Multiple headwinds are now upon us (part 2)
(this is the latter part of our flagship, please findpart 1 here)
.... Will the Brexit debacle, the US mid-term elections and the Italian budget start to affect the outlook for growth, profits or the cost of funding? The answer for me is unequivocally yes and not just within the specific geography. The widening of Italian spreads will lead to EM spread widening, Euro weakness, and a flight into quality sovereign bonds. .....
Italy is the problem that we have to address immediately. I mentioned in last week’s flagship report that investors needed two structural hedges:
A hedge against USDRMB moving above 7.00. This would be a sign that Beijing was prepared to weaken its currency to levels not seen in over a decade. This would create a market panic and therefore this risk must be mitigated.
A hedge that protects a portfolio in the event that Italian spreads widen significantly. Italian / German 10-year spreads widened by 30bps on Friday and looking back at the major corrections that we have witnessed in developed markets over the last eight years, they have almost exclusively been driven by either China or Italy.
Shorting Italian spreads is expensive, so look for proxies. The cheapest expression of this is shorting EURCHF in option form. Therefore, upon the release of this report, the thematic model portfolio will buy some year end puts on EURCHF at a 1.12 strike to protect the portfolio against Italian risks
Brexit will be slower moving but the UK Conservative Party Convention that is getting underway on Sunday should continue to show the divide that exist over the Chequers Plan. Boris Johnson will surely continue to muddy the waters and it is difficult to see how anything positive comes out of the gathering that will last into next week. This should be GBP negative and brings up a huge concern for me:
If the Euro and the GBP are going to face pressure because of the Italian Budget and Brexit fears, how does this not lead to a sharply higher USD between now and the end of the year?
As you can see by the relationship between the trade weighted GBP and the GBPUSD exchange rate, the USD is the key determinant of the direction of the GBP against all other currencies. If the GBP is going to weaken appreciably due to Brexit concerns, will that mean the USD strengthens more broadly? History says yes.
I’m really concerned about global beta
One of the major reasons why I have been encouraging you all to buy dips in emerging market equity and credit has been due to the fact that fears about the USD being strong have been grossly exaggerated. While investors in India or Turkey may beg to differ, the broader USD index has been stuck in a tight range for most of the year and the USD is actually weaker if you go back to the beginning of the Trump Presidency. What is the outlook for global asset markets if the USD is going to strengthen appreciably, driven by concerns on the Continent? Frankly, it is negative and while I am convinced that EM underperformance versus US stocks has come to an end, a sharply stronger USD would create problems for all asset classes.
You can continue to buy cheap emerging market assets, but you must have hedges on US stocks.
This week’s headline will be dominated the Italian Budget, the Kavanaugh Supreme Court hearings / FBI investigations, the UK Conservative Party Conventions and the future of Elon Musk. The key consideration for me is whether or not the talk of an Italian downgrade begins to grow as a 2.4% budget deficit is absorbed. This will be the key for future performance of European banks and more importantly, sovereign bond yields. Technically, the narrative that US 10-year yields have again failed at new highs could lead to an aggressive rally in US bonds, especially if Italy fears begin to grow. A move back to 2.90% would be damaging to risky assets globally.
The RBA and RBI meet this week. Monday PMI’s from around the world. Tuesday Hong Kong Retail Sales. Wednesday US Mortgage data, and Thursday US Durable goods. On Friday, Korean CPI, Australian Retail Sales, German Factory Orders, Canadian Employment data and in the US NF Payrolls numbers.