UK economic data have been encouraging. The mainstream financial press continues to reveal the bias of its views towards Brexit by adding "despite Brexit" and/or the caveat "but we expect the situation to deteriorate as a result of Brexit" after any positive economic news. Given the negative bias, it is perhaps unsurprising that almost half of the UK population think the UK is in recession, according to Nielsen.
But this week we have seen a lower-than-expected (headline and core) inflation rate, higher-than-expected wage inflation and stronger-than-expected retail sales (admittedly with some downward back revisions). From our perspective, not only is the market too negative in its view of the UK economy (and therefore GBP), but it is also looking in the wrong place.
UK rate expectations are currently bimodally distributed. The first "mode" is centred around expectations of a near-term UK rate rise as a function the near-term inflationary impact of GBP’s sharp fall since the UK referendum on EU membership. The second is a function of the proximity of escape velocity for the UK economy, or where growth and demand-driven inflation warrant a more sustained process of monetary normalisation. From our perspective, the value of GBP should be less driven by whether inflation (justifiably in our view) invokes a near-term rate rise in defense of the credibility of the inflation mandate, but about when, where and how the start of the tightening cycle should be.
We see an impending sharp pivot for "inflation (wages and prices) economic sentiment, monetary policy expectations and ultimately currency valuations" (as discussed over recent weeks), and the fact that the SONIA (sterling overnight index average) curve-implied probability of a rate hike is not fully priced by the market until March 2019, so interest rates and GBP are significantly undervalued according to our current assessment of the UK.
Going forward, business investment is key in the trajectory of productivity, wage inflation and growth. It seems we have now passed "peak uncertainty" in relation to muted business investment. Over recent days, Hilton has announced it will open 30 new UK hotels over the next two years, Amazon has announced a further 1,000 new jobs (in addition to the post-Brexit pledge of 5,000 new jobs by the end of this year), manufacturing exports had their strongest sales increase since the end of 2014, mortgage lending and first-time buyer activity rose significantly in June, and the job availability in London is up 27% year-on-year and 17% month-on-month.
"There are two rules to success:
1. Never reveal everything you know…" — poster slogan
The British government yesterday released the first of many position papers ahead of Brexit negotiations, declaring its intention to begin a consultation with industry before the talks. Clearly prefaced as aiming to set out "key issues which form part of the government vision for that partnership, and which will explore how the UK and the EU, working together, can make this a reality" — specifically in relation to the UK’s potential options for a future customs relationship with the EU27. The mainstream press were perhaps unsurprisingly critical, yet the response from business was far more upbeat.
“Every custom begins with a broken precedent” — Will Durant
The government paper has been criticised on the basis that some of its suggestions are untested or have no clear precedent. The paper clearly points out that "while the government has looked at precedents set by customs agreements between other countries, it is not seeking to replicate another country’s model and will pursue the approach that works best for the UK." Presumably in just the same way that EU outsider Norway did when it came up with "the Norway model", similarly Switzerland, Turkey and even Canada. Why is it so unthinkable that there could be such a "UK model"?
“Three things can not be long hidden: the sun, the moon and the truth” — Buddha
Last night brought the release of the minutes of the Federal Open Market Committee's July 25-26 policy meeting. Effectively, there was little new information in the release of the broader debate behind the statement. In essence, the discussion highlighted a greater concern over the recent softness in the inflation data and so, on the face of it, this was interpreted as dovish for rates and the US dollar.
But if we look at the views of the different FOMC members on the likely progression of inflation, there are broadly three camps. First, those who feel rate hikes are off the table until or unless inflation makes a convincing move higher. Second, those who think that the traditional Phillips curve relationship between jobs and inflation remains and that the current soft patch in price pressure is transient. Third, there are those who feel that the current extent of labour market strength justifies further (gradual) monetary normalisation in itself.
Against a backdrop of easier financial conditions and a labour market that is below almost all convincing arguments for equilibrium, we maintain that that any signs of inflation (particularly at the wage level) put the FOMC sharply behind the curve and liable to a hawkish pivot that could be significant for rates and the USD.