The euro, the French stock market, OAT-German debt interest rates spreads, the Volatility Index (VIX) and the ghosts of Vichy, Oradour and Algérie française convince me that Emmanuel Macron will be the next President of France on Sunday. So I see no reason to abandon my euro bullish strategy even though the single currency has traded as high as 1.0985 on the eve of the second round French vote. It is significant that the euro has risen to these levels despite the strong US April payrolls, the bankruptcy of Alitalia and ECB President Mario Draghi’s denial of an imminent taper. For now, the trend is my friend until the trend comes to an end, possibly when the financial markets focus on a June FOMC rate hike.
‘Sell in May and go away’? Not for my tribe of global currency market junkies. Even though a 100 MP Tory majority in Westminster in June has boosted sterling, Mrs May and the European Union are now embroiled in a bitter conflict over the UK’s Brexit divorce settlement. Sterling is still the best performing G-10 currency against the US dollar since early April, when Mrs May’s decision to call a snap election triggered the move from 1.24 to 1.2950. The dilution of the power of Little England, anti-EU Tory backbenchers and extension of the parliamentary term to three years lowers the Brexit risk premium and justifies cable in the 1.34–1.36 range. The EU’s demand for a $100 billion Brexit bill is a non-starter for Downing Street – I found it significant that Junker’s demand did not trigger a sterling sell off. This shows the resilience of the sterling bulls, as does implied vols and risk reversal skews in the FX options market. It also did not hurt that UK manufacturing data is at its strongest since 2014. As hedge funds slash short cable positions, not even nasty Brexit rhetoric can avert a sterling move to my 1.36 target!
The Japanese yen at 112 reflects not just US Treasury-JGB interest rate differentials but also the foreign exchange market’s complacency about the risk events de jour – North Korea, FOMC, the French second round elections and US data. Implied volatility in yen options has drifted lower and I see no urgent demand for protection against safe haven flows and as stronger yen. The 50 day moving average at 111.70 was no deterrent to yen weakness. Momentum and positioning suggests the yen can slip to 113. The ideal level to buy dollar/yen would be at the 111.60 chart point.
The Canadian dollar has now tanked to 1.3740 as interest rate spreads between Uncle Sam debt and Canadian government debt continue to widen, as West Texas crude oil falls below $50 a barrel and the Trump White House slaps tariffs on softwood lumber from the kingdom of the maple leaf. The loonie was last at these levels in January 2016, when crude oil was $30 and Chinese markets in free fall. If the CFTC positioning data is reliable guide, macro hedge funds are accumulating short loonie exposures.
The Bank of Canada’s policy statements have amplified the bearish pressure on the loonie, as the rise in implied volatility and risk reversal downside protection premia suggest. Planet Forex loves an ambush and Trump’s tariffs have ambushed the loonie. As the father of a Lord Sebastian Flyte wannabe undergrad at McGill in Montreal, the loonie free fall is a bonanza. Momentum/trend signal suggest the Canadian dollar can well fall to 1.3850 as the next strategy target.
While the Reserve Bank of Australia kept policy unchanged, the foreign exchange markets expects the Canberra central bank to ease rates this autumn. The plunge in iron ore prices and the weakness in Dr Copper shows that China risk cannot be discounted. I was stunned that the Aussie dollar stabilised after the RBA decision near $0.7550, not coincidentally the 38.2% Fibs retracement of the decline from its late March 0.7760 high.
Crude oil prices have sunk to their lowest level since November as Brent slid below the psychologically critical $50 a barrel level. The latest spasm of selling was triggered by reports of Libya’s return to the oil export market and Kremlin spokesman Dimitri Pashov’s denial that Russia has decided to extend the Saudi brokered pact to extend last December’s output cut deal. IEA data shows US output is now 9.29 million barrels per day and the Baker Hughes land rig count (a proxy for shale drilling) has doubled since last year. Saudi Arabia and OPEC face a strategic dilemma at their next conference in Vienna. Either extend the output cut pact with Russia as part of the deal or Saudi Arabia abandons the role of swing producer. This means an oil crash once again, as Euro/Norwegian kroner (at 9.48) suggests.
Macro Ideas – Modinomics and Indian financial markets
It has now been three years since Narendra Modi swept the BJP into power in the 2014 general election with the highest majority since Rajiv Gandhi’s election on a sympathy vote just after his mother’s assassination three decades earlier. Modi’s reputation – as a pro-business reformer as chief minister of Gujarat – preceded him while a succession of sordid corruption scandals eroded the last vestiges of political legitimacy for Congress under the ostensible rule of ‘Mr Clan’ Dr Manmohan Singh. Modi’s rule has proved to be a game changer for the Indian economy. The Goods and Services Act (GST) has the potential to add a full percentage point to India’s GDP growth rate, now a stellar 7%. Modi also deregulated diesel and natural gas prices and moved to end retrospective taxation of foreign investments. Modi reformed the coal mining sector and instituted transparent auction regime on telecom spectrum.
The rupee redenomination last November had major execution flaws but will add $265 billion in new deposits into the Indian banking system and penalize ‘black money’ hoarding. The bankruptcy law is mission critical to defuse the non-performing loan time bomb at the heart of India’s predominantly state owned banking system.
Political metrics and financial markets have both vindicated Modinomics. In 2017, the Indian rupee has appreciated 4% against the US dollar to 64 as I write. The Sensex index of India equities scaled 30,000 and India now trades at the highest valuation metrics in Asia, up 18% in the past twelve months. Above all, Modi’s BJP win in the state elections in Uttar Pradesh, India’s most populous state and set the stage for BJP dominance Rajya Sabha (upper house) and a victory in the 2019 general election. To add insult to injury, BJP even beat Aaam Aadmi Party (AAP) leader Arvind Kejrival, an anti-corruption zealot, on his home turf in New Delhi local elections.
However, the ancient Greeks believed in the concept of hubris (the idea so brilliantly presented in Sophocles plays), that excessive pride precedes a great fall. Modi has taken political and economic decisions that could prove disastrous for India’s future as a liberal, secular parliamentary democracy. Modi selected a communal demagogue like Yogi Adityanath as the chief minister of Uttar Pradesh. He has not repudiated his own support base in the fanatical RSS, whose activists assassinated Mahatma Gandhi in January 1948. Modi has imposed price controls on airline tickets, medical devices and pharmaceuticals. He also sacked Dr Raghuram Rajan, arguably the finest Indian monetary economist alive, as Governor of the Reserve Bank of India.
The strong US April jobs data ensures two more Fed rate hikes in 2017. The UK snap election will mean Mrs May will be reelected with a large Conservative party majority in the Commons. These factors, coupled with BJP economic advisor Arvind Subramanian’s aversion to a strong rupee since it hits Indian export growth, leads me to position for a fall to 65. However, despite the $15 billion in offshore money attracted to Dalal Street in 2017, I doubt the RBI will cut interest rates as local banks are flush with deposits due to last November’s banknote reforms. The monsoons will also boost food price inflation and GDP growth has been robust. This means the RBI will be on hold in the next four months while the Federal Reserve increases rates by at least another 50 basis points. The Indian rupee could well slip to 65.40 before the bullish uptrend resumes.
India faces multiple economic challenges in 2017-18 that the Prime Minister cannot ignore. Private sector capex is still mediocre. The Indian banking system’s non-performing loan crisis must be resolved. India must offer a credible privatization program to attract foreign direct investment. The twin deficits must be narrowed. Above all, India must implement labour reforms that no Congress or BJP government since independence has bothered to confront. The Nifty now trades at 19 times earnings, making it the most expensive stock market in the world. Earning growth of 15–17% is all too possible, thanks to PSU banks, metal producers and auto makers. Yet if Trump enacts major tax reforms, Modinomics should accelerate its reform momentum to ensure the world’s financial passage to India.
Stock Pick – Goldman Sachs is a humbled money machine
The Treasury Secretary and chief economic advisor in the Trump White House are both former partners and senior executives of Goldman Sachs, the New York investment bank whose alumni were also luminaries of the Reagan, Bush (père et fils) and Clinton administrations. Yet the meteoric rise of Steve Mnuchin and Gary Cohn to the pinnacles of international politics has not been an argument to the shares of their alma mater Goldman Sachs, once revered as the most profitable money machine ever seen on Wall Street. Goldman’s first quarter 2017 earnings report was a huge disappointment. Goldman missed revenue forecasts of $8.45 billion by at least $400 million. Goldman earnings per share for 1Q was $5.15 a share, for below the sell side Street consensus at $5.31. The shares are now $30 below their post Trump win high of $225 as I write. It is obvious that one of swiftest, most spectacular rallies in global money centre banking ever witnessed on the NYSE has come to an end.
Goldman Sachs used to deliver returns on equity as high as 24–25% in bull market cycles prior to 2008’s global credit meltdown. That world is as dead and gone as Nineveh and Thebes. The Volcker Rule, restrictions over the counter derivatives and proprietary trading, a scaling back of balance sheet leverage, fines related to the Abacus scandal, higher compliance costs and lower fixed income, currency and commodities trading has had a huge impact on Goldman’s bottom line. Goldman Sachs is now lucky if it can deliver even a 10% return on equity, especially now that global cross-border mergers could well have peaked.
Goldman Sachs trades at a valuation premium to Citigroup or Bank of America even though it now trades at 1.25 times book value and 11 times forward earnings. It is entirely possible that the shares could fall below $200 a share this summer on global financial market angst about the successor to its legendary chairman and CEO Lloyd Blankfein, who has reigned for more than a decade as Capo di tutt’i capi at Death Star in lower Manhattan. David Solomon, Harvey Schwartz or Pablo Salame are on the short list to succeed Blankfein since Gary Cohn decamped to Washington. Of course, succession is not the only catalyst to goose Goldman Sachs this summer. The Federal Reserve will raise the overnight borrowing rate at the June FOMC. President Trump has promised to ‘do a number’ on Dodd Frank and the Volcker Rule. Europe, Japan, China and the emerging markets are all in stealth bull market – and are all regions where Goldman Sachs has vast trading, sales, asset management and corporate finance franchises. I expect Goldman Sachs to trade in a 190–250 range in 2017.
Unlike Goldman, Morgan Stanley blew apart its first quarter 2017 revenue and earnings forecasts. Morgan Stanley exceeded its $9.27 billion forecast by an incredible $480 million and earned $1.01 a share in the first three months of 2017. Morgan Stanley has also boosted its return on equity to 10.7, the highest since 2014. Morgan Stanley’s investment banking revenues rose 43%, securities sales rose 30% and asset management up 22%, though equities posted a small loss. Morgan Stanley has raised its capital, derisked its balance sheet in fixed income trading and built the most formidable fee based global wealth management franchise since Charlie Merrill and his Thundering Herd rocked the pre-Stan O, pre-Abnass Wall Street. It is now rational for Jim Gorman’s Morgan Stanley to trade at a higher valuation than its archrival ‘the vampire squid of humanity’ at 12.4 times earnings and 1.3 times tangible book value. A credible trading range for Morgan Stanley could well be 40–48. As long as there is no recession or a steep stock market slump, Wall Street investment banking shares are perfect for range/option spread strategies.
While both Morgan Stanley and Goldman Sachs had spectacular 30–40% rallies after Trump’s elections, bank valuation have now lost their froth. As the IMF scales up global growth forecasts, as the Trump White House dream team (Gary, Steve, even Barron is ex-Goldman!) implements his economic agenda, as the Fed nudges interest rates higher in its summer and autumn monetary conclaves, as deregulation and laissez-faire replaces the legal Gestapo on Wall Street, money centre banks are still in the embryonic stages of an epic valuation rerating. I recommended Citigroup in 2012 at $25. It is now 59 – but still trades at only 0.9 times tangible book value!
This article originally appeared in the Khaleej Times.
