Macro Matters: US Rates and the UK election

We are used to the experience of economic developments influencing and sometimes determining political events. This past year we have seen political events influencing markets and economic forecasts more than usual. The rise of the populists as a reaction to the specific disaffection with wage stagnation, immigration and terrorism is a factor the markets are continuing to focus on. This movement is unlikely to end merely due to the failure of the current crop of populist leaders but requires addressing the underlying issues. The current movement would best be summed up as a continuation of the de-democratization movement started in the 1980’s as a reaction to the explosion of social reforms from the post WWII period of the 1950’s through to the 1970’s.

UK Election

In short, although terribly embarrassing for Theresa May the concentration of votes to the two major parties in the recent UK election shows a continuing mandate for Brexit. The Conservatives should take away 3 key points in the aftermath of the election.  Voter disappointment with the lack of clarity between a hard and soft Brexit, disappointment with continued austerity in health and social welfare and a new understanding of how younger voters identify as  both European as well as British. The ability of the conservatives to deliver on their core agenda will be determined by how well they understood and incorporate these themes into their future policies and subsequently govern for the majority of the population.

GBP has sold off around 1.5% post the announcement of the hung parliament which seems a reasonably accurate reflection of the damage caused to UK prestige. Practically speaking the likely increase in fiscal spending as a reaction to the clear vote against current austerity and the lower GBP caused by the election will lead to a dampening effect in the near term fall out on the economy.

Federal Reserve Meeting and US Politics

Enough policymakers still believe that the economy is growing sufficiently strongly that the board will raise the US federal funds rate 25 basis points this week. The language around balance sheet size and path to ‘normalization’ is unlikely to change. It is likely that Yellen will make reference to a gradual reduction in the balance sheet towards year end as part of the statement and press conference.

The FOMC statement is likely to be a reaffirmation that the US economy is still on the right track towards moderately improving growth. Inflation data although subdued recently has not been weak enough to change the trajectory of rates. Importantly the Fed will outline a ‘steady as we go’ approach to a gradual increase in rates and a very slowly decreasing balance sheet which will provide the market confidence about the future direction of monetary policy.

This is important given the now uncertain political environment and by extension fiscal policy backdrop.  

In US equity markets we believe that this will lead to a rotation from big tech (in the 100th percentile of L/S equity ownership) to financials (in the 6th percentile). Positioning in US equities is clearly extremely concentrated to big tech.

In rates the reaffirmation of the direction for the US economy will see bond yields somewhat higher despite the market being well priced for the rate rise. The beta of rates to big tech versus the broader equity market will be key to how far rates can adjust upwards to a confident Fed statement. Our view is the very narrow breadth of equity ownership in the US big tech will dominate and the sell off in US Treasuries will be rather muted. Also, given subdued wage growth (at 4.3% unemployment rate) we may see a further reduction in the assumption of NAIRU and the medium term unemployment rate from 4.7% to nearer 4.5%. This will further quell the impulse for the market to drive bond yields higher.

In Foreign Exchange the US political theatre has seen a reasonably large fall in USD recently and this week will provide renewed confidence in the long USD trade. Given the damage to US prestige caused by political factors, the USD is likely the best expression of the boost to confidence from a steady handed US Federal Reserve Bank.

On US politics we are concerned that the political tail may end up wagging the economic dog as we do not see any near term resolution to the emotional polarity caused by the Trump administration. This would not usually be of much concern and most of the big ticket agenda items have been discounted by the market, however, the politics of Capitol Hill continue to be more about beating the opposition than getting policy measures agreed. Also, there is no end in sight for any of the 3 main investigations presently underway, although the appointment of a special counsel helps to de-politicise the Russian interference investigation.

At any rate as we have previously written the additional nominal GDP created per dollar of taxpayer money spent in a fully employed economy is arguably too low to justify the additional debt in the US at this point. As pointed out by Dr Lacy Hunt economies that are top heavy with debt generate less nominal GDP per dollar of debt spent. In the US between 1952-99 it took $1.70 of debt to generate $1 of GDP, from 2000-15 $3.30 of debt created $1 of GDP, and in 2016 it took a full $5 of debt to generate $1 of GDP.

The steady hand of the Yellen run independent Federal Reserve will provide the market with a greater feeling of certainty as to the direction of the US economy and monetary policy this week. It is also a very welcome respite from the political tail wagging the economic dog.