Exclusives: Asia FX Momentum Strategies / USD Dominance Under COVID / EU Summit Agreement + Top Picks

EU leaders have finally concluded one of their longest ever summits with an agreement on a €750bn recovery fund, of which just over half will come in the form of grants. Caroline Grady wraps up the key details. I modelled how to improve G10 FX momentum strategies by adding Asian currencies using a range of momentum rules, while Dominique Dwor-Frecaut teamed up with Aaron Cantrell from Record Currency Management to show why the USD remains king in the post-COVID world. 

The peak dollar debate, inflation and bullish Europe also feature in our top picks this week. Russel Napier warns of inflation above 4%, while VoxEU analysis suggests inflation during COVID may be higher than CPI data suggest given the rapid change in spending patterns. We also include a list of 10 investment implications of a weak USD and Amundi on the diversification benefits of US rates, particularly for European investors.          

Enjoy!

Bilal

EU Recovery Fund Agreement To Set Tone For The Summer (1 min read) After four days of negotiations, EU27 leaders have agreed a landmark deal on a European recovery fund and the next seven-year budget. The recovery fund remains unchanged at the proposed €750bn, but with grants cut back to €390bn from the original €500bn.

(Caroline Grady | 21st July, 2020)

How Asia FX Futures Can Improve FX Momentum Strategy Performance (9 min read) G10 FX momentum strategies have delivered poor returns over the past decade. Part of this could be due to a lack of diversification; Asian FX futures could therefore add significant value to such strategies. We test a wide range of momentum trading rules and find that Asian FX futures deliver superior returns to G10 currencies

(Bilal Hafeez | 20th July, 2020)

Dollar Dominance In The Age Of COVID (8 min read) The virus has catalysed more, perhaps, than it has caused. Established trends in geopolitics, economics, financial markets, public policy, and social structure have accelerated as the disorder removes the brakes from those changes – like shaking the ketchup bottle to make gravity work faster.

(Dominique Dwor-Frecaut | Aaron Cantrell | 21st July, 2020)

Global COVID-19 Tracker – India Exceeds 40,000 New Daily Cases In the DM world, new cases in the US visibly dropped on Monday to 51,947, which is almost 26,500 lower than last week’s record of 78,289. Deaths have also been fewer, standing at 423 on Monday which is less than half compared with last week. But some states still recording increases.

(Bilal Hafeez, Stefan Posea | 21st July, 2020)

Amundi likes US fixed income, and echoes of bearish 60/40 portfolio from Man and KKR

10 Major Investment Implications (and 32 charts!) of a Weak US Dollar (Advisor Perspectives, 7 min read) Segments of the stocks market (value, small-cap, EM) where investors are currently underweight may do well in a weaker USD environment. Precious metals and real assets also tend to outperform equities during falling USD periods. Also, credit outperforms stocks, and copper also fares better than gold.

The End of the Beginning (KKR, 30 page read) They see a square root-shaped recoveryby 2021rather than a V-shaped one. KKR is bullish on real assets, including infrastructure (data centres and optical due to digitalisation growing), real estate (housing, warehouses and logistic due to e-commerce growing), gold and TIPS (upside inflation surprise). They reasoned a 60/40 portfolio would not generate significant returns going forward, which also makes them bullish real assets. [Bullish Real Assets]

Views From the Floor (Man Institute, 4 min read) Man Institute forecasts long-term negative returns of equities (using Shiller CAPE) and US bonds. The only time the outlook for both assets was simultaneously so weak was during the Great Depression, underlining that the traditional 60/40 portfolio construction could pose a challenge for investors in the future. [Bearish 60/40 Portfolio]

Why USD Fixed Income May Look Increasingly Attractive to European Investors (Amundi, 7 min read) US fixed income could provide diversification benefits to European investors. Hedging cost has also fallen from 3.64% in 2018 to 0.85% currently, and it could decline further as EU growth rebounds. [Bullish US Fixed Income]

US 2020: The COVID Election – Part II (State Street, 6 min read) State Street sees a risk of higher inflation under a Biden presidency than a Trump second term. With this backdrop, they prefer real assets such as commodities, Real Estate Investment Trusts and Treasury Inflation-Protected Securities. They also see individual equity or sector selection to be more rewarding (i.e. green industries to do favourably with regulatory pivot encouraging capex) than broad large-cap indices exposure under a Democratic policy mix.

Russel Napier on inflation, and how CPI weights could underestimate inflation during COVID

Central Banks Have Become Irrelevant (The Market, 11 min read) Scottish market strategist Russel Napier saw disinflation as the dominant theme for the past two decades but now warns investors to prepare for inflation rates of 4% and more. He alludes to rapidly growing broad money aggregates (23% in the US) and control of money supply shifting from central banks to politicians (who would need inflation to get rid of high debt levels) as the main factors. [Bullish Inflation]

If We Can Print Our Own Money Why Do We Have to Pay Taxes? (A Wealth of Common Sense, 4 min read) The former chief economist on the US Senate Budget Committee, Stephanie Kelton, underlines four reasons in her new book, The Deficit Myth: 1. If people did not earn money to pay taxes, who would carry out essential jobs or how would the government find them? 2. For wealth and income distribution purposes. 3. To discourage specific behaviours (i.e. carbon and cigarette taxes). 4. Inflation could return.

The Fed Has Better Tools Than Yield Curve Control (PIIE, 5 min read) David Wilcox believes ‘there is a better way for the Fed to use its balance-sheet capacity… it should commit to holding the overnight rate at zero at least until inflation is as high as the Fed’s 2% target and the labour market has returned to full employment. It should also commit to purchasing longer-term securities until a similar set of thresholds has been met.’ This approach would clarify the Fed’s commitment, unlike YCC.

Weighting Bias and Inflation in the Time of Covid-19: Evidence from Swiss Transaction Data (VoxEU, 10 min read) COVID inflation might have been higher during the lockdown than suggested by CPI inflation in Switzerland. Utilising high-frequency and alternative data sources (i.e. debit card transactions) on both prices and consumer spending might be a better indicator of inflation. This is mainly because CPI basket weights fail to capture sudden changes in consumer expenditure and hence introduce bias. [Bullish Inflation]

Why expectations of further US fiscal stimulus might disappoint SPX, and how rising stocks lead to inequality

Investors Perhaps Too Enthusiastic About Future Fiscal Stimulus (Janus Henderson, 6 min read) After analysing Fed meetings, speeches, and beige book releases, Janus Henderson estimates that accommodative monetary policy only explains the rise of the S&P 500 to about 2750. The remainder of the rally is likely due to ‘expectation of continued fiscal accommodation’, yet this expectation of additional fiscal stimulus could disappoint. In this scenario, they estimate the S&P would correct to around 2700. [Bearish US equities]

The Stock Market and MMT: The DOW Is Not Your Friend (CEPR, 4 min read) Rising stock prices lead to a stock wealth effect on consumption. This article argues that the inflationary pressures of rising stock market prices lead governments to pursue deflationary policy that disproportionately affects non-stockholders. Otherwise stated, as the rich spend more money on stocks, the poor have less money to spend on consumption.

COVID-19 and Implications for Automation (NBER, 11 page read) The paper provides the first analysis of the demographic groups and US labour markets that face joint risks from COVID-19 and automation. They find (i) mid-educated females are more like to be in occupations at high risk from transmission and automation; (ii) geographically, commuting zones that are diffusely distributed across the US are likely to be impacted; and (iii) sectors that could be notably affected are healthcare, office and administrative support, and protective service occupations.

Krugman on upcoming financial distress in the US, and disincentives of LT cash transfers to the poor

The Next Disaster Is Just a Few Days Away (NY Times, 6 min read) Nobel laureate Paul Krugman considers cancellation of the $600/week unemployment benefit on the basis that it discourages people from working to be a catastrophic idea given the depressed economy. He forecasts that the US economy will be under extreme financial distress in the coming months. [Bearish US Growth]

The Incentive Effects of Cash Transfers to the Poor (NBER, 27 page read) Using data from the first cash transfer program in the US (Mothers’ Pension Program), the paper shows that long-run transfers have no labour supply effects and do not improve the economic conditions of recipients. This is crucial evidence on the potential trade-off between the benefits of transfers versus the disincentives to work. In the short-term, they also find cash transfers reduce geographic mobility and delayed marriage of recipients.

The Short-Term Effect of Tax Changes: The Role of State Dependence (JME, 12 page read) In periods of high unemployment, the short-term effects of tax changes on output and employment are smaller. Furthermore, more labour market slack and tighter credit conditions in economic downturns reduce the responsiveness of labour supply to changes in labour income taxes. This can further dampen the effect of tax changes on output.

Mutual Fund Flows and Fluctuations in Credit and Business Cycles (JOF, 36 page read) A measure, based on intra-family flow shifts towards high-yield bond mutual funds, can be used to offer an early indication of GDP growth and unemployment. Specifically, it predicts growth in financial intermediary balance sheets, increases in shares of high-yield bond issuers and downturns in various measures of credit spreads.

Private and Public Debt Interlinkages in Bad Times (JIMF, 33 page read) This paper finds that if large private debt accumulations precede recessions, larger accumulations of public debt ensue. Furthermore, ex-post build-ups of public debt are associated with a sharper rise in financial distress. As such, the authors argue, private debt is a relevant factor in assessing the soundness of the fiscal position.

Potential NATO disintegration, and the factors driving populism

NATO Is Dying (Project Syndicate, 7 min read)Ex foreign minister of Spain Ana Palacio believes that without US leadership NATO may disintegrate. She says Trump’s withdrawal of US forces from Germany signalled that European security is not a US priority, and that the Franco-Turkish spat at a similar time might not have been a coincidence. She also argues that the US drifting away from Europe has been happening for a decade, and Trump only accelerated the process. [Bullish Russia]

Why Does Globalisation Fuel Populism? Economics, Culture and the Rise of Right-Wing Populism (NBER, 24 page read) An empirical analysis of the 2016 US presidential election shows globalisation-related attitudinal variables were important correlates of the switch to Trump. This paper also discusses how trade, financial globalisation and immigration can stimulate populism.

Tracking the Economic Impact of COVID-19 and Mitigation Policies in EU and US (IMF, 11 page read) Using high-frequency indicators, this paper examines the early phase economic impacts of COVID-19 in Europe and the US. They find that states and countries with larger outbreaks suffered larger losses, and heterogeneity in those losses were captured mainly by changes in people’s mobility.

The role of yield curves in predicting FX, and the macro factors driving equity and bond risks

Uncovering Uncovered Interest Parity: Exchange Rates, Yield Curves and Business Cycles (Bank Underground, 8 min read) The slope of the yield curve can help explain exchange rates (especially during shorter horizons of 0-4 years) in excess to and departure from the UIP benchmarks. It is argued that the yield curve slope reflects information about investors’ future expectation of business cycle risk, and exchange rate movement prices this in.

Macroeconomic Drivers of Bond and Equity Risks (JPE, 36 page read) Using a new consumption-based model, this paper examines why correlation between inflation and the output gap switched from negative to positive in 2001. They argue this can be explained by the fact that higher inflation lowers real bond returns and that higher output raises stock returns. Furthermore, they show risk premia amplify this change in bond-stock return co-movement.

Mortgage Design in an Equilibrium Model of the Housing Market (JOF, 70 page read) Countercyclical mortgage designs outperform mixed payment plans. For example, front-loading payment reductions in recessions is better than those plans that spread relief over the full term because it reduces default and stimulates housing demand.

Sovereign Credit and Exchange Rate Risks: Evidence From Asia-Pacific Local Currency Bonds (NBER, 24 page read) Focusing on the Twin Ds and the interaction between credit and currency risk, reflected in local currency bonds issued by sovereigns in Asia-Pacific, the paper finds (i) strong interaction between credit and currency risks, (ii) that local variables are significant in the dynamics of currency and credit risk, and (iii) local currency bonds dramatically improve the investment frontier.

Decoding the UK sanction on China, and why JP likes Chinese Equities

China’s Deepening Geopolitical Hole (Project Syndicate, 6 min read) Minxin Pei sees the UK’s action to ban Huawei 5G network as a stand on Hong Kong. China must not retaliate, even though it has leverage; for example, British bank HSBC earns more than 50% of its profit from Hong Kong, and 120,000 Chinese students study in the UK. Reasons for non-retaliation are China’s increasing international isolation and any reprisal hurting China more (i.e. HK loses its status as a global financial centre).

Is China’s Recession Really Over? (JP Morgan Asset Management, 4 min read) Half of the world’s consumption of copper stems from China. With both import volume surging 50% MoM and copper prices rising 10% in July (a good proxy of Chinese manufacturing and infrastructure activity), JP is confident that China is the only V-shaped recovery story in the world. It says, ‘Chinese equities remain one of the most attractive opportunities in the COVID world – and beyond.’ [Bullish Chinese Equities]

DoL’s new rule on ESG holding in 401ks, and how natural disaster can trigger sovereign defaults

BlackRock Shows Resolve and Restraint in Public Climate Test (Advisor Perspectives, 4 min read) BlackRock screened 244 companies that weren’t doing enough for climate change. It voted against 53 directors and warned the rest to make progress on climate change in the coming 12-month issues or else their directors would be voted against as well. [Bullish ESG]

UU Department of Labor Proposes New Investment Duties Rule (DoL, 3 min read) The Department of Labor has proposed a rule that might ban the ability of corporate-sponsored retirement accounts (e.g. 401(k)s) from holding ESG funds. It also states that retirement plans are not vehicles for furthering social goals; rather, the focus should be on providing for the retirement security of the workers. Currently, 401(k)s hold $5.6tn AuM. [Bearish ESG]

A Theory of Social Impact Bonds (NBER, 23 page read) This paper shows that social impact bonds, which are a financing mechanism for public goods, can expand the set of implementable projects for government. Specifically, they do this if they are pessimistic about the success of an intervention or if they are averse to paying costs associated with a project that does not generate offsetting benefits.

Natural Disasters, Climate Change and Sovereign Risk (IFDP, 18 page read) This paper investigates how natural disaster can exacerbate fiscal vulnerabilities and trigger sovereign defaults. It extends a standard sovereign default model to include disaster risk and calibrate it to a sample of seven Caribbean countries that are frequently hit by hurricanes. The author shows that hurricane risk reduces a government’s ability to issue debt and that climate change may further restrict market access.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)