In the eye of the storm

A North Korean missile, potentially capable of carrying a nuclear payload, soared over Japan in late August and sunk into the Sea of Japan. In response, 10-year Japanese government bond (JGBs) yields sunk too, from 0.009% to -0.009%.

It makes you think about the idea of safe havens and whether they are less havens and more habits. The yen, and the debt it’s denominated in, is a favoured bolt-hole for global traders when the going gets tough. Never mind that its public debt stands at a whopping 250% of GDP. And even when a rogue state has painted a rather large target over the island nation, traders follow the same old habits. As with everything financial – and everything human – there’s some madness and some brilliance in this trade.

When the spectre of war grows, it’s expected that investors will try to repatriate overseas investments to protect them. Sort of like a modern day equivalent of gathering all your livestock and gold inside the castle before raising the drawbridge. Because Japan owns a huge amount of foreign assets (only China holds more offshore), traders assume that repatriation would boost demand for yen, thereby sending the currency higher and JGB yields down. Added to that, because Japanese interest rates are so low, a popular trade is to borrow in yen, immediately sell it and then invest the proceeds elsewhere to get higher returns. When international relations start to look a little dicey, these trades start to get unwound, which works much the same as a short squeeze on equity markets. As all those speculators tumble back into yen to ensure they can repay their original debt, it pushes up the price of the currency.

The threat of a nuclear strike doesn’t change this calculus much. You either make money on the brinksmanship or, if Japan really is hit with a nuclear weapon, you get hit by a wave of panic that is likely to spread to every financial asset in the world anyway. Well, everything but gold, which is why its price jumped 4% in August to $1,317.

Still, the truth remains: nothing is intrinsically a safe haven. Unless you can eat it, drink it or protect yourself with it, something’s only a harbour if everyone believes it is. Even gold.

  Index 1 month 3 months 6 months 1 year FTSE All-Share 1.4% 0.1% 5.3% 14.3% FTSE 100 1.6% 0.0% 4.7% 14.0% FTSE 250 0.4% -0.2% 7.4% 14.9% FTSE SmallCap 0.5% 1.8% 9.8% 20.0% S&P 500 2.6% 3.0% 1.7% 17.4% Euro Stoxx 2.8% 3.3% 16.0% 27.9% Topix  2.7% 4.0% 4.6% 18.7% Shanghai SE  7.0% 11.5% 4.1% 11.9% FTSE Emerging 5.4% 9.9% 11.9% 24.9%

Source: FE Analytics, data sterling total return to 31 July

Digging deeper

North Korea’s growing belligerence has weighed only slightly on share markets.

US, UK and German bond yields took a significant step down, however, with 10-year yields falling about 20 basis points. It could be argued that much of this was due to the European Central bank rowing back from a misunderstanding in June, where investors thought stimulus would be pared back. Yields are now roughly where they were before that late-June leap.

The dollar remained relatively steady in August on a trade-weighted basis, although it’s down more than 9% year-to-date. Popular opinion has turned against the US Federal Reserve (Fed) raising interest rates any more this year. That stance was reinforced in early September when Fed vice chair Stanley Fischer, a proponent of higher interest rates, announced he would resign in mid-October. His term was set to expire next June.

During this month’s Fed meeting, the governors are expected to come up with a timetable for reducing the $4.5tn of bonds and mortgage-backed securities on the central bank’s books. We expect this programme to be tentative and elongated because the Fed will be worried about tightening monetary conditions at a time when it is unsure of the true strength of the American economy.

As for us, we remain relatively optimistic about the US. Its workers and consumers have had a tough time, having been squeezed by pretty meagre wage growth and higher inflation. But America continues to add jobs at a clip: about 12 million more Americans are employed than in 2012. Meanwhile, companies are healthy and buoyant, economic data show little signs of trouble and the housing market is expanding steadily. 

In the UK, conditions seem a bit gloomier as autumn approaches. The Brexit negotiations are plodding along with little agreement to be seen – except for a broad acknowledgement that Europe appears to have the upper hand. The Euro Stoxx was the only market significantly down over the last three months (in local currency terms), but that was probably driven by a sharp rise in its currency. Continental data are strong and company earnings. UK economic data haven’t been bad necessarily, but they have been muted recently. Sterling dropped 3% in August. Of particular concern is the pitiful growth in wages and what it means for consumption – the lifeblood of the British economy. Pay has actually gone backwards in real terms because of higher inflation.

We believe it’s important to dig beneath headline numbers with our research. Delving deeper into the UK’s labour market statistics shows some interesting trends. At the moment, there are about 1.5 vacant jobs in low-paying sectors for every unemployed person. And there is only one empty position in high-paying sectors for every two jobless Britons. The types of jobs where applicants are in higher demand are not all that lucrative, unfortunately, so the UK’s average wage is unlikely to go much higher. Still, greater competition for lower-paid jobs should lead to a long-overdue pay bump for the poorest in our society. Typically, those people spend more than they save, so unless they use the extra cash to pay down debt, consumption could see a boost.

Overall, it appears that the skills of the unemployed are not those that businesses, government and organisations are searching for. This may put a cap on how much further the UK’s unemployment rate can fall. It may also drive wages higher. But without better productivity growth, this may simply fuel greater inflation. The Government’s staunchly anti-migration stance would only exacerbate Britain’s skills mismatch.

Bond Yields

Sovereign 10-year Aug 31 Jul 31 UK  1.04% 1.23% US 2.12% 2.30% Germany 0.36% 0.53% Italy 2.04% 2.09% Japan 0.01% 0.08%

Source: Bloomberg

Julian Chillingworth, Chief Investment Officer