Warning Signs ?

“May impair your ability to operate machinery” ? ???????? Green Day, Warning

Written by Neil Staines, 1st November 2024.

Last week, we discussed the evolution of ECB speaker narratives. Set against the IMF meetings in Washington, a broad subsection of the decision makers at the ECB gave differing summaries of the policy backdrop and even of the risks. We highlighted the divergence between Governing Council members over what, at the time, was a debate over 25bps or 50bps. On balance, we argued that a more cautious pace of rate cuts was more likely from the ECB - in line with the sentiment of Chief Economist Lane, that “we do not see a dramatic weakening of the economy”. Inconsistent in our view with an accelerated (or dramatic) increment of rate cuts.

More importantly perhaps, we also argued that, despite what we would consider to be an updated ECB narrative inconsistent with an accelerated pace of normalisation, markets continued to price an accelerated rate cut pace. Conversely, in the US, markets had priced out rate cuts, essentially, although not exclusively, on the back of a stronger-than-expected September payroll number - a payroll number for which there are debates over the seasonal adjustments and survey response rates, within a series where revisions as a percentage of the nominal (initially reported) figure are already very high.?

This weeks payroll data, for October, reverses what we argued was a seasonal adjustment-driven overstatement of the data in September. The US added just 12,000 jobs in October, and the previous two monthly payroll figures were revised lower by 112,000!

Extrapolated divergence?

We ultimately argued that, from our perspective, the extrapolated divergence expectations between the US and Europe (but also, to a degree, the rest of the world) are unsustainable. In fact, we expect markets are too negative on European growth prospects and too positive on US equivalents. Even the IMF global growth revisions this week (which upgraded 2025 US growth and downgraded eurozone 2025 growth) show growth convergence in 2025, not divergence.

Furthermore, while we expect US growth will be supported by continued disinflation and lower interest rates, we continue to see growth below the equilibrium level (somewhere around 2.2% in the short term, before drifting lower in the medium term, according to Fed assumptions). That soft landing configuration puts the dollar in the trough of the dollar smile. If, as we assume, the combination of lower rates, China stimulus and RRF / Next Generation EU funding implementation prove supportive for the eurozone (and the rest of the world) growth, then the dollar will likely struggle. At the margin, this has happened over the week (DXY has rolled over modestly from recent highs).

Volatility Premium?

Over recent weeks, another of the more dominant arguments we have made is the likelihood of higher baseline volatility as geopolitical, macroeconomic, fiscal and monetary uncertainties increase risk and volatility premia. Indeed, the US Presidential Election now carries a significant day weight or event risk premium in the volatility (or options) markets, and baseline vols remain high in surrounding tenors.

Over recent weeks, markets have been keen to price in a higher probability of a Trump Presidency and thus ‘Trump trades’, predominantly focussed on the prospect of tariff imposition and, by extension, expectations of higher inflation - higher rates, steeper curve, stronger dollar. It is unclear to us that tariffs will be used in the way markets are anticipating, nor that the anticipated inflationary impact is certain.?

Indeed, the previous episode of China tariffs from the Trump administration (as one of the sell-side analysts pointed out this week) saw the price impact mostly absorbed by retailers in the form of lower margins, with the ultimate impact coming from lower volumes in the medium term. Despite this, the market remains very confident Trump = higher rates, a steeper curve, and a stronger dollar. We are not so convinced.

Risk warning?

While we have been clear over recent months that our core macroeconomic configuration argues for continued disinflation and growth moderation in the US and that this is consistent with a soft landing in the US (and by extension, consistent with higher equities, higher bonds and a weaker dollar). More recently, there have been signs that the risks may be starting to err to the downside in equities.

While earnings for Q3 have been broadly in line with expectations, there has been a more pronounced concern about the forward demand trajectory in guidance and reporting. Furthermore, while the Q3 earnings growth expectations were a relatively low bar at +4% y/y - Q4 expectations are currently much higher. AI capacity demand continues to positively dominate headlines, but increasingly it is declining demand expectations that are dominating sentiment.

We continue to see the macro backdrop as supportive for risk assets in the medium term with falling inflation and a substantial support from the lowering of currently restrictive policy rates to cushion the blow… but question marks are starting to arise about the consumer. To quote Green Day, it is not yet clear if this is a “public service announcement”, or “only a test”.

What is happening next week?

For professional investors only

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