US Politics stretching equity catapult elastic.

The broad thesis that TMM have been running over the last few months is that the world continues to recover from the great financial crisis and we don't expect that to stop.  If we were to look at the recovery as a Formula 1 race then though everyone is generally moving forwards, emerging markets have pulled into the pits to refuel, Indonesia and India having been found to have severely overheated. Europe has just left the pits after having had most of its bodywork patched together after a nasty crunch and is catching up fast. But the leader over the last 2 laps, the US running on natural gas, has suddenly pulled over. Not due to equipment failure but  to an insane in-fight between its own management team leaving the leading driver under instruction to shut the car down. Team Macro Man think that the Fed should do a "Vettel" and ignore team instructions and just get on with winning the race.

Early August had a definite feel that good news was pretty much fully discounted with respect to direction (but not yet fully priced - more later) and that we should be looking for something for the disasternistas to get their teeth into in order balance things up and wow hasn't this US showdown been just the ticket? However we maintain our dogged view, last employed during the European crisis, that when politicians are close enough to the edge of mutually assured destruction they WILL get their acts together. The frightening part for everyone else is seeing them dance so close to the edge.

So where are we in the US? The political risks appear to be limited now to an extended government shutdown. GS estimates something like ~15bps off 4q GDP growth per week of shutdown, but it will be made up when the government re-opens, so it’s not clear how big of an impact it will have. But the main driver for the recovery of markets is the removal of both the default tail risk ( cf. European response to OMT) as well as the risk from a sudden stoppage in entitlement programs.

It seems unlikely that the Fed will taper while the government is shut down and we have to cope with a lack of reliable macroeconomic data. People have also noted that even if the government IS reopened shortly, much of the released data will be affected by the shutdown in various ways anyway resulting in noisy feedback loop debate as to what reality is.

Given that the FOMC minutes showed a fairly close vote towards a taper last month, it seems reasonable to assume that taper mania will be back in full swing as soon as the shutdown is over. Consensus seems to be moving towards 1Q right now, which seems reasonable. But barring a downturn, it seems hard to imagine a substantial fall in yields in the near term. The Eurodollar strip is priced almost to perfection vs the FOMC’s projections after adjusting for a ~20bp spread for Libor-OIS:




What is interesting is that the pace of hikes priced into the market slows starting in 2018, ~5 years forward. There are several possibilities for this, but one may be that Yellen has said in the past (6/6/12, specifically) they she thinks the economy’s equilibrium real Fed Funds rate is probably well below its historical average. She didn’t give a number of course, but with the FOMC central tendency estimate for the equilibrium rate at 4% at the last SEP, there was 1 vote at 3.75, 2 and 3.5, and 1 at 3.25. Note also that in her “Optimal Policy” speech, she has Fed Funds at 3.25 in 4Q 2018.






Watching market response through all of this has been interesting and indicative. Considering the moves in T-Bills and the responses by Hong Kong to haircut them as collateral ( the Swiss considering the same) it looked as though the closest thing to cash and the world's favourite safe haven was doomed to destruction. But relative nonplussed performances of Eur/usd and indeed the non-cataclysmic equity response had us wondering if maybe some Machiavellian political forces were encouraging this run to spur the other side back to the negotiating table. The US10year back to 2.60 can be seen as a return to comfort levels after the last panic spike higher. This leaves us with the view that this US congressional mess is a valley that has to be bridged to higher lands on the other side.

In the meantime, traditional measures make the conditions for equities look pretty benign here, although given the repricing in the VIX, arguably almost all of the default tail risk has been priced out already. BUT, and this is the big but, we are strong believers that in an environment where people continue to have to choose between cash, bonds or stocks, the inflows into stocks will continue. To TMM there is a mismatch between folks talking the equity talk and walking the equity walk,  perhaps because they are afraid of the the micro-analysis telling them that equities are fairly/over/madlyover priced. But if we are to look at how markets have behaved and how the current environment of excess savings chasing minimal returns is playing out, then traditional fine measures will be nothing in the face of sloshing tides of money chasing anything that is simply "going up". (We recommend Izabella Kaminska's great post on yield chasing and bubbles here).

TMM has, as regular readers will know, been a great fan of overweight Europe for the past year or so but popularity is catching up with us and we note that based on forward P/E, the Eurostoxx50 has now exceeded late 2009 levels. Against the S&P, the Eurostoxx is as rich as it was last December, and before that in late 2006.





Now as we said above, this matters little if we are looking for another tidal wave of renewed portfolio switching (this US scenario has offered a secondary "out" opportunity to those having missed the boat re bonds to equities) but it does make us look at reweighting more to US from our very overweight Europe view.

TMM feel that the debt stuff will be resolved, or put on the back burner again European style, enough for a market melt UP into the year end.


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And as a footnote - Whilst TMM believe the pricing and distribution of UK's Royal Mail issue was designed to act as ground bait to attract the shoals to take the hook of a trickier upcoming RBS sale, its success has given the UK public's general interest in equities a real boost. TMM reckon that for every cry of "Foul easy profits" from left-wing spokespersons there are a hundred responses - "Easy profits? Where?"