Friday, 20th of September 2019
“The supreme art of war is to subdue the enemy without fighting.”
– Sun Tzu
________________________________________
Stock markets were flat this week, despite the US easing monetary policy and tensions in the Persian Gulf rising to fever pitch. On Wednesday the Federal Reserve cut the US policy rate by 25bps in an attempt to assuage fears that the bank was being complacent about the many risks to global growth, including the simmering US-China trade war, the economic weakness in the Eurozone and China, and the slow-motion collapse of the Iran nuclear deal. Going forward, the central bank will target an Effective Federal Funds Rate (i.e., the rate at which commercial banks and other depository institutions can lend to one another, usually overnight) of 1.75-2.00%, some 50bps below the recent cycle peak.
The magnitude of the rate cut was well-telegraphed and thus in line with market expectations. However, many investors believed that the Fed would also adopt dovish forward guidance and signal further cuts ahead, particularly after worrying moves in the repo market on Monday and attacks on Saudi oil fields over the weekend. Indeed, the pricing of interest rate futures on the morning of the Federal Open Market Committee (FOMC) meeting implied that the market’s central forecast was for a further 50bps of cuts before the end of 2020. In his statement, however, Fed Chair Jerome Powell was upbeat about the US economy and reiterated his commitment to a ‘wait-and-see’ approach to monetary policy in the face of global uncertainty. This was a clear rejection of the pre-emptive easing of policy that the US President has so noisily demanded, and the Donald was quick to slam the Fed’s decision (on Twitter, of course). Several FOMC members also dissented from the majority position. Two policymakers argued that rates should be left unchanged given that inflation is close to target and most US economic data remains strong, and one argued for a 50bps cut to get ahead of the negative effects of ongoing trade uncertainty. This split in the Fed’s rate-setting committee reflects the challenge of navigating an environment where US economic data is solid but political decisions and events over which the Fed has no control present binary outcomes for growth. Powell probably struck the right balance with this latest rate decision even if the fundamental picture is more robust than would normally warrant policy easing. (Moreover, if he had not cut rates you can be sure that markets would have panicked.) In the end, the stock market impact of this ‘hawkish cut’ was fairly neutral as the Fed’s rosy outlook encouraged the market to claw back most of the losses suffered as shifting interest rate expectations caused an initial repricing.
In other monetary news, a market anomaly occurred this week that required the Fed to intervene in a manner not seen since the depths of the Global Financial Crisis. On Monday, the cash available to US banks for their overnight funding needs suddenly all but disappeared and rates on some money market instruments rose as high as 10%. This is far higher than where the Fed wants to maintain short-end rates and, embarrassingly, the move caused the overall Fed Funds Rate to climb above the central bank’s then 2.00-2.25% target range. The stress started in the repo market, through which $2tn of funds flow every day but which rarely makes headlines. Repos, or repurchase agreements, are short-term loans from money market mutual funds used by banks and hedge funds to finance everyday activities like bond trading and brokerage. The repo rate is typically very low given the minimal duration and credit risk involved in this sort of overnight lending. Thus, a high repo rate suggests something has gone wrong… indeed the last time the repo market exhibited significant stress was when banks were facing massive funding shortages during the 2008 credit crunch. In response to the money market stress this week, the Fed has had to inject $75bn of funding on three consecutive days and has promised further measures if the problem returns. Despite the apparently ominous signal of a surging repo rate gives, we do not recommend that you sell everything and barricade the doors and windows, yet: this funding squeeze looks very different from the last. What appears to have happened is that two coincident events caused a sudden shortage of dollars in the system, which is already starved of cash because of the long period in which QE was in reverse: (1) quarterly tax bills are due, forcing corporates to sell their money market positions to generate cash; (2) $78bn of US Treasury notes and bonds sold last week had to be settled by investors, further reducing the supply of money market funds. Neither factor is a cause for concern, but the fact that such pedestrian events can shake the market suggests that the Fed balance sheet reduction may have gone too far too fast.
The final topic for this week’s newsletter is the brazen assault on Saudi Arabia’s oil infrastructure, which took place over the weekend. The sophisticated and targeted attacks, which included pinpoint strikes by both drones and cruise missiles, took out half of the Kingdom’s oil production in a single day. Iran or its regional proxies were almost certainly behind the attack, which is consistent with Iran’s strategy of aggressive brinksmanship in international relations. By ratcheting up tensions in the Gulf, Iran hopes to intimidate its regional rivals, deter the US from closing the strait of Hormuz, and prevent a strike on Iran or its nuclear facilities so enrichment can proceed unabated. Iran can then build up negotiating leverage before any possible talks with America and the growing stockpiles of enriched uranium can be used to barter for sanctions relief in the event that talks begin in earnest. If not, then they may one day provide Iran with the ultimate security of deliverable nuclear weapons. We suspect that the ousting of Trump’s hawkish ex-National Security Advisor, John Bolton, has emboldened Iran to push back harder against the US containment strategy. Although the Houthi rebels in Yemen have claimed that they were behind the attack, their rag-tag army does not have the hardware or skills to carry it out without direct assistance from Iran. Everyone knows this and Iranian denials are simply a propaganda tool to strengthen internal support and provide a face-saving mechanism for leaders in rival countries to point to while ducking a military response. However, Saudi Arabia has chosen to name Iran as the culprit – something it has often skirted in the past – and now appears to be building a coalition of support before acting. Conflict has never been closer. That said, we strongly doubt that the Trump Administration is prepared for a significant military campaign in the Middle East and Saudi Arabia could never defeat Iran without Uncle Sam in tow. Any response is therefore likely to fall short of all-out war. Expect this dispute to rumble on and for the oil price to remain supported until a resolution is found.
In March's news roundup, we look at some of the big deals and trends in the London office market, which has seen a very active month driven by the return of private equity (PE) buyers seeking to take advantage of discounted pricing. We highlight some of the biggest deals and what these mean for the capital.
As families expand, diverse perspectives, voices, and expectations emerge. Each generation brings unique dynamics and values, shaping the family business's future. We offer three key considerations for grooming future leaders within the family business context.
In this market update, we discuss the strength of the equity rally this year, the end of ultra-easy monetary exceptionalism in Japan, and the investment case for gold.