Market jitters hit EM currencies
The global economy remains in "Goldilocks" territory, but surprise upside inflation data could change all that, State Street's Michael Metcalfe tells Roger Blitz
Presented by Roger Blitz
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Welcome to Hard Currency, the podcast on the foreign exchange market from the Financial Times. I'm Roger Blitz, and this week has been a nervous jittery one across many markets, including equities, junk bonds, and especially, emerging market currencies as investors worry about risk and decide to take money off the table. So is this a blip or a portent of a more sustainable period of market uncertainty?
My guest is Michael Metcalfe who heads up global macro strategy at State Street Global Advisors. Michael, a period of uncertainty could also be called a panic. Are we heading for anything significant, or is this a blip?
Oh, let's not panic just yet. I think the one thing whether there is a correlation is that the longer the markets go up, when we do get a correction, the more we worry about it. And I would say right now, the signals of whether this would have been something more serious than just a blip is that volatility is still quite low. And also, correlations haven't risen.
In fact, actually this has been one of the things, which I think has sustained the risk rally for so long last year is actually that correlations generally have been quite low. Markets have not been systemic.
Yes, which correlations do you look at most?
Well, for FX, a really interesting thing to think around is many risky assets have performed very well in almost a straight line this year. And that's why people are so concerned. That's why that's why people are calling this little blip something more.
But the really interesting thing in the FX market is the stereotypical risk on trade in FX. Of course, it's the Kerry strategy. And it's really interesting to me that this year the correlation between other risky assets and Kerry has more than halved. And certainly, really since March onwards, actually Kerry hasn't performed that well. So there is no bubble in FX.
No, OK, so what do we attribute it to? You talked about the end of the year. Is it a calendar thing? Is that a reason why investors would say, we've done pretty well this year. Let's take the money and start again in January.
Yes, certainly this time of year we always worry about technical factors like year-end book closing. And look, returns have been so attractive in many asset classes, you can understand that you'd book some profit. But here's the thing. I wouldn't read too much into this about this being about valuation or anything like that.
Let me give you an example. So it's sort of been led by Japanese equities where actually valuations are arguably the most attractive. And so I think you can't really argue this is a massive overvaluation that's finally burst. I think it's more technical reasons. And look, fundamentals haven't really changed.
The Goldilocks story has to end some time, doesn't it? What is likely to be driving that? Do we look at the US and do we look at inflation as the probable point at whereby there might not be a market correction but there has to be a rethink about what is the norm, the equilibrium, the best conditions?
No, absolutely, I love the fact that Goldilocks is now part of the narrative because the same levels of growth a year ago, we talked about secular stagnation. But I think the interesting thing now is that growth, very clearly for the moment, has been enough to generate labour market improvements, good earnings growth, but no inflation. And right now, if you look at all the leading indicators, none of the leading indicators are suggesting that there's that many downside risk to growth.
And so to the question of what breaks Goldilocks, it's actually that it gets too hot and that, for some reason, inflation comes back. Now we don't see any time in the near term, inflation doesn't look like a risk. But here's an interesting counter-factual for you.
We know that US inflation has been biassed downwards by one-off factors. What if they had been in the other direction? What if we get shocks to inflation into core inflation? And that's the kind of thing that could upset Goldilocks.
Yeah, someone said to me the upside inflation surprises are going to be very market driving whereas actually downside probably the market won't react. Market seems poised to expect something on inflation, at least on the upside.
Well, I think the reason why the risks are one way is that you look at the shape of the US curve and think, well, actually it's very difficult for the market to take out all the tightening of the Fed next year. They've got that sort of halfway there in terms of 1 and 1/2 hikes.
And so I think there is an asymmetric risk here that we conflationists sort of priced in. Any upside surprises are not. If we get an inflation shock, that's when we're talking about the correction. That's when we start to panic.
Yes, OK. Is there a bit of-- Well, panic, again, is a strong word. But is there a bit of new thinking about China? We've heard the party Congress, and we are now seeing some pretty stern words coming out of the Central Bank governor and some slowdown in the economy, which, granted, China did say they were planning. But there's something different about actually experiencing it and seeing it to preparing for it. Did you think there's a rethink going on with China? Is that part of some of the blippy instability around?
Well, it'd be very tempting to go back to end of the 2015, early 2016. China was a big part of that as was the commodity price weakness. I think, right now, there's not enough evidence that Chinese growth has slowed enough to be disruptive, and I think we're just waiting to see what kind of monetary tightening we potentially get. And so it's definitely a risk, and I think the stability that we've had in global growth overall-- this year we had concerns about US growth, but the reason why we did OK was that, all through this, China has actually done fine. So I think it is important--
Well, you say China has done fine. We've been told that China has done fine.
We have been told that China's done-- And that's absolutely right, and I'm not going to say anything else other than that on air. However, one of the other things we'll need to wait and see in December is we know that after the Congress, we know that there's going to be a different focus on growth. We don't know whether the growth targets will continue. Goodness knows, if the growth targets didn't continue in two or three years time, then the growth numbers may become more volatile.
Yes, you compare it to 2015 when market had a poor understanding of China. Presumably, they have a better understanding. But even so, we have to see how market would react if these numbers came in below.
Oh, absolutely. And it remains a risk. So downside gross surprises in China, yes, so upside risks of Western inflation, downside surprises in Chinese growth.
Yes, indeed. What about the euro, Michael? We've been looking at the prospect a dollar revival. It's been very spotty since the start of the fourth quarter, and we actually did see quite a big push, again, in the euro this week. It's my inclination to think that we actually have to go through periods of believing in a dollar revival, work our way through them, and then we can get back into a euro revival. What you make of how the euro has been doing?
Yeah, I think sentiment has swung hugely this year in the sense that we were far too pessimistic at the start of the year. And then I think by the summer, and certainly in the run up to the German election, sentiments probably swung too far in the other direction. Everything was just too optimistic and too negative on the US. And the reason why we need to take a step back to move forward to your point is just to clear out positioning, so it's just not too extreme. And I think the key for the year-- and here is really puzzling and interesting observation-- is that typically, historically, euro dollar has been driven by the link with two-year rate differentials rather than 10-year rate differentials. The short term policy expectations have driven the currency.
This year that's not true. This year it's long-term yield differentials that have been the driver. And that's kind of interesting because it sort of speaks to the fact that even though the ECB is not moving policy any time soon, and obviously we had all the speculation about when the taper would come and it came and it's passed, actually long term growth expectations, as reflected in long term yields, can help drive the euro going forward.
And that would make investors feel solid about growth in general, about global growth, not just in Europe but more broadly?
I think so. Europe was one of the success stories in terms of growth this year. And the interesting thing, if you look at eurozone growth expectations for 2018, they're still not that high. And obviously, certain eurozone yields aren't that high either. And so if there is potential for an upside surprise on growth, it's interesting that the surprise that we got in 2017 in Europe isn't expected to be repeated in 2018. So if there is growth momentum there, there is some upside for eurozone yields and therefore the euro.
A tricky week to conclude Michael. What do you think investors have to hold onto? What are the most important fundamentals, you think, that should enable investors to say, hang on a minute. Yes, there's something going on, but perhaps, to your point, it's not more than a blip. What do you think is the key issues? Is it broadly global growth? Is it confidence? Is it those PMI numbers? What do you think it is?
Well, look, the growth numbers do matter. Don't get me wrong. But they looked to be in a pretty steady, ongoing recovery, and that's fine. I think the really important thing is that inflation remains under control. And without a upside inflation shock in developed markets, Goldilocks still goes on.
OK. My thanks to Michael Metcalfe of State Street. Next week, we'll look at how US tax reform prospects will influence the dollar and whether the euro is about to go on another bull run. We'll re-look at that issue. Until then, from Hard Currency, it's goodbye.