Fed is draining the liquidity swamp, sees no alligators · 2019-09-07 · Cross-Asset Weekly 16 June 2017 1 | Cross-Asset Weekly Fed is draining the liquidity swamp, sees no alligators

Cross-Asset Weekly 16 June 2017

1 | Cross-Asset Weekly

Fed is draining the liquidity swamp, sees no alligators

The Fed hiked rates and announced plans to reduce its balance sheet, showing little concerns for the deceleration in consumer prices. In our US Macro section, we discuss how financial markets appears too sanguine about the tightening cycle. Despite the markets worry about the weak inflation readings, the Fed conveyed a relatively optimistic tone about the economic outlook. The Fed’s tightening path is unlikely to cause major headaches for equity investors in 2017, as we explain in the US Equity Strategy section. The trend in the 2-year US bond yield confirms the medium-term uptrend in US equities. We measure however a decline of macroeconomic liquidity. A period of weakness in late June / early July islikely for US equities, which would provide a buying opportunity. Our European Macro theme is a cultural explanation for the German export bubble. Most Germans don’t understand being called “very bad on trade”, as they see the trade surplus not only reflecting the quality of German products but also vindicating the decisions made to reform the labour market and contain consumption and wage growth. Hence, what seems to be a mercantilist obsession also reflects cultural traits towards saving and working that are unlikely to change easily and are thus important to understand. Finally, our Emerging Markets section discusses the latest development in Brazil, where some of the accusations against President Temer were dismissed. We believe these new/old news would lose prominence as the Brazilian economies improves further. This week’s highlights

US Macro 2The Fed is not worried by weaker inflation

European Macro 4The German export bubble – a cultural explanation

US Equity Strategy 6No material risks as Fed is draining the liquidity swamp

Emerging Markets 8Brazil: more corruption, nothing new

Economic Calendar 9Week of 12/06 – 16/06/2017

Market Performance 10Global Markets in Local Currencies

Contacts Dr. Karsten Junius, CFA Chief Economist [email protected] +41 58 317 32 79 Adolfo Laurenti Global Economist [email protected] +41 58 317 30 86 Ursina Kubli Forex Strategist [email protected] +41 58 317 32 80 Cédric Spahr, CFA Equity Strategist [email protected] +41 58 317 31 28 Dr. Florian Weber, CFA Fixed Income Strategist [email protected] +41 58 317 31 14 Emiliano Surballe, CFA Emerging Market Credit Strategist [email protected] +41 58 317 35 64 Kunal Singh, CFA Emerging Market Credit Strategist [email protected] +41 58 317 31 21 Thilina Hewage, CFA Emerging Market Credit Strategist [email protected] +65 6230 66 61



US Macro

The Fed is not worried by weaker inflation

The Fed hiked rates and announced plans to reduce its balance sheet, showing lit-tle concerns for the deceleration in consumer prices. Financial markets appear less sanguine about the tightening cycle, showing some worries for weak inflation.

Weaker than expected inflation readings did not halt the Federal Reserve’s resolve to proceed on the path of interest rates normalization. This week the FOMC raised the fed funds target rate to by a quarter percent point to 1%-to-1.25%. The Fed conceded that inflation on a yoy basis is likely to remain below 2% in the near term, but it reaffirms its view that prices will finally rise to the Fed’s 2% target over the medium term. The Fed also announced the operational plan for the reduction of the balance sheet, aiming at implementing the plan later this year. We think that the official announce-ment might occur at the September FOMC, with operations starting by the end of the year. At first the Fed will limit the amount of assets that it will let run off the balance sheet based on incrementally rising caps, with different amounts for Treasuries and mortgage-backed securities. Based on our calculations (see Exhibit 1), the caps should become de facto ineffective in about 9 months, and we anticipate that by late 2018 re-investment of the asset principal will stop altogether, and the shrinkage of the balance sheet will accelerate. The Fed has apparently succeeded in making the plan fully trans-parent, as it was its intention. It remains to be seen if the plan will also be as market neutral as the Fed hopes – we worry that, when reinvestments stop, the tightening in financial conditions might be more severe than currently priced by financial markets. All in all, the Fed conveyed a relatively optimistic tone about the economic outlook, and the statement might be interpreted as showing a slight hawkish bias, despite some significant adjustment in the revised FOMC economic projections. To this regard, the most notable change was a drop in the median expectations for inflation based per-sonal consumption deflator, which is now seen at 1.6% for the year vs. the 1.9% in the March projections. And yet, the Fed doesn’t show much concern for the latest inflation readings. Consume prices slowed further in May. The overall index slipped by 0.1% for the month to 1.9% on a yoy basis, driven by a drop in gasoline prices. Excluding volatile items as energy and food, “core” prices were also soft, with surprisingly broad-based declines in the cost of vehicles, appliances, apparel, prescription drugs, televisions.

Adolfo Laurenti Global Economist [email protected] +41 58 317 30 86

As widely anticipated, the Fed raised the target rate by 25bp

The FOMC detailed its plans to start reduc-ing the balance sheet later this year

The optimism of the Fed brushes aside worries about the deceleration in consumer prices

Exhibit 1: Expected shrinkage of the Fed’s balance sheet ($ bn) Exhibit 2: Muted market reaction to the Fed’s hike

Source: Datastream, J. Safra Sarasin, 16.06.2017 Source: Datastream, J. Safra Sarasin, 16.06.2017

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On a yoy basis, core prices decelerated from 1.9% in April to 1.7% in May, marking the fourth consecutive month of slowdown. The Fed’s conviction notwithstanding, it is hard to entirely attribute the slowdown in core prices to temporary factors or to the base-effect. In fact, markets appeared to be less sanguine than the Fed about the trend in inflation: on the CPI announcement, yields on the 10-year Treasury Notes dipped to 2.10%, and the 2-year Note showed little response to the Fed’s hike (see Exhibit 2). Going forward, we expect the price environment to remain soft through the summer, and slowly recovering in the fall. Recent declines in the price of oil (which fell to a sev-en-month low of $44 on news of surplus stock) may also add to some further inflation weakness in June and July. We still believe that the evolution of prices should give the Fed reasons to pause in September and assess the impact of the three hikes that have been delivered in the six months from December 2016. The focus on the balance sheet policy could be the opportunity for delay additional action on the rates front until later this year.

Markets seems to think that the slowdown in core inflation might not be just tempo-rary

Inflation might stay muted through the summer

Despite its hawkishness, the Fed might have the opportunity to pause and reas-sess in September



European Macro

The German export bubble – a cultural explanation

Germany faces an unprecedented level of criticism from the US president for its trade surplus. Being called “very bad on trade” is counter-intuitive for most Ger-mans. They take almost as much pride in the title of “world export champion” as they do in being world football champion. For many, the trade surplus reflects not only the quality of German products but also having made the right decisions to re-form the labour market and not to indulge in excessive wage growth, consumption or idleness. Hence, what seems to be a mercantilist obsession also reflects cul-tural traits towards saving and working that are unlikely to change easily and are thus important to understand.

Intuitively, German households agree with Finance Minister Wolfgang Schäuble not to increase spending or to cut taxes significantly despite the extraordinary tax revenues of the past years. There may be good economic reasons for a “black zero,” as the bal-anced budget is known, and against debt-financed consumption. However, ethical and cultural factors also play a role in Germany. Surpluses are perceived as good, deficits are seen as bad. Many Germans would also agree with Schäuble’s recent statement in an FAZ-interview in May that Martin Luther most probably would have liked the “black zero.” Small linguistic differences testify to this: the German words “Schuld” and “Schulden” are much more similar and heavy than the English equivalents “guilt” and “debt,” or “trespass” that is used in The Lord’s Prayer; where German also emphasiz-es “Schuld” and “Schuldigen” and French and Spanish uses “offenses“ and “ofensas“ respectively. “Saving” (“Sparen”) in German has a positive connotation in the normative sense. Sav-ing is more than an economic quantity or the difference between income and expendi-ture. It is a virtue as people save by foregoing consumption. If this is not promoted by the state, it must at least be rewarded by the market. Negative deposit interest rates fly in the face of Germans’ sense of justice. Small wonder it soon acquired the pejora-tive label "penalty rate." German populists exploit this when criticizing the ECB, even though they should realize that central banks neither punish nor reward. They try to balance the economy by reducing key interest rates when they want to boost invest-ments and consumption. Such incentives meet with little response in Germany. Their private consumption, imports and wage growth remain below levels that would support an inflation rate compatible with the ECB’s inflation aim – prolonging the much-criticized low interest period. No surprise that German is also the only language that knows the expression “Angst”-Sparen. Interestingly, the strong propensity to save of German speaking households does not stop at the border. A recent working paper by Benjamin Guin of the University of St. Gallen shows that households located in the German-speaking part of Switzerland are more than 11 percentage points more likely to save than similar households in the French-speaking part. Hence, it may not be a coin-cidence that France’s trade deficit of EUR 57 billion is the lowest and Germany‘s sur-plus of EUR 257 billion is the highest in the EU. There is little discussion in Germany that any imbalance between savings supply and credit demand on this scale would beat down market interest rates. At some point, Germans may come to understand that a current account surplus of 8% of GDP and resulting foreign assets of now more than EUR 8 trillion or 2.5 times GDP are not in their own interests either. It might be true that an aging society needs to fall

Dr. Karsten Junius, CFA Chief Economist [email protected] +41 58 317 32 79

Would Martin Luther really have liked the “black zero”?

Saving is often considered to be a virtue and interest rates its reward – no surprise that many Germans do not understand the concept of negative deposit rates

Foreign savings only make sense if they can be transformed into future consump-tion



back on its foreign savings at some point. But in order for this to happen, foreign debt-ors must run up trade surpluses. Germany knows from Greece’s example how difficult this is both economically and politically. Without a flexible exchange rate to its major trading partners and borrowers, Germany must rely on them discovering ‘the virtue of thriftiness’ themselves. The monetary union lacks other market-based or effective insti-tutional means to force them. Before the financial crisis, private capital flows financed European countries’ current account deficits with Germany; since then it increasingly is the public sector including its central banks. At some point, Germans may realize that the success and the size of their export sector depend on their willingness to extend public money at taxpayers’ risk to its foreign creditors. Economic historians may one day even write about the credit financed “German export bubble” just as they see the pre-2008 Spanish con-struction sector right now. President Trump’s complaints about the overabundance of German cars on America’s streets may not make much sense, but neither does Ger-many’s indifference to its own macro-economic imbalances. It would be helpful for fu-ture discussions between the two trading partners to obtain a better understanding of the cultural values of the counterpart – in addition to critically reflecting on their own ones.

The size of the German export would be unsustainable without the public support and the implicit financing to foreign credi-tors the Target 2 system provides

Exhibit 1: High German savings rate despite low interest rates Exhibit 2: Germany current account surplus still at very high levels


Exhibit 3: National Target 2 balances vs. the Eurosystem (bln eur) Exhibit 4: German net international investment position (NIIP)


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US Equity Strategy

No material risks as Fed is draining the liquidity swamp

The Fed’s tightening path is unlikely to cause major headaches for equity investors in 2017

The trend in the 2 year US bond yield confirms the medium-term uptrend in US equities.

However we measure a decline of macroeconomic liquidity, mainly due to slacker loan growth, a flatter yield curves, and the beginning of Fed bal-ance sheet contraction.

A period of weakness in late June / early July is likely for US equities, which would provide a buying opportunity.

The Fed’s June rate hike is likely to be followed by another before year-end. It has been our contention this year that measured tightening steps would not create significant headwinds for US equities. There are two key reasons for this. The ab-solute level of short rates remains low. There is also a positive relationship be-tween the short end of the yield curve (2-year bond yield) and US equities (see Exhibit 1). As long as bond and equity investors share the view that higher 2-year rates reflect stable growth prospects in the US, we do not expect Fed monetary policy to hurt equities in 2017.

The recent upside breakouts in the Dow Jones Industrials and NYSE Major Market indices show that US investors are not unduly concerned with recent monetary policy trends (see Exhibit 2). We still observe strength in US industrials, insur-ance, healthcare, and utilities, while energy stocks performed poorly and we ex-pect more rotation out of technology stocks in coming weeks.

We monitor a broad number of sentiment, flow and macroeconomic liquidity indi-cators to assess the underlying health of the US stock market. Liquidity matters over the medium-term. Our key measures of macroeconomic liquidity are as fol-lows:

Excess liquidity (M3 less industrial production growth)

Yield curve shape (US 10 year bond yield minus 3M T-Bill rate)

Changes in yield curve shape

Cédric Spahr, CFA Equity Strategist [email protected] +41 58 317 31 28

US equities can keep moving higher with measured rate hikes in 2017

Macroeconomic liquidity matters – here is how we measure it

Exhibit 1: The 2-year US Treasury yield has moved since 2015 inlockstep with the S&P 500, confirming the trend in US equities.

Exhibit 2: US blue chips (NYSE Major Market index) broke out tonew highs in early June, a sign of medium-term strength


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While almost every analyst would agree that the quantity of money and credit made available in the financial system does eventually influence the valuation of equities, not to mention other financial assets, the relationship between macroeconomic liquidity and asset prices is finicky to gauge and obviously oscillates over time. It is also con-tingent upon other factors such as macroeconomic trends and sentiment. We apply li-quidity analysis as one tool among several others in our toolbox. Our composite macro liquidity indicator for the US (see Exhibit 3) declined in early 2016 and rebounded in the second half of 2016, a move which was broadly consistent with US equities gains. It drifted lower since January 2017, without having much of an impact on US equities, as improving economic growth and reform hopes stoked gains in US equities. A pattern of shrinking liquidity — mostly in terms of slowing loan growth and Fed balance sheet contraction — might matter more if US growth momentum peaks, as recent PMI readings suggest. That being said, we do not expect US growth to decelerate in the second half of 2017 and this is expected to fuel earnings growth and support the US stock market. Our work on market breadth (net number of advancing stocks), volumes and flows indi-cate that market internals have lost some momentum (see Exhibit 4), yet do not her-ald a general shift in trend. Our short-term S&P 500 sentiment indicator flags a diver-gence between the recent upward acceleration and sentiment. We reiterate our expec-tation of a period of weakness in late June and July, which would probably take the S&P 500 down to a range between 2’330 and 2’360. We would buy this sort of cor-rection, anticipating the S&P 500 to bottom during the summer and afterwards to move higher to reach 2’500 by year-end.

Liquidity analysis is one tool among others

US macro liquidity in declining, yet earn-ings growth is resilient

Short-term sentiment reveals some vulner-ability; we advise to buy weakness during the summer

Exhibit 3: Our composite US macro liquidity indicator is declining.This warrants a closer look at macro and sentiment indicators.

Exhibit 4: Volume trends and market breadth are not a cause ofserious concern, yet we expect some summer weakness.


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Emerging Markets

Brazil: more corruption, nothing new

Brazil’s Supreme Electoral Court rules in favour of Temer, dismissing accusation of illegal funding during his political campaign

New allegations on corruption will be investigated; normally these processes take years

We believe these new old news would lose prominence as the Brazilian econo-mies improves

Last week, Brazil’s Supreme Electoral Court (TSE) concluded on the trial involving al-leged funding irregularities of the Rousseff-Temer formula during the 2014 presidential elections in Brazil. The seven-judge court ruled in favour of Temer by 4 to 3 votes. This improves the already precarious political situation of the current Brazilian President. However, one serious lawsuit is out of the way but a potential new one lingers. A tape revealing a conversation between the president and a prominent businessman abstractly suggests the president took bribes in exchange for political favours. We be-lieve the tape conversation to be too abstract and won’t result in criminal charges to the president. The Supreme Court opened an investigation on President Temer for po-tential obstruction of justice, corruption and participation in a criminal organization. If the charges are accepted, the Supreme Court can only trial the president with the au-thorization of the Lower House (a qualified two-thirds majority). Overall, we see two consequences from this new scenario: (1) lower political support to Temer as opposition would try profit from the new alleged corruption scandal and, (2) less chances that Temer leaves power before next presidential elections, as the new investigation would take time. In regards to the reform agenda, we are not com-pletely sure whether an immediate approval of fiscal reforms is so urgent, especially if the economy improves and fiscal revenues increase with a positive economic cycle. We believe the situation is better than a couple of years ago: (1) economic activity is more stable, (2) the current account is not an issue anymore, (3) the government has come clean with its off-balance sheet funding and (4) rapid falling inflation is making funding cheaper. Corruptions allegations on members of the Brazilian congress have been prominent in recent years; thus we fail to see why the situation is so different this time. We believe the recent selloff provides better entry levels to buy and hold in-vestors.

Emiliano Surballe Emerging Market Credit Strategist [email protected] +41 58 317 35 64

The Supreme Electoral Court rules in favour of Temer

A new investigation on corruption might not succeed unless there is new evidence

We see this as a bump on the road rather than a game changer



Economic Calendar

Week of 12/06 – 16/06/2017

Country Time Item Date Unit Consensus

Forecast Prev.

Monday, 19.06.2017 CH 10:00 Total Sight Deposits Jun 16 CHF bn - 576.4 10:00 Domestic Sight Deposits Jun 16 CHF bn - 476.2EMU 11:00 Construction Output Apr yoy - +3.6%

Tuesday, 20.06.2017 CH 07:45 SECO June 2017 Economic Forecasts

Wednesday, 21.06.2017 CH 09:00 M3 Money Supply May yoy - +3.0%US 13:00 MBA Mortgage Applications Jun 16 % - 2.8%

Thursday, 22.06.2017 CH 08:00 Exports Real May mom - -2.5% 08:00 Imports Real May mom - +2.6%EMU 16:00 Consumer Confidence Jun index - -3.30US 14:30 Continuing Claims Jun 10 1 000 - - 15:00 FHFA House Price Index Apr mom - +0.6% 15:45 Economic Expectations Jun index - 49.5

Friday, 23.06.2017 CH 09:00 KOF Institute Summer Economic Fore-

cast index - -

DE 09:30 PMI Manufacturing, prel. Jun index - 59.5EMU 10:00 PMI Services, prel. Jun index - 56.3DE 09:30 PMI Services, prel. Jun index - 55.4US 15:45 PMI Manufacturing, prel. Jun index - 52.7 15:45 PMI Services, prel. Jun index - 53.6 16:00 New Home Sales May 1 000 600 569

Source: Bloomberg, J. Safra Sarasin



Market Performance

Global Markets in Local Currencies

Government Bonds Current value Δ 1W Δ YTD TR YTD in %

Swiss Eidgenosse 10 year (%) -0.15 2 4 0.3

German Bund 10 year (%) 0.31 4 10 -0.1

UK Gilt 10 year (%) 1.04 4 -20 2.4

US Treasury 10 year (%) 2.17 -3 -27 3.4

French OAT - Bund, spread (bp) 35 -4 -13

Italian BTP - Bund, spread (bp) 167 -16 6

Spread over govt bonds

Change in credit spread Credit in-

dex

Credit Markets (bp) Δ 1W Δ YTD TR YTD in %

US Investment grade corp. bonds 60 0 7 4.1

EU Investment grade corp. bonds 57 2 16 0.8

US High yield bonds 328 -1 27 5.2

EU High yield bonds 238 3 50 3.5

Stock Markets Level P/E ratio 1W TR in % TR YTD in %

SMI - Switzerland 8'943 17.9 0.5 11.1

DAX - Germany 12'749 14.0 -0.2 10.5

MIB - Italy 20'927 14.5 -0.9 10.5

IBEX - Spain 10'753 15.0 -2.0 16.3

DJ Euro Stoxx 50 - Eurozone 3'546 15.1 -1.0 9.9

FTSE 100 - UK 7'473 15.1 -0.4 6.2

S&P 500 - USA 2'432 18.7 0.0 9.7

Nasdaq 100 - USA 5'701 21.2 -3.1 17.9

Nikkei 225 - Japan 19'943 17.4 -0.4 4.6

MSCI Emerging Markets 1'004 12.6 -1.4 17.3

Forex - Crossrates Level 3M implied volatility

1W in % YTD in %

USD-CHF 0.97 6.4 0.5 -4.4

EUR-CHF 1.09 4.0 0.2 1.5

GBP-CHF 1.24 7.6 0.7 -1.1

EUR-USD 1.12 6.4 -0.2 6.2

GBP-USD 1.28 7.9 0.2 3.5

USD-JPY 111.3 8.0 0.9 -4.8

EUR-GBP 0.87 7.8 -0.4 2.5

EUR-SEK 9.75 5.2 -0.1 1.8

EUR-NOK 9.47 6.4 -0.5 4.3

Commodities Level 3M realised

volatility 1W in % YTD in %

CRB Commodity Index 443 8.2 7.2 4.7

Brent crude oil - USD / barrel 47 28.2 -2.1 -16.0

Gold bullion - USD / Troy ounce 1'256 11.0 -0.9 9.4

Source: J. Safra Sarasin, Bloomberg

Contacts Dr. Karsten Junius, CFA Chief Economist [email protected] +41 58 317 32 79 Adolfo Laurenti Global Economist [email protected] +41 58 317 30 86 Ursina Kubli Forex Strategist [email protected] +41 58 317 32 80 Cédric Spahr, CFA Equity Strategist [email protected] +41 58 317 31 28 Dr. Florian Weber, CFA Fixed Income Strategist [email protected] +41 58 317 31 14 Emiliano Surballe, CFA Emerging Market Credit Strategist [email protected] +41 58 317 35 64 Kunal Singh, CFA Emerging Market Credit Strategist [email protected] +41 58 317 31 21 Thilina Hewage, CFA Emerging Market Credit Strategist [email protected] +65 6230 66 61


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Fed is draining the liquidity swamp, sees no alligators · 2019-09-07 · Cross-Asset Weekly 16 June 2017 1 | Cross-Asset Weekly Fed is draining the liquidity swamp, sees no alligators