“... and it all promised so much“
Manic Street Preachers, La tristesse durera
Last week, we discussed the announcement of the UK General Election and how political uncertainty (albeit against a backdrop of a wide and steady polling lead for the opposition Labour Party) complicates the Bank of England's rate cut calculus. This would be especially problematic for the MPC if no party gained a majority (unlikely, given current polling) and coalition talks made fiscal projections vague or incomplete.
Last week, we also questioned the markets' reaction to the modestly higher-than-expected CPI print in the UK, arguing that markets were likely focussing too much on the relative rather than the absolute. At just 2.3% on the headline (and we suspect some volatility surrounding the base effect change on the services component), inflation is clearly close to the target, and the Governor has been clear on several occasions that the Bank would want to start reducing restrictiveness ‘well before’ inflation reaches the target.
Growth squared?
Last week, we also argued that while the market continues to see inflation as the dominant macro factor, from our perspective, growth is the likely dominant policy swing or volatility factor. We continue to see disinflation as dominant (as the supply side continues to recover for goods and labour). However, the persistent upside surprises to the inflation data through Q1 (even if we see that data as seasonally, or one-off factor, distorted) likely mean that several better-behaved inflation prints are needed to instil confidence in the Fed that inflation is still headed to 2.0%. Growth, however, has a much more asymmetrically dovish correlation with the Fed reaction function. The July (31st) FOMC is currently priced at -3bps, and the September meeting is around 15bps. However, there are 2 non-farm payroll prints between now and the July meeting and two CPI prints. If the latter is well-behaved, as markets expect, and there is a downside surprise to one of the NFP prints (or a clearer slowing trajectory), then we could very quickly get close to pricing 25bp rate cuts in both July and September!
This asymmetric dovish reaction function in relation to growth also holds for the UK. From our perspective, a higher unemployment rate can boost confidence in the need to cut rates very quickly and (like in the UK) the risks of faster rate cuts in the US towards the end of the year remain a distinct possibility.
Emerging Elections
As we close the week, global markets are focused on the near-term elections in South Africa, India and Mexico. The South African ballot closed on Wednesday evening, and while early exit polls suggest that the ANC count is around 41.5%, we will not know the outcome formally until the weekend. At that level, however, significant uncertainty remains about the constituent members of a ruling coalition (assuming the ANC doesn’t try to form a minority government). While some of the parties big enough to fill the void are distinctly market-unfriendly, we think the prospect of a collaboration of small parties in coalition with the ANC (if their vote share is at the top end of expectations) or the most market-friendly coalition partner of the DA (if vote share disappoints) are the most likely scenarios - both broadly positive for ZAR (which we continue to see as significantly undervalued) and South African assets.
The weekend also sees the concluding round of the Indian elections and the General Election in Mexico where the continuation candidate (Morena’s Claudia Scheinbaum) remains the favourite to win with a simple majority.
Show me the Monetary
Next week will be an important week for several reasons. Firstly, we get the release of the ISM (both manufacturing and services) activity indices. These releases will be very important as the April ISM releases showed a dip into contractionary territory, adding to the case for near-term policy normalisation in the US. The recent PMI data though (an alternate, yet less reliable series, in our opinion) saw a sharp jump in the services component for May. Next week’s ISM will confirm or dispel the rebound narrative.
Secondly, it is jobs week again in the US. Expectations are for the unemployment rate and average hourly earnings to remain at 3.9% and for the headline payroll gain to be broadly similar to the April data.
Lastly, perhaps most symbolic or important next week will be the ECB meeting and the likely (current market pricing is around 98%) start of the Eurozone rate-cutting cycle. While the rate cut should be in little doubt, there will be a keen focus on the new economic projections (especially after recent inflation and growth data coming in on the strong side of expectations)
The Long & Short it…
We have some significant data next week, not to mention the election results for the South African, Indian, and Mexican elections. From our perspective, the data are important.
Important in that they have the ability to question the stronger growth narrative.
Important in that the implied Fed reaction function is asymmetric to the distribution of data outcomes.
Important in that broad market positioning is likely significantly biased towards carry trades that would outperform in a low-volatility environment… and vice versa.
To paraphrase the Manic Street Preachers consensus continues to see the markets as promising so so much. However, la tristesse durera (reputedly from Van Gogh’s last words) means ‘the sadness will last forever’. But from our viewpoint, markets have the potential to break from their sadness next week!
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