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Focus on the fundamentals

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Last Friday, ECB President Mario Draghi gave little away when it came to policy. Markets nonetheless detected a whiff of change with the potential for tapering of the QE programme to be announced in either October or December, and concluded that European bond yields are set to rise. As a result, EUR/USD spiked over a cent before giving back around half its gains. At the time of writing EUR/USD, at 1.2010, is up over 14% so far this year, as the respective outlooks for the European and American economies continue their volte-face.
 
In the UK, the endless Brexit shenanigans have been testing the stamina and concentration of traders and investors alike. Speaking on Radio 4’s ‘Week in Westminster’ on Saturday, ex Greek Finance Minister Yanis Varoufakis declared that anyone trying to negotiate with Europe is on a hiding to nothing. His rationale for this position – and he has more practical experience than most on this subject – is that the last thing that the EU wants is a mutually advantageous outcome, lest this is "interpreted by the riff-raff of Europe – the Greeks, the Spaniards, the Portuguese and so on - as a sign that you can confront the deep establishment of the European Union and get a decent deal out of it”.
 
For this reason, Veroufakis argues, the EU does not want to negotiate with Britain and has crucially not given Michel Barnier a mandate to do so. Instead, he has only a list of concessions which Britain must make before we can talk about anything that we want. Perhaps it is no surprise, then, that David Davis has been accused by Michel Barnier of not regarding “his direct involvement in these regulations as his priority”. If Barnier cannot negotiate, what is the point in trying? Varoufakis’s view is that there are only two alternatives: either walk away now and pursue the hardest of Brexits, or opt for a Norwegian-style European Economic Area set-up, file an application for a five-year interim agreement from March 2019, and hope that the EU’s position can be softened in the meantime.
 
Varoufakis conceded that Britain is not Greece – we are not bankrupt, for a start – but re-stated an absolute conviction that a mutually advantageous deal was not on the cards, despite the obvious interests of European exporters to the UK. If he is correct and there really are, in practice, only two possible outcomes to the so-called ‘negotiations’, the implications for sterling are pretty binary. In the event of a ‘walk-away’, diamond-hard Brexit, the pound would take more of the strain and drop another 10% or so. However, if at some point Davis and his team opted for the Norwegian-style agreement, rendering Barnier and his team instantly redundant (according to Varoufakis), sterling would doubtless embark on a strong relief rally.
 
Outside the UK, the markets have been concentrating hard on fundamentals. In the case of Europe, these are increasingly good and have elicited speculation on a tapering of QE, while in the US, weaker data have put into serious question the Fed’s reversal of QE and accompanying rate hikes. The exception to this focus on fundamentals has been in the UK, with its obsession with Brexit.  Mercifully, tomorrow gives the UK markets something tangible to focus on in the form of inflation data for August. Having hit 2.9% in May, CPI unexpectedly fell to 2.6% in June and, again unexpectedly, held this 2.6% rate in July. Given that most forecasts until recently put the peak in the sterling-induced inflation blip at least a full percentage point higher than this, the relatively subdued figure for June and July was interesting to say the least. Whether this lower-than-expected inflation is a good or bad thing is a moot point. Clearly the economy will benefit if consumers’ real wages are being squeezed a little less than expected. On the other hand, if the precipitous fall in sterling since June 2016 is not actually going to have much of an inflationary impact after all, markets will start fretting that there remain at large deflationary forces so huge that even a 15% fall in the value of sterling cannot offset them. The inflation data will therefore be watched even more closely than usual.
 
The announcement over the weekend that the government is to lift its 1% cap on annual pay rises for public sector workers, starting with the police and prison warders, will not affect inflation data for some months. However, the eventual impact has the potential to be significant, with many public sector workers claiming a fall of around 15% in real wages since the freeze in 2010, followed by the 1% cap from 2013. That will require a great deal of ‘catch-up’. One of the reasons why wage growth in general has been so restrained since the Great Financial Crisis has been the austerity surrounding public sector pay. If this is about to change, one must expect upward pressure on both public and private wage levels as the public sector becomes relatively more attractive – or relatively less unattractive, depending on one’s point of view.
 
As noted, we shall see crucial UK inflation data tomorrow. CPI is expected to have risen from 2.6% in July to 2.8% in August, while RPI is also expected to have risen a couple of notches to 3.8%. Manufacturing input prices are expected to have risen 7.3% in the year to August, while output prices are expected to have risen only 3.1%, showing a continued but sharply reducing squeeze on manufacturers. It is no wonder that, when input prices were rising at almost 20%, exporters initially used the weaker pound to try to maintain margin. Now that the rate of growth in input prices is declining, as the shock of sterling’s depreciation works out of the data, exporters should hopefully be in for easier times – particularly given the improving conditions in Europe.
 
Wednesday sees UK labour market data. Unemployment is expected to have remained unchanged in August at 4.4%, while average earnings are expected to have risen by 2.3% in the three months to August (up from 2.1% in July), compared with the same period last year. There is an MPC meeting on Thursday, but no change to policy – either in terms of Base Rate or QE – is expected.

All views expressed here are the author’s own and are based on information and data available at the time of writing

 

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