Fault Lines - Transcript

Speaker 1:

Hello and welcome to Macro Minutes. During each episode, we'll be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.

Jason:

Hi everybody and welcome to the September 27th edition of Macro Minutes called Fault Lines. So fiscal policy has cracked the UK bond market, it's opened fissures in the currency and is causing ruptures in other bond markets and by extension risk and cyclically sensitive assets. The UK fiscal side, it's been dubbed irresponsible by markets. And today you'll hear from [inaudible 00:00:48] on this topic. Adam is going to tell us how far the British pound can fall. Simon is going to opine on the Canadian dollar depreciation and its impact on macro and Bank of Canada policy. I'm going to discuss the massive outperformance of Canada's bond market versus the US and Canada's curve inversions. And Lori is going to tell us what this all means for equities. So to kick off the call, I'll turn it over to the UK side to hear about the dire situation there.

Speaker 3:

Thank you Jason. And hello everybody. Well, as Jason alluded to there, we have seen some major moves in [inaudible 00:01:26] markets over recent days. Market is now pricing a terminal bank rate of just north of 6%. Now that's compared to about 4.5% at the time of the last Bank of England meeting, which was just last Thursday. Now 10 year yields have also risen from about 3.25% to a little above 4%, having at one point peaked towards the 4.25% with that move coming exclusively from a step higher in real yields. So what's behind these moves? What explains them? Now, the market moves we've seen came in the back of a fiscal statement from the UK [inaudible 00:02:05] on Friday. Now the strange thing to those of us who observe these events pretty regularly is that 90% of what was announced on Friday was actually known in advance. Earlier this month the government had announced a major package of assistance for households and businesses to help them with the cost of gas and electricity prices over the next two years.

Most of the tax measures which were announced on Friday had also been trailed heavily in advance throughout the conservative party leadership campaign over summer months. What we think the market reacted to was less the magnitude of what was announced, but more that it represented a loss of confidence in the UK fiscal policy framework. The tax cuts were unfunded and the chancellor paid only lip service to any plan to manage the public finances over the medium term. By extension, that also eroded confidence in the UK's wider macroeconomic policy framework. In particular, with fiscal and monetary policy now operating in such obviously opposite directions, the market began to build an expectation that the Bank of England would have to tighten policy aggressively to counter the impact of the government's fiscal policy announcements on Friday. So last night we had coordinated statements from both the Bank of England and the Treasury. Essentially this saw the bank playing for time until its next meeting in early November, but the fundamental issues here, the two parts of the UK's macroeconomic policy mix are now working in obvious directions and the associated loss of confidence stemming from that haven't gone away.

Jason:

Okay, great. Thanks very much. Very insightful. Now over to Adam on the FX market and specifically how much further the pound could get pounded.

Adam:

Thanks Jason. So I think the answer to that question very much depends on time horizons. And near term, I do think there is a case for some consolidation and the adjustment in Sterling and other risk premium has been significant. And looking at it, for instance, through Sovereign CDS in the UK versus other major markets, we have gone from the bottom end of a decade long range right to the top of that range. And if that's a reflection of the risk premium carried in the currency, which I think is probably fair, then it's not unreasonable to think, having gone from one end of the range to the other, that we could at least for a few days or weeks consolidate around these levels. Longer term, however, this process for us is nowhere near over. And what the chancellor did on Friday was bring to the foreground the imbalances in the UK that have been significant but in the background for some time. And that issue having come to the foreground is unlikely to go away without a major changing policy, which is something we're very unlikely to get under the current PM and Chancellor.

So the UK runs both a large current account deficit, 8% or so of GDP, and a structural budget deficit of 5% of GDP. And the former is a consequence of the lack of domestic savings. Most countries that run structural budget deficits the size of the UK's fund them from a large stock of domestic private savings. I'm thinking Italy and Japan as the prime examples of that. That's not the case in the UK. We rely very much on funding our domestic deficits by borrowing from abroad, and that has been brought sharply into focus by the events of Friday, and it is unlikely to go away, as I say, without a major change of policy. Second factor I'd mentioned in this context of the longer term outlook for Sterling is that on the measures that matter, it's not the case yet that Sterling [inaudible 00:06:28] commerce cheap. On the measures of the real exchange rate that we focus most squarely on, relative labor costs in the UK compared to our trading partners, we are still above the long term average for the Sterling exchange rate.

So all the focus on us hitting record low levels cable and historically very low levels for Sterling trade weighted, none of that holds if you look at those exchange rates in real terms. So I think it's still fair to say that Sterling is not playing a large role in correcting those imbalances that are the root of the weakness. So longer term we think this process has further to run and Sterling has further to weaken before we get into the kind of territory that it's playing its role in reversing those imbalances that have caused the moves over the last few days. So short term, a little bit of consolidation. Longer term we are in the process of reworking our forecast at the moment. We just hit our longer term targeting in cable, and in all likelihood those will be moving lower for the reasons that I just mentioned. So consolidation near term, longer term this process is further to run in our view. And with that, bouncing back to Jason.

Jason:

Okay, excellent stuff, Adam. Shifting gears, we're going to move over to Simon on Canada.

Simon:

Hi everyone. So increasingly over the last little bit we have gotten questions on the impact of weaker CAD on bank policy and the macro backdrop. To give some context to this, dollar CAD was at 1.30 on September 12th and this week's been around 1.37. So in CAD dollar terms, that's going from 77 cents to about 73 cents. And a few things to keep in mind when looking at this, one, CAD comes into the bank's NPR projection via the average over the previous six weeks or since the previous meeting. This is a way of avoiding the need to forecast CAD and not being too dependent on temporary moves. So the assumption at the last NPR in July was 78 cents. Current level of 73 cents would be 6.4% D depreciation. So if it is the average at the next meeting ... so obviously there's a lot of time between now and then, but if it is the average at 73 cents, then that's a 6.4% depreciation.

And if you look at research that's been done, this would translate to about 0.2 percentage points upside to core inflation about 0.4 to headline inflation. However, CAD depreciation is not independent of other market moves, and obviously we've seen lower oil prices over the last chunk of time. For example, WTI was assumed in the $95-$110 range over the projection horizon in July, and now below $80. And as well, global and US growth are likely weaker than assumed in the July NPR. So for the US, the July NPR had 1.9% for this year, 1.1% for next year. And our economics team currently has 1.7% for this year and 0.2% for next year. Now we'd expect the bank to keep their forecast above the 0.2% for next year, but certainly there are downside risks to what they had in July. So the overall takeaway here is that the weaker CAD is offset by lower oil prices and weaker global/US growth assumptions, leaving their high even at the time inflation projection from the July NPR likely to be lower in October.

The difficulty, or one of the complexities comes from we've already seen oil and gas prices move lower, so they've already come down. Headline inflation has moved from a peak of 8.1% in June to 7.6% in July, 7% in August. Meanwhile, the CAD weakening has only come recently. So that's more likely to show up say as soon as the October CPI report ... sorry, it comes out mid November. So there's a timing issue there in terms of a mismatch and when the CAD depreciation may show up in the CPI report. As an aside, to also highlight that recent bank tender research, looking at the impact of CAD depreciation on exports showed that actually the direct relationship is relatively weak. Instead, US growth, where 75% of Canada trade is done, is the main driver of export. So not a huge shock on the latter, but just that the CAD depreciation isn't as strong a relationship as one might think. And that's it for me. I'll flip it back to Jason.

Jason:

Okay, thank you very much, Simon. Next I'm going to discuss three topics. One, Canada's yield curve inversion, two, Canada/US spreads, and three, US duration. So on yield curve inversion, Canada's curve, yes, it's inverted across all segments. When you look at this back to the mid 1990s, the degree of inversion does seem quite excessive, but it is broadly in line with the experience of 1981 and 1990. And indeed there are macro similarities between those periods and now, so it's not implausible for curves to invert by a similar magnitude as they did in those periods in '81 and 1990, which would mean that twos tens could get to the minus 100 to minus 125 basis point type of range.

And this could happen for a number of reasons. First, the Bank of Canada surprises with a larger quantum of hikes or extends the cycle longer. Secondly, the growth downturn turns out to be exceptionally large. I do think consensus is too optimistic on the growth front for 2023 in Canada. Or three, policy rates are kept at higher levels for longer. So these are all plausible scenarios that could unfold. And one of the key lessons from past rate hike cycles is that curves do not steepen before the last rate hike. What those curves do, particularly twos tens and twos fives, after that is dependent on how quickly policy reverses course, whether it actually does so or whether the market bets on that quite heavily. But independent of policy in the year after the last hike, the fives thirties and tens thirties curve, those have shown the most reliable steepening patterns after the last rate hike.

On the second topic of Canada/US spreads, there's been a lot of outperformance of Canadian bonds versus their US counterparts across the whole curve over the past couple of weeks, and this has been a hot topic for clients. To me it seems pretty straightforward, that the move in the bond market has been exclusively driven by the repricing of relative terminal rates. So for almost all of 2022, the market was pricing Canada's terminal rates to be at or above the US. And this was a bit odd versus history. The fed has usually finished 50, in one case 100 basis points higher than the Bank of Canada in the past cycles over the past few decades. Now in the past few weeks, the market has repriced the fed terminal rate higher and it's now around 50 basis points above Canada. So we are at levels now on policy rate differentials that seem more consistent with history.

So given that, it doesn't surprise me that Canada is trading through the US, as far as bond market spreads. So if we assume that Canada/US spreads being negative makes intuitive and macro sense, then the debate is really about the level. And at least looking at history again, Canada/US spreads, they are not outside the realm of sanity if the fed finished 50 to 75 basis points higher than the Bank of Canada. So going forward, I do think cross market spreads should remain a high beta to relative terminal pricing. So this is similar to what we've seen over the past six weeks. And finally on duration, given the cheapness of the US to Canada and what seems to be contagion from the UK driving the US long end rather than necessarily fundamentals, it might be worth fading and scaling into long 10 year treasury positions at these levels. With that, I'll pass it over to Lori for her thoughts on the equity market during these tumultuous times.

Lori:

All right, thanks Jason. Thanks for having me, everyone. So I was on the road last week talking to equity investors. It was an interesting time to be out and about, but there were really kind of two topics that were on peoples' minds. First is how in the world do you position as an equity investor when the curve inverts? And second, what does hire for longer from the fed mean for PE multiples? And I think that it's important to note that that last question was really in focus for investors on the equity side even before the Wednesday FOMC meeting. So first topic of the yield curve, this is unfortunately just a very, very tricky environment to navigate for US equity investors. We looked at sector performance and we found that trends are not highly consistent. Market performance also is not that highly consistent, but if you look in the bits and pieces of the market, you do tend to see a pretty clear defensive bias, and we do tend to just assume that's because recession fears are in focus, whether or not a recession ends up happening or not.

So areas you want to be hiding out in are things like commercial and professional services. So think business services, stocks, food and staples, retail, household, personal products, materials, pharma, biotech, life sciences, software services, telecom, transportation, and utilities. One area that does tend to underperform that I think will be relevant to this crowd is energy, along with consumer services, which is restaurant heavy and tech hardware and equipment. I do think a lot of these takeaways are obvious, but when we saw the big sharp drop in energy at the end of the week, this was really kind of the first thing that popped to my mind. Moving on to the valuation discussion, and I think this is something investors on the equity side have been struggling with all year, but again, it's really the question of what does hire for longer in terms of rates and maybe even inflation mean for PE multiples going forward.

So we published over the weekend a new model we've been tinkering with for a while that forecasts a year end 2022 S&P500 PE. And it's really just based on four variables, 10 year yields, fed funds, core PCE, and PCE. And what's I think unique and helpful about this model is that we do leverage data going all the way back to the 1970s. So we basically just plugged in 2022 expectations on inflation in the fed from last week's summary of economic projections. I did speak with Blake about what were some reasonable interest rate assumptions and we plugged in just sort of those variables to the model. It spits out a PE of 16.35 times, which assumes a 57% contraction from the pandemic high of 37.8. And that level of contraction, importantly, is close to the contraction we got throughout the entire 1970s peak to trough and the contraction that we saw in the broader market after the tech bubble.

So I wouldn't say that this has to be the multiple at the end of the year, but it's certainly a very reasonable starting point for thinking about where markets could plausibly trade in terms of the PE at the end of the year. And if you take that 16.3 times on our 2022 EPS forecast of 218, that will tell you that 218 is very far below the bottom of consensus of 243. We would see the index fall to about 3564. Now before we move to Q&A, I just want to mention that we come up with this number 3,500 a lot in our market discussion. So if you think about the median recession, and obviously the June lows have now broken, but a median recession draw down in the S&P500 is 27%. That takes the index to 3501. Also, if you look at forward PE and our earnings numbers, we'd get back to an average PE if we see the market trade around 3561.

So I think this is going to be an important level to watch. We are obviously worried about what's going on in the UK, but we have seen things like the equity put call ratio has finally spiked. It is at its highest level that we've seen since the pandemic and getting close to December, 2018 highs. So there is a lot of fear in this market, but that's not to say we have to have bottomed in here. I just want to leave you with one final thought. If 3,500 on the S&P doesn't hold, do you want to look at 3,200 next? That is where you see a 32% or typical kind of average recession draw down as opposed to a median.

Jason:

Okay, thank you everybody for joining our regular Macro Minutes series. Whether the fault lines and bond markets and risk assets turn into a full blown earthquake remains to be seen, but what is clear is that the trend of high volatility should remain in place for the rest of the year. So stay tuned for our regular calls to hear from RBC experts on these developments.

Speaker 7:

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