below the growth rates experienced just prior to the crisis. Surveys on housing activity have recently picked up. This may reflect a new flurry of activity as individuals seek to buy properties ahead of the additional 3% stamp-duty tax on buy-to-let houses that will become effective in April this year. National house prices continue to grow at a solid pace of around 7%, albeit slightly slower than the high pace in early 2014. The UK economy is expected to grow moderately in the face of persistent headwinds including fiscal austerity and modest global growth. Moreover, the upcoming European Union membership referendum may further dent growth through reduced confidence and business investment; however there has been no evidence of this yet. The labour market continues to tighten at an exceedingly brisk pace. The unemployment rate has continued its down-trend reaching 5.1% in November 2015, the lowest since December 2005. Surveys continue to suggest that company headcount will continue to grow swiftly, though not as quick as in recent months. Despite the tightening in the labour market, wage pressure is still lacking. Wage growth started to rise in the summer of 2015, but has since moderated; wages are currently growing at an annual rate of 2%, well below the 4% pace experienced before the crisis. Members of the Bank of England’s (“BoE”) Monetary Policy Committee (“MPC”) have speculated as to why a pick-up in wage growth has not been seen. Possible reasons include low inflation reducing the bargaining power of employees as well as compositional effects of the labour force. Nonetheless, the MPC members do not yet see signs of inflationary pressures, especially with core and headline inflation only averaging 1.2% y/y and 0.1% y/y in Q4 respectively. At the most recent MPC meeting, all 9 members unanimously voted to keep rates unchanged (whereas previously one member had voted to raise the Bank Rate). However, it remains the case that each member of the committee still expects the next move in the Bank Rate to be up, somewhat in contrast to market pricing which currently reflects the possibility of a rate cut in 2016.
Brevan Howard – Japan
At the end of January, the Bank of Japan (“BOJ”) followed the ECB by pushing overnight interest rates into negative territory. However, the actual three-tier scheme is more complicated. The BoJ will pay banks 0.1% on the balance of excess reserves held prior to the cut. It will apply a 0% interest rate on the so-called macro add-on balance, which is legally required reserves, balances on various lending facilities and a to-be-determined add-on exemption. Banks will have to pay interest on additional reserves held at the BoJ. As the slice of reserves on which banks will have to pay interest is estimated to be fairly small, likely under 10%, some surprisingly assume the effect of negative rates will be trivial. Prices are made on the margin, and the interest rate on marginal reserves is now -0.1%. It is better to think of the scheme as negative interest rates with a fixed subsidy to the banks. Moreover, now that Governor Kuroda has crossed the zero line, Europe’s experience suggests that overnight rates can be pushed much lower.
The latest inflation data point to the need for additional accommodation. The recent national CPI data have stalled. After moving up over the first three quarters of last year, the seasonally adjusted western core measure (prices excluding all food and energy) ended 2015 at the same level as in September. The Tokyo data for January were poor with the seasonally adjusted western core index dropping 0.2%.
Important inflation fundamentals have also been disappointing. Consumer inflation expectations have been falling for several months and are now at their lowest level since expectations started improving after the initial three-arrow announcement. The rapid appreciation in the yen against the dollar in the first half of February, despite the BoJ move to negative interest rates, has been breathtaking. Furthermore, ongoing declines in energy prices will reinforce these near-term trends. Wage negotiations are not progressing as well as the BoJ had hoped; speculation is that wage hikes will be no greater than last year.
Activity data are not as bad as the inflation news but aren’t inspiring either. The latest prints look similar to the last several months with some measures edging up in the last month, some slipping and most of them flat on balance over the year. The Shoko-Chukin index of small and medium-sized enterprises reversed January’s decline, but has moved sideways on balance since the second half of last year. The Economy Watchers survey fell 2 points, crossing back down below the par line. Industrial production in December fell for a second month, wiping out most of the improvement seen on balance over the previous three months.
Brevan Howard – China
Activity in China in Q4 and in December 2015 was somewhat slower than expectations. GDP growth slowed from 6.9% y/y in Q3 to 6.8% y/y, with the front loading of fiscal expenditure preventing a more marked slowdown. Industrial production slowed in December from 6.2% to 5.9% y/y, disappointing expectations of 6.2% growth. In January, both the Caixin and the Official Manufacturing PMI stood at low levels, below the 50 threshold. In the same month, trade data signalled a steep drop in imports, while credit numbers indicated a pickup. However, a more thorough assessment can be made once February data are available, as well as output numbers to be released in March. The country will hold its National People’s Congress in March, at which the growth target and the fiscal budget will be announced. It is widely expected that the growth target for 2016 may be further lowered to about 6.5%, and the government will likely run a larger fiscal deficit to support its growth target.