U.K. And U.S. Economic Similarities Are Striking

U.K. and U.S. economies are at a similar stage of the cycle, but terminal rates are very different.


The acceleration in U.K. wage growth amid low unemployment and dismal productivity growth reminds us of another economy. The similarities with the U.S. are striking, extending to the current level of real GDP growth, consumer spending, consumer confidence, the rate of home price appreciation, and employment growth.

These similarities make one wonder why the OIS curve in the U.K. is so much lower than in the U.S. The BoE’s lift-off date discounted in the market is not far behind that in the U.S. However, the BoE is expected to tighten at a slower pace than the Fed, and to a much lower terminal rate. In 2020, the central bank policy rate is expected to be about a percentage point lower in the U.K. than in the U.S. After adjusting for expected inflation, the gap between the policy rates is expected to be even greater in real terms. The BoE’s real Bank Rate is expected to still be negative in 2030! Our global fixed income strategists see no reason for the long-term equilibrium rates in these two economies to be that far apart.


On a shorter-term horizon, expectations for depressed real rates versus the U.S. over the next few years likely reflect the view that the U.K. economy is much more globally exposed and integrated with the euro area than the U.S. This means that Governor Carney will be more constrained in raising rates, since a stronger pound would undermine the UK economy a lot more than a stronger dollar would damage the U.S. The potential risk of economic fallout in the broader Eurozone if Greece eventually exits the currency union also hangs over the U.K.

Moreover, PM Cameron’s latest budget calls for years of painful belt-tightening beginning in FY2016, creating a strong headwind for growth. Please see the next Insight, (Part II) U.K.: Fiscal And Monetary Policies.

Strategy Outlook Third Quarter 2015

Our Global Investment Strategy service recently published their Strategy Outlook for Q3 2015.

The quarterly report highlights the following points:

  • Global growth should pick up in the second half of the year, but will remain too low to counteract the persistent shortfall in demand facing most major economies.
  • For now, contagion to the rest of Europe from the Greek crisis is likely to be contained. The longer-term viability of the common currency, however, is fraught with doubt.
  • Investors should remain modestly overweight global equities, stay neutral bonds and spread product, and underweight cash.
  • Within the equity portfolio, overweight the euro area, Japan, and China; underweight most other emerging markets and the U.S.
  • The dollar is likely to strengthen modestly against the euro, sterling, and most EM currencies. The yen has reached a bottom.
  • Oil prices have further to fall. Chinese stimulus could help metals in the near term, but the longer-term outlook is grim. Gold is due for a bounce.

Clients interested in reading the full Report can access it here: Strategy Outlook Third Quarter 2015.

China: The Economic Fallout From The Stock Selloff

It is premature to tally the economic damage from the equity market selloff while it is not yet clear that the market riot is over. However, based on what has happened so far, our China strategists expect the economic fallout is muted.


  • The stock market turbulence is not echoed in other financial assets, a sign that the sharp selloff in A shares is corrective in nature rather than driven by fundamental economic issues. The corporate bond market has remained stable, interbank liquidity has in fact improved, and there is no abnormal move in the RMB exchange rate in either the onshore or offshore market. The CDS spread of Chinese sovereigns remains well behaved.
  • Aggressive margin accounts and equity leverage are the root cause of the market riot, but the financial sector is likely to stay immune. Anecdotal evidence suggests that the majority of margin lending provided by banks and brokers are accompanied by healthy amounts of collateral, and the leveraged positions provided by “shadow institutions” such as Internet finance companies and private networks strictly follow “stop loss” instructions. Investors with leverage who are being “stopped out” have borne heavy losses, but financial institutions have not been adversely impacted.
  • The stock market crash could be a blow to consumer sentiment, but the wealth effect should be small. As a share of GDP, the A-share market’s value has dropped from over 85% in early June to about 65% currently, a much smaller drawdown than historical bear phases. In fact, even during major bear markets in the past, falling stock prices had had little impact on business activity. Furthermore, despite rising significantly since 2014, Chinese households’ exposure to the equity market is still very limited.

Bottom Line: The A-share market will likely remain unsettled for a while as policymakers try to mitigate the downward pressure generated by liquidation among margin investors. The economic impact should be limited, unless the A-share market riot continues to deepen.

Fixed Income Strategy: Implications Of Renewed Commodity Price Weakness

All eyes are on Greece at the moment, but in the background EM demand continues to lag and non-oil commodity prices are quietly softening. Metals have been particularly weak, while the rise in iron ore prices since April is beginning to look like a dead-cat bounce. Weak demand and accelerating production is beginning to take their toll on oil prices. There are several implications for fixed-income investors:


  • EM US$ Bonds: As highlighted in a recent Insight, we believe that EM sovereign and corporate bonds will eventually “catch up” with the drop in commodity prices and EM currencies. Though difficult to time, incremental commodity price weakness and/or dollar strength would turn up the heat on EM sovereign and corporate spreads.
  • High-Yield Bonds: Spreads in the U.S. energy sector would blow out again if oil prices suffer anew. Our global fixed income strategists have cut speculative-grade bonds to underweight in the major countries in anticipation of higher Fed-related bond and equity volatility. Declining oil prices provide another reason to avoid junk bonds in the U.S.
  • Linkers: Exit overweight positions in inflation protection at the long end of the curve. Our global fixed income strategists have recommended these positions in most of the major countries given our view that long-term inflation expectations are likely to mean-revert from still-depressed levels as long as output gaps continue to shrink. Holding inflation protection at the long end is risky when oil prices are falling, although the correlation between oil and 10-year and 5Y/5Y forward CPI swap rates appears to be eroding.
  • Canada: GDP contracted for the fourth month in a row in April, creating the possibility that the country could have back-to-back negative quarterly real GDP growth in the first half of the year. We warned that the Bank of Canada was overly optimistic when it claimed that the worst was over in terms of the economic fallout from lower commodity prices. Stay overweight Canada versus global hedged benchmarks.

Greece: It’s All About Debt Relief Now

Market reaction was fairly subdued following the weekend’s historic referendum that rejected the Troika’s offer. The ball is now in Greece’s court as the government must provide a new proposal. The key question is whether creditors are willing to offer meaningful debt relief.


The Greek government is willing to accept more austerity, but only in exchange for debt relief in some form. The problem is that Greece’s creditors can’t offer more than a token reduction in debt because of the moral hazard problem; other countries in the currency union may then also demand “a better deal”. On Greece’s side, the country can get maximum debt relief via default, giving it a strong incentive to hold out.

Our geopolitical strategists still estimate the probability of Grexit to be 20-30%. If Greece heads down the exit path, we believe that global markets will likely see the country as an outlier in the near term. Contagion to U.S. financial markets will likely be minor, unless the euro breaks down and sends the U.S. dollar sharply higher.

As for Peripheral sovereigns, the risk/reward balance is not very attractive at these levels. Our global bond service remains underweight the sector versus core European bond markets. Spreads have widened by about 50 basis points over the past couple of months, but they still do not offer value good enough to justify gambling that the Greek situation will come to a speedy and smooth conclusion. The government’s use of IOUs to pay its bills domestically would signal that the situation could hang over investors for another long while.

We would be tempted to buy Portuguese, Italian and Spanish bond spreads if they were to widen another 50 basis points, or if the Troika signals that it is willing to provide meaningful debt relief.

Nonetheless, we would view any purchase of Peripheral debt as a tactical trade rather than a strategic buy-and-hold. BCA’s Global Investment Strategy service argues that investors could begin to question the view that Greece is an outlier when Eurozone economic growth slows, debt/GDP ratios start to rise again and voters in the Periphery refuse more fiscal austerity. The saga continues.