Risk Rally Ahead of fundamentals Short of a Bubble

With several risk events behind us; and several queued up immediately ahead, it is the right time to take fresh guard. Following are the key takeaways from the recent events.

  1. French Election (1st Round): This time around the opinion polls got it right (for a change) and the two candidates who were likely to progress to the second round (Emmanuel Macron and Marine Le Pen) managed to do so. Immediately after the exit polls came out, the risk premium dropped significantly across asset classes, even though the second round is yet to take place (on 7th May). This was evident from the way the Euro, European stock indices, French OAT- German Bund spreads moved and EUR/USD vols moved (Refer Appendix). The market participants would have been relieved that two anti-European candidates did not make it to the second round (Le Pen and Melanchon). This greatly reduces the chance of a Frexit. Most opinion polls are pointing towards an easy win for centrist Macron (60% votes). The only thing that could possibly work out in Le Pen’s favor would be a low voter turnout. Markets are not pricing in a Le Pen victory at this juncture. I do not expect a significant move up in Euro purely on account of Macron winning the second round as it is already priced in to a great extent.

    EUR/USD 1M ATMS Vols collapse post 1st Round results
  2. Landmark 100 days: Trump completed 100 days in the White house without any major legislative victory despite Republicans being in control of both the House and the Senate. On the contrary, the Trump administration barely managed to avert a federal government shutdown.
    The current US tax system is thirty years old and there are certain aspects of it that require an overhaul in order to ensure competitiveness. The details of the tax plan that the Trump administration outlines and the political strings its pulls to push the plan through the Congress will be keenly watched by the market. The passage of the healthcare bill in the house is a positive which could possibly clear way for bigger reforms ahead.

    The US has the highest marginal corporate tax rate (35%) among OECD nations. It is one of only 7 out of 34 OECD members that taxes corporations based on worldwide income instead of territorial income. As a result, US companies currently hold more than USD 3Tn in capital overseas. Many US companies do not repatriate overseas earnings in order to avoid paying high US taxes. It is also the only OECD member that does not have a Value Added Tax (VAT). While US has an income tax based model, most of its major trading partners have a VAT based tax system. Under WTO rules, whenever a foreign company manufactures domestically and exports, it receives a rebate on the VAT it has paid. As US state sales taxes are much lower than the VAT of trading partners, absence of VAT in US translates into an implicit export subsidy for foreign exporters.

    Therefore in the tax reform plan to be tabled by Trump Administration in the second week of May, we may see:

    1. Announcement of lower corporate tax rate
    2. Move to a territorial system of taxation: This would partly offset the revenue loss due to lower corporate tax rate as corporates would start repatriating earnings from abroad
    3. Some form of border adjustment tax (BAT)

    Given the stiff opposition to BAT from US retailers and considering the market disrupting consequences of BAT (In the form of USD appreciation which in turn would have a negative wealth effect as it would lower the value of US holdings of foreign assets and overseas profits of US corporations), it is possible that the plan may propose a VAT instead of BAT. A VAT would be WTO compliant. It would level the playing field between US and foreign goods. It can be revenue neutral and can generate as much revenue as a 20% tax on imports. This would make reduction in corporate tax rate possible.

    If the above plan materializes we may see a significantly stronger US Dollar, higher real US interest rates and higher potential US GDP.

  3. ECB April meeting: The ECB governing council kept rates unchanged, as expected and maintained its dovish, accommodative tone. It highlighted the possibility of asset purchase program continuing beyond December 2017 if economic situation warranted. It acknowledged that though downside risks to inflation were dissipating, downside risks to growth were still prevalent.

    Spread Between French and German Bonds Collapse post 1st Round French election result
  4. UK Elections: Announcement of early elections scheduled for 8th June did take the market by surprise. However the rally in Sterling had more to do with positioning, short covering and stop losses getting taken out. A labour party victory would reduce chances of a hard Brexit. Early polls however indicate that the Conservatives have a lead. A Tory victory would thus hardly alter status quo and the Sterling could correct back to 1.26-1.27 levels.
  5. May FOMC meet: The US Federal Reserve kept rates unchanged. Fed Fund futures now indicate a 90% probability of a hike in June. Markets are currently pricing in 2 more hikes this year. The Federal reserve acknowledged the strength in the labor market and maintained that pace of rate hikes would be data dependent.

    April NFP came in at 211k against expectations of 190k and unemployment rate further reduced to 4.4%. The average hourly earnings grew 2.5% YoY against expectations of 2.7%. The US Dollar and the US yields did not react to the strong headline number due to disappointing growth in average hourly earnings.

    Looking forward we have the French elections (2nd round), unveiling of US tax plan, UK elections.

    The 2nd round of the French elections is not expected to throw up any surprises. The UK elections too are unlikely to alter the status quo. All eyes would therefore be on the tax plan that the Trump administration outlines. An aggressive tax reform plan coupled with balance sheet trimming by the US Federal Reserve could push US yields higher, which would be negative for EMs and risk in general.

    It seems at this point as though the entire rally in EM and DM is fuelled by liquidity rather than growth expectations. Lack of participation from commodities and commodity currencies is supportive of this. Though it appears that the valuations could have run ahead of fundamentals, it would be premature to call it a bubble. It would be important to track changing correlations (Broad USD strength and weakness V/s Risk on / Risk off theme). In case of broad USD strength or weakness, the USD strengthens or weakens against EM as well as DM currencies where as in case of risk on/risk off moves USD strengthens against funding currencies and weakens against currencies offering a higher carry (typically EM currencies)

    On the domestic front, though FPI inflows into equities showed signs of easing in April (USD 400 Mn), FPIs continued to pour money into debt (USD 2.6 Bn). Due to superior fundamentals, India is likely to be the biggest beneficiary of inflows out of all EM economies in case of a risk on scenario. Progress of Monsoon, pick up in rural demand, pick up in investment demand, corporate earnings, pick up in credit off take would be the key factors to watch out for. As far as the Rupee is concerned, 63.80-63.90 appears to be a good support. A break and close above 64.50 would qualify as a medium term reversal. It would be interesting to see if the May seasonality plays out for broader Dollar index as well as USD/INR. May is typically a month when Rupee tends to depreciate.

    USD/INR heat map indicating that Rupee tends to depreciate in the months of May, August and November.

    The Bloomberg Dollar index (BBDXY) has risen in May on 10 out of past 12 occasions.

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