Category Archives: equities

What will it take for the CHF to weaken?

real-chf

Source: BIS

Equities have certainly had a good run this year so far, and there should still be more to come for European equities as long as the European economy continues its modest growth, with EuroStoxx still well below its highs and value relative to bonds looking excellent. But despite the strength of equities and good Eurozone data, EUR/CHF continues to test the lows, even on a day when the Swiss GDP data reports a disappointing 0.1% q/q and 0.6% y/y rise, underpinning the expectation of continued easy Swiss monetary policy. Why is the CHF so strong?

Well one reason is likely to be concern about European politics. The markets seem to have got themselves in a state worrying about the possibility of a Le Pen victory in France and even about Wilders in the Netherlands. People explain their concern by pointing to the victories for Brexit and Trump as illustrations of the populist movement sweeping the world and the unreliability of polls. But Brexit and Trump were not huge outside bets according to the polls. They were marginal outside bets. Sure, the markets seem to have treated Leave and Clinton as foregone conclusions, but that was never justified by the polls, which always suggested the votes would be close. But the polls don’t suggest Le Pen will be close to winning the French presidency. They suggests she needs to turn around 8 million French people Fascist in the next 2 months to win. That isn’t just unlikely, it’s wildly improbable in a way that the UK “Leave” vote and the US vote for Trump never were (at least not once he was the Republican candidate). Similarly, Wilders Freedom Party could just about be the largest party in the Dutch elections, but has effectively no chance of forming a coalition as no other party is prepared to join with them. Even with their most optimistic poll results, they will need double the seats they would achieve to form a government. So worries about European politics seem overblown, and European equities seem to get this, but the Swiss franc nevertheless remains near its highs.

This is puzzling because the Swiss franc is normally seen as a safe haven. Valuation wise it is always expensive relative to purchasing power parity (PPP) because it is seen as so safe. But safe havens will normally weaken in risk positive, strong equity environments, because safety is in less demand. The Swiss franc is a little weaker than it was at its peak, but it is lagging well behind the recovery in the European economy and European equities, even though yield spreads remain very unattractive with Swiss yields significantly negative out to 10 years.

 

So what will it take for the CHF to fall to more normal levels? The underlying problem is that money has stopped flowing out of Switzerland. Normally, surplus countries like Switzerland see heavy portfolio outflows looking for better returns elsewhere in the world, but the Swiss balance of payments data shows that portfolio outflows have effectively dried up since the crash. The SNB’s intervention has dealt with speculative and hedging  flows – captured in the “other investment” category of the balance of payments – but until portfolio outflows recover properly they will not be enough to cover the current account surplus – which remains substantial. This will be required if the CHF is to reverse its uptrend. Of course, it would also at some stage make sense if the speculative flows that have gone into Swiss francs – making a tidy profit – were to go out as risks decline and appetite for foreign assets returns. This other investment category has totalled more than CHF410bn since the beginning of 2008, and has been offset by an increase in reserves of more than CHF600bn. If confidence returns, this cash should flow back out and push the Swiss franc back to fair value, which is around 10-15% below current levels.

When will this happen? Well there are obviously a lot of uncertainties. But if Le Pen doesn’t win, and Trump/the House Republicans produce a detailed infrastructure/tax reform proposal by the Spring the Swiss franc could be under pressure from May for the rest of the year.

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Source: SNB

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Trade ideas for 2017

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  1. Long Euro Stoxx 50 – Entry 3280, target 4000, stop 2870.

European equities are just too cheap. The Euro Stoxx 50 has massively underperformed the S&P 500 since the financial crisis. Part of this is of course because the Eurozone economy has underperformed the US. But the scale of US outperformance is excessive. US nominal GDP has risen 24% since 2008. Eurozone GDP has only risen 10%. But the S&P 500 has risen 45% since the 2008 high, while the Euro Stoxx 50 is still 28% below its 2008 high. Of course, part of the strength of the S&P is due to easy monetary policy – US 10 year yields are, even with the recent rise, around 1.5% below where they were pre-crisis. However, this is even more of a case for Euro Stoxx strength. Bund yields are more than 4% below pre-crisis levels, and while peripheral yields have fallen less than bund yields, most have fallen more than the US 10 year.

With Euro Stoxx down 28% from 2008 highs and long-term yields down around 3% or more, the risk premium has increased enormously. Now, many will point to all sorts of risks to justify this. French, German, Dutch and maybe Italian elections next year. Greece still an issue. Brexit.  But if the US can welcome Trump with higher equities, a European political shift to the right won’t necessarily be bad for stocks. European growth appears to be improving slowly, and European yields are set to stay a lot lower than the US. Plus the above calculations don’t take account of the 35% decline in the Euro since 2008. Currency adjusted, the underperformance of  European equities is even more dramatic.

Of course, it may be that higher US yields lead to a US equity decline, so perhaps some of this should be taken relative to the US. But if US yields rise because of stronger growth and inflation under Trumponomics, it will benefit European growth as well, and will probably not mean a drastic decline in US equities, making European equities all the more attractive.

2. Long USD/CHF – Entry 1.03, target 1.20, stop 0.95.

There is also a case for long EUR/CHF but it makes sense to be long USD on the basis that even after the latest change in the Fed outlook the market is still pricing quite a moderate US rate profile through 2017. An aggressive Trump spending programme could lead to still more spread widening in favour of the USD.

Even so, I find it hard to sell EUR/USD looking for moves below parity. It does look likely to happen, but long-term the EUR will be good value at those levels assuming the Eurozone disaster scenarios don’t play out, so I look for a trade that is better value. The CHF remains the world’s most overvalued currency, and continues benefit from general distrust of the EUR. But if Italian banks don’t go under and growth continues to steadily improve helped by further US fiscal expansion, the case for holding CHF against the EUR looks weak, with the EUR likely to benefit against the CHF from improving equity market confidence (see above). Negative Swiss interest rates will become even more of a disincentive to hold CHF if other assets are becoming more attractive.

In disaster scenarios, the SNB is likely to ensure the CHF benefits less than the USD.

3. Short GBP/SEK – Entry 11. 50, target 9.50,  stop 12.25.

This was to some extent the trade of 2016, but I think it has further to run given that it has had a sharp correction higher since sterling’s “flash crash” on October 7th. The Swedish economy continues to show the strongest growth in Europe, and although the Riksbank remains highly focused on inflation and will consequently not be tightening policy anytime soon, the Riksbank is nevertheless likely to tighten before the ECB and before the Bank of England, as growth in the UK looks likely to be restricted by rising inflation and consequently weak real incomes and consumption.

Brexit is more of a swing factor than a pure negative for GBP, but it seems unlikely that the UK will achieve any real clarity ahead of the major European elections this year, while concerns may build about another Scottish referendum. The risks consequently see to be more on the GBP downside in the short term.

Although the SEK has gained against GBP in 2016, it has been generally weak against other currencies, and despite the UK’s Brexit issues and massive current account deficit, GBP/SEK is only in the middle of its range seen since the financial crisis. Furthermore this doesn’t take into account GBP’s real appreciation due to relatively high UK inflation over the period, which means that in real terms GBP/SEK is nearer the bottom than the top of its post crisis range. Rising UK inflation will be creating more real GBP appreciation going forward, further supporting the case for nominal SEK gains.

 

Disclaimer: These are my ideas and I believe them to be well founded. However, they could easily go wrong. All trades are taken at your own risk. I take no responsibility for losses (and no claim on profits) made due to following these ideas. 

Short term risk recovery

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“It’s dark, and we’re wearing sunglasses”. The Blues Brothers

So we’re in a bit of limbo Brexit-wise. We don’t know when it will happen (some say even if it will happen), what trade deals will be done, who will be allowed to stay in the UK when we leave, how the elections elsewhere will go, and so on. Still, it is reasonable to say it will have some negative impact on the economy on the short-term. Increased uncertainty will reduce investment by at least a few firms, though it may only be delayed if we finish up with a comparatively benign outcome. I am less sure there will be any direct impact on consumer spending, but the decline in GBP will raise prices and reduce real incomes and spending as a result. Conversely, the impact of a weaker pound on exports may be positive eventually, but not in the short run and perhaps never. While UK exports will be cheaper, it takes time for new orders to be found, and the pound still isn’t cheap enough for the UK to compete in most areas. Plus exports to the EU may suffer because of the lack of any detail on the future relationship. All this is broadly known and in the price, but the extent of the economic impact is very uncertain.

We won’t get any post referendum data until August, and it may be that it is hard to see a clear impact for a few months even if there is a slowdown. So we’re driving if not blind, then at least in the dark with sunglasses on (like the Blues Brothers).

The Bank of England needs to decide this week whether these conditions justify some new action. They have already eased capital requirements on the banks but many think this is just a preamble to a rate cut, as bank profitability will now be partially protected. Carney has said he believes some monetary easing is justified. Many think a rate cut will be delayed until August, but we will know very little more in August than we do now. So I expect the Bank will cut rates this week, though other measures are also possible. It probably doesn’t matter too much exactly what the measures are, as in reality the issue is building confidence rather than adjusting the cost of borrowing.

What will be the impact on the FX markets? If there is no action risk will suffer and with it the pound as well as the other “risky” currencies. If there is a cut an initial dip in the pound may well prove a buying opportunity as risk recovers. The Bank knows that something is expected and is unlikely to take the risk of doing nothing because of the probable negative impact on markets of what would be perceived as dithering. Carney has effectively forced the hand of the rest of the Monetary Policy Committee by saying action is necessary. So look for a bold Bank and a risk positive reaction, especially since the global background is better after the better US employment numbers and the withdrawal of the ludicrous Leadsom as candidate for PM. EUR/JPY (or probably better still, SEK/JPY) seem the cheapest major currency pairs to me. Of course, it may not last if the economic impact of the Brexit vote turns out to be very negative, or if the negotiations between the UK and Juncker and co. break up in acrimony. But for now, while the outcomes are unclear, expect a risk recovery as the Bank tries to build confidence.

Over to you Angela

merkel

After the vote for Brexit, everyone will be talking about what happens next, what trade deals the UK can cobble together, how we deal with the collapse in the pound. But these economic problems are all soluble. Some of them aren’t even problems. The devaluation of the pound is 100% welcome. OK, it might have been better if it had happened slower, but the pound has been overvalued for years, and the drop only takes it back to something close to fair against the USD. It remains quite expensive against the EUR (see previous blogs). I wanted to sell GBP whether we voted in or out.

Trade deals are a bigger issue, primarily in the area of financial services. However, my belief is that in the end it won’t be in most people’s interests to change things too much. The passporting issues with Europe may make some things difficult for international banks headquartered in London, but won’t change the fact that the talent and the infrastructure are in London. In practice business will be done in the places with the greater comparative advantage. London may suffer a bit, but I sincerely doubt that Paris and Frankfurt will be taking over.

The economic issues may create some short-term pain, but regardless of the various studies out there from supposedly independent institutions, we simply don’t know the long-term impact, mainly because it depends hugely on politics. It is the political fallout from this that will be the key longer term determinant of the impact both on the UK, Europe, and the world as a whole.

In the UK, Cameron is going anyway at the end of this parliament. He may well have to go earlier. It seems likely that he will be replaced by a right-winger, though the Tory Party may try to find someone to bridge the rifts. Theresa May could be the closest thing they have. But it is far from clear that the Conservatives will win the next election.  They are likely to suffer losses to UKIP, and Labour may do better than many think, though in the end Corbyn still seems likely to be a liability.

But more important is what happens in Europe. Will Brexit prove to be a trigger for similar votes in the Netherlands, Denmark, even Italy?  This seems to me to be the crucial question. The EU is not loved in many countries at the moment, and their reaction to the UK vote may now determine whether the bloc survives in its current form. If they follow through on the threats to make things difficult for the UK, it may discourage others from exiting, but it could also backfire. The votes who want to leave are a little bloody-minded by nature. Attempts to assert central control from the EU make anti-EU movements more rather than less powerful. It could also crucially damage confidence. The markets and business now desperately need reassurance. They don’t want to see increasing difficulties in doing business.

From an FX perspective, I would expect the initial response of GBP to broadly stick. The big question is now what happens to the EUR. A moderate response from the EU which attempts to build bridges with the UK would be positive for world markets and for risk. Attempts to punish the UK will be negative for risk assets and negative for the EUR. The EUR is already a cheap currency at these levels, but the economy is fragile and the EUR can get cheaper if leaders mishandle the situation and fail to support confidence.

So it’s over to you Angela and Francois. Accept a new European landscape with grace and forgo all thoughts of punishment and protection and this need not end badly. Try to tighten the reins on the rest of Europe and strike fear into potential exiters and it will finish the worse for everyone.

Risk on after Easter pause – sell CHF

realeffectives

I have not written here for a while, mainly because I have not had a lot new to say. I continue to think that equity markets, particularly European equity markets, are extremely cheap. They continue to behave as if we are still in the midst of a financial or Eurozone crisis, when as far as I can see the data has been no more than mildly softer than expected, and yields remain incredibly low. Equities are extremely good value, and even though nothing very exciting is happening or likely to happen, I expect they will move sharply higher before too long.

In FX, the EUR is relatively chipper, helped, like the JPY and the CHF, by the prevailing gloom and lack of risk appetite rather than any optimism about the Eurozone. Most of the FX volatility has been seen in GBP, which is turbocharged by the big Brexit related options positions. Poor UK current account data and what I see as a big risk of a Brexit panic in the next two months suggests to me that GBP remains one bad poll away from a major tumble, so I see current GBP/USD levels (1.42+) as attractive to sell. Long  EUR/GBP has been the better trade in the last few weeks, but has hit a big Fibonacci retracement level above 0.81, and without clear news is likely to struggle to break through that, especially if global risk appetite improves to be more in line with the global data. While GBP and the UK should not be the biggest beneficiaries of any improvement in global risk appetite given the Brexit risks, GBP does tend to benefit against the EUR, JPY and CHF from any improvement in risk sentiment. So in the absence of Brexit news GBP may prove more vulnerable against more risk positive currencies, if, as I suspect, the market starts to realise that they are priced for something much more dramatically bad than the rather dull and sluggish growth story we currently have. But too many people are probably now focusing on GBP to make their year. It may happen, but the big option exposure and reliance on news means timing could be everything.

Thematically, I prefer selling the other heavily overvalued major currency – the CHF. In the recent low risk appetite conditions the CHF has benefitted from its still large current account surplus, but there is nothing good to say about domestic growth, inflation is very negative and the currency remains dramatically overvalued (see real effective exchange rate chart above). In spite of that, The SNB has probably been intervening modestly to help prevent the CHF rising, because in line with the general gloom, Swiss investors continue to refuse to invest abroad so that their current account flows continue to pressure the CHF higher. What domestic investors find attractive in Swiss rates or the Swiss economy I don’t know, and I can’t see it lasting. As long as the Eurozone continues to grow, albeit sluggishly, the EUR represents vastly better value than the CHF. Long EUR/CHF consequently makes sense to me, as does long USD/CHF, though the USD is unloved at the moment and a little expensive too from a big picture perspective. Still, despite all the millions of words written about the US economy and the Fed, not a lot has really changed, with growth a bit sluggish but still OK, employment still growing strongly and inflation on target. If this state of affairs remains the Fed will hike again once or twice this year, and that should be enough to revive appetite for the USD. USD/CHF has important support at 0.9475, and I would stay long while it is above there.

GBP – History repeating.

It’s all just a little bit of history repeating” The Propellerheads

“We learn from history that we do not learn from history.” Hegel

“The history book on the shelf is always repeating itself” ABBA

Instinctively, I tend to assume the human race has made progress over the last 100 years and our understanding of most things has increased dramatically. Technology has advanced enormously and clearly one thing that has changed in financial markets is the ability to access liquidity in all manner of financial instruments. But has the understanding of what drives financial markets and what is the appropriate valuation for markets improved?  I would like to say yes, but my experience tells me that the answer is no. Technology has vastly increased the amount of information available to market participants, but the understanding of the importance of various different pieces of information seems no better than it was in 1929, 1974, 2000, 2008 or times in between. In fact, the huge increase in the amount of information available may only serve to obfuscate the information of real importance, as markets react to red headlines and systematic asset managers are programmed to react in the same way as in the past or to follow the crowd. An increase in the volume of information only reduces the impact of the information that is of real importance if the market assigns some importance to every piece of information. Or in other words, the more information there is the more possible reasons there are to justify any given market valuation. Thus, the 2000 dotcom bubble found a reason for a wildly out of line valuation, and there were enough greedy investors and trend followers to send equity markets to stratospherically silly levels.

So much for philosophy. What’s the relevance to today’s markets? I wrote recently about the low valuation of European equities (see “A huge opportunity”), and I stick by that view. Some have come back to me worrying about low European growth, Italian banks, Cocos, European immigration, populist movements, but this seems to me to miss the point. There are always risks and concerns, but they have to be evaluated relative to the things that matter for value – in the case of equities this means growth prospects, the initial level of  earnings and dividends, alternative investments (interest rates), and risk premia, which is a bit of a catch all and can be used to justify almost anything, but a sensible view tells me that risks now are less serious than they were at the height of the Greek crisis.

For currencies the metrics are different, and although most of the time the markets are dominated by risk on/risk off trades, it makes little sense to think of currencies moving in this way over the long run. Real currency levels are ultimately anchored to fairly static long run valuation measures, unlike equities which rise over time with nominal growth. Relative growth rates can certainly matter for currencies, not least because they affect relative interest rates, but in the developed world there is actually relatively little long term divergence in growth rates, especially when adjusted for population growth. This isn’t really that surprising, as in the developed world technology and capital is very mobile, and it is hard for one country to show a sustained superior growth performance. Most of the time, better growth is temporary, and comes with a price, usually a bigger current account deficit, as is currently clear in the UK. Changes in the terms of trade – as can be seen with the big move in the oil price – will of course have a long term impact, but I distrust debt fuelled growth (and any growth that is generating an unsustainable current account deficit is debt fuelled from a whole country perspective) as long run reason for currency strength. Sooner or later (admittedly usually later) the positive currency impact of stronger growth and higher rates is reversed either by the need to rein back on growth to control the current account or inflation or the budget, or by others catching up.

What does this have to do with history repeating for GBP? Well it’s a roundabout way of saying that the strong pound, the growing UK current account deficit (and indeed twin UK deficits) are a repeat of a long history of similar episodes in post war UK economic history. The strength of the pound won’t last and we are headed for either a slow or a fast decline in the pound, depending on whether the UK stays in the EU (staying will hold GBP up) and whether the world economy picks up (if it does the decline in GBP will be slower). But the period of UK and GBP outperformance is hitting traditional current account buffers. Sure, UK won’t have to go cap in hand to the IMF this time as in 1976, and a fading of Brexit fears may trigger a GBP rally of sorts. But whatever the politicians agree, the risk of a vote to leave will remain, and more importantly, the underlying economics doesn’t justify a stronger pound, or even as strong a pound as we have now in the longer run. With even McCafferty accepting that UK rates aren’t going up, EUR/GBP is a buy on the dip, even if the ECB cut again as is widely expected and add to QE. Look for 0.85 this year in EUR/GBP, possibly 0.95 if things go badly on Brexit.

 

A huge opportunity

The EuroStoxx 50 index is now at the lowest level it’s been since 2012. It’s below the highs seen in 2009. Of course, it’s possible that we’re going to enter another major recession/depression and it continues on down to new lows. Possible, but frankly not very likely, as there is precious little evidence of slowdown, never mind recession in Europe. Sure, the US and Chinese data have been driving things, and there is no doubt that there has been some evidence of slowdown in those economies But even there, growth is positive, and we have seen plenty of uneven growth patches in the US in the quite recent past to make me doubt that the slowdown will last very long. After all, part of the cause of the slowdown is commodity -particularly oil – related, and there are positive effects from lower commodity prices on consumer demand (and on the cost base of many firms) which will take time to come through but will have a growth positive impact down the line. There are clear weaknesses in the world economy in the oil dependent economies – notably Brazil and Russia – but lower oil prices, when supply driven as most agree they primarily have been – are at worst ambiguous in their implications for global growth longer term. Now, as we all know confidence is fragile and a general loss of confidence can lead to a recession even if there is no sensible cause. But consumer confidence is not generally weak by historic standards in Europe or even the US, and as long as that is the case this has to be considered a massive buying opportunity for risky assets, and European equities look the most obvious.

For those who doubt that there is real value, consider the following.

Eurozone GDP at market prices is 8% above the peak level seen in 2008, and 13% above the trough in 2009.

Bond yields are dramatically lower than in 2009. 10 year government bond yields and 10 year EUR swaps are 2.5%-3% lower than in 2009. Most peripheral bond yields are dramatically below their highs. This means that the equity risk premium is at remarkably high levels. You’re being paid about 4% on top of capital appreciation to hold European equities.

Eurozone PMI data is showing almost no sign of slowdown. Sure, the January data was the lowest in 4 months, but 53.6 for the composite PMI is a very respectable number by recent standards, very close to the highs seen since 2011 and broadly indicative of GDP growth in the 0.4% region q/q (according to Markit).

So why are equities so weak? Well, there are some concerns about banks, though it seems  extremely unlikely that exposures to commodity producers are going to bring them down given the improved capitalisation  and reduced risk profiles. But mostly this is panic, flow related moves perhaps with some liquidation at the beginning of the year from some big players. But the economy would have to be a lot weaker than this to justify the weakness of the equity markets. Maybe it will be, but a lot is now in the price.

Of course, you have to be prepared to wear it for a bit if you’re going to make a value based call and buy European equities and other risky assets here. But it is the logical call at these levels.

From an FX perspective the risky currencies are obviously the ones that have the most potential to recover. But it’s not as simple as it used to be, as a lot of the traditionally risky currencies are justifiably lower because of commodity price weakness. And on a relative basis, the USD, which has been one of the most risk positive currencies in the last year, doesn’t have a huge amount going for it on the latest data. The most obvious victim of all this has been the SEK, which ha been sold off heavily because people had it as a risk positive play (though nowadays with negative short term yields it’s not at all clear at this ought to be the case), and I like the SEK here against the EUR and the USD. The EUR may start to worry about ECB action in March especially as we have hit the key retracement levels from the October-December decline in EUR/USD. GBP continues to worry about the referendum and possible Brexit. So FX in general is tricky. But the recovery in the CHF looks like a selling opportunity too.