Surveillance: Defaults Are A Necessary Evil, Kong Says

A little bit length from Cham and Pound and coug So, I think the equity market and kind of risk assets in general have become pretty comfortable and complacent with the idea that monetary policy is going to stay accommodative forever and ever and ever. So I think the biggest thing to watch is going to be for equity markets, the

dot plot. I think for kind of broad our markets and fixed income, we're gonna be focused a lot on the bound sheet and reinvestment and the composition um the treasury composition, which is a little bit more technical, but in general, equity investors and I would say risk asset investors broadly want to see that monetary policy is not going to move much or slash at all in the near term. But here's my question. One is bad news

bad news again? I mean, one is the idea that the FED is being cautious because the economy really does not have the strength that many people thought that it did. Uh, when is that bad news for risk assets? Yeah, that's a that's a really important question. You know, for a large portion of the last ten years, we've been in this cycle where you know, markets stop panicking when policymakers

start panicking. You know, as long as policymakers have our back, it doesn't matter that the data is bad, or the data has softened, or that activity is slowed, or that we're talking about a new growth regime. And you know, I'm a little worried that we're back there again because a few years ago we were really hopeful the markets would be focused on fundamental let's talk about activity, let's talk about earnings, let's talk about the real idiosyncratic opportunities,

and we're back to obsessing about monetary policy language, body language. Uh, you know, who's had coffee with who and what that could potentially mean for stimulus around the world. So this is a fair question. I just don't think that we're going to get there in the second quarter. So let's talk about fundamentals if we can, we have the opportunity to do so this morning. How are they? How are learnings?

Expectations for the rest of the year not great? John, I mean, this is this is the this is the problem. Most of the returns from the equity market in two thousand nineteen have come from multiple expansion. You have higher prices and lower earnings expectations um, and we really need to turn around in fundamentals. I think in order to

carry the market meaningfully higher in the second quarter. It's like hard to get to a twelve percent return in the second quarter if it's not driven by earnings and it's just driven by a rerating. So a lot of people would actually disagree, and they would say that stocks have actually been held back by the trade tensions and the ongoing concerns about Brexit, etcetera. You disagree. I think that trade concerns, concerns over Chinese growth, concerns over US growth,

concerns over policy mistakes. I mean, we can make a long list. We're all really putting pressure downward, pressure on risk assets in the fourth quarter. But some of that has eased, and we've gotten to we worry actually a little We've gotten a little bit a complacent point where

we don't really worry so much about trade. We think some of the risk there is not being properly priced, that people are not as worried about growth, and as I mentioned, are expecting a lot of monetary and fiscal stimulus from all different regions of the world concurrently in two thousand nineteen, and so you know, we need to see a little bit more volatility, We need to see a little bit more of like fundamental driven markets. So this is actually where I was going to go. I

was looking at the move index. This is the Bank of America Mary Lynch Option Volatility Index, and it's fallen to its lowest level on record. This is the implied volatility and treasury yields over the next three months. I'm just wondering, is this dangerous? This setting a warning signal about complacency and sort of signaling that there could be some kind of more violent move in the very near future.

You know that the volatility markets in general have been really difficult, right, I mean, you think about the last couple of years. We keep on making new lows sometimes it's really difficult to explain why. What I can say in general is that there seems to be on the equity side very light participation in the rally. More recently, people have been fading that risk have been taken down

their winners. You know, if they were in the market and well positioned at the start of this year because of the d rating last year and because they felt like the baby was getting thrown out with the bath water, uh, they have been systematically taking their their equity exposure down. We see this in fund flows from a number of different providers. We see this in terms of overall et F flows for the best performing parts of the market. And so you know, it has all of us scratching

our heads. I wish I had a better answer on volved whether it's the equity or the treasury option involved, but it does feel like it should rise a little bit. Long fed patients. Short volatility has been the trade of the last three months, and in the words of Bank of America, the pain trade for stocks is still up. Um. Do you agree with that there is simply no greed to sell in equities. That's the line from Bank of America. It sounds like to some degree it resonates with UK.

There is some sympathy, you know, full disclosure, I used to work on that team, uh some years ago now, so I'm very familiar with the pain. Trate is higher view UM from a fun flows perspective, I think that's right. From a flows and positioning and technical perspective. You can make some of that argument. From evaluations perspective. I think we're neutral. You know, we've rerated back to a level that that feels fair with a UM, you know, an

economic and macro backdrop, or still having growth. I'll be at a slower pace where monetary and fiscal policy looks more supportive than it did six months ago. Uh. But the fundamentals is what I keep on getting hung up on. It's the earning story, the fact that their earnings vision ratios are the weakest in three years and are not abating. So Kate, where is the biggest opportunity in equities right now? Well, so qualities performed very well in two thousand nineteen, but

I think this is still an opportunity for quality. We're really focused on kind of secular growers, and so that takes us to technology and healthcare, which I know had been very consensive sectors, but frankly deliver. They deliver on earnings, They're delivering on consistency of earnings, their balance sheets are great, and I really want to own companies that you have the ability to continue to expand even in a slowing growth environment. So that's kind of our favorite bit. And

we're also pretty excited about emerging market. Still great to catch up with you as always, Thanks for dropping by. Kate more blank Rock Investment Institute Chief equity strategist on the pain trade, and a whole lot more forecasting patients. That is what investors expect from the Federal Reserve later today, unchanged. That is what investors expect to happen with interest rates.

The news conference is where the focus will be with Chairman Pale and the summary of economic projections, all of the forecasts for the economy, including where each and every individual policymaker on the fo MC expects rates to be in nineteen twenty and perhaps beyond two. Let's bringing the team, shall we to get their forecast, their outlook and the

day's guide for Federal Reserve decision Day. Carl Rickadonna, Bloomberg Economics Chief US economist and on the phone from Washington, d C. He will be in the room with Chairman Pau a little bit later. Michael McKee, International Economics and Policy Correspondent, Mike, you get the honors, sir. Give me

the outlook the day's guide for the Federal Reserve. Well, really, what Wall Street is looking for is for no mistakes, no deviation from the Wall Street line, which is the Feds on hauld and there's no deem year of them raising rates this year. Not likely to get an absolute view from J. Paul, but I think he'll be as cautious as possible, not try to say anything that will lead them to think one way or the other. The Fed may change policy this year. Um, we're gonna see

in new forecast for growth and inflation. They'll have to be marked down a little bit, but enough to justify a major move in the dots. Not clear, all right? So coming in here, Calra Kadonna, because right now I'm looking at the work function on the Bloomberg terminal showing that there is a thirty seven percent chance of a rate cut come January, zero chance of a rate hike again this cycle. Probably is this something the Fed like seeing.

I don't think they like seeing that high of a probability of a rape cut at the start of next year. That's not really their intention at the moment, and I suspect the dot plot will lean against that. Now. The Fed is in a bit of a difficult a bind here because if they're too optimistic on the economic outlook, then they risk a repeat of December, where the markets viewed the Fed is having a tin ear two signs

of economic strain. That being said, if they really focus on acknowledging weakness in recent data like retail sales, like the last payroll report, then they're going to push those rate cut probabilities even higher. And if that's not their intention to start cutting rates next year, which I don't believe it is, then this creates a significant communications challenge that they're going to have to address later this year.

So that being said, I think they maybe air on the side of caution with respect to sounding too dovish because they don't want to reinforce that that rate cut. But an important question yesterday, when you and I caught up, Mike, you said, what does the Federal Reserve do in inflation expectations remain low or in fact go lower. Do we have any idea, Mike, No, we don't at this point.

They haven't been able to generate inflation. They're talking longer term about changing some of their policy regimes, but that's not gonna come up today. So the question is what is their inflation out look and what drives it, because nobody seems to have a way to get inflation up to or above two percent except hope that the Phillips curve actually holds. We're waiting on that right now, and

we haven't seen any evidence that it's happening. We're getting stronger wage growth, we've got cycle high wage growth, but it's not feeding into the inflation indexes. Although Carl chair Powell did say that he thinks that some inflation, some wage pressures in particular, are greater than are being reflected by the data. Is there any sign that we actually are starting to see a return of the Phillips curve.

I think we're seeing the early stages. Mike's right that it's not showing up in the inflation data just yet, but we've only recently seen the pickup in wage pressures. It really started around November of last year. Amazon had the minimum wage increase a lot of retailers. UH followed suit, and from November through February you saw a pretty significant acceleration and average hourly earnings and the jobs report that number may actually underrepresent what's happening in the broader economy

because it reflects a lot of UH. I hate to use the term lower quality, but the lower skilled, lower quality jobs which tend to be lower paying, and that tends to deflate UH the number overall. So we're seeing wage pressures show up, and it's a matter of time for that to percolate through the system. So Mike says we're not seeing signs of the Phillips curve working. I would add a footnote to that, we're not seeing it just yet, but I think we will see it later

this year. It's too soon for the flip FED to start focusing on that because they want the data to really lead the way. But I do suspect with the economy growing above trend and wage pressures at a post recession high, we will see more consumer inflation later this year and that will put the FED back into play. And and and to that point, the fact that we are getting some kind of a melting in trade tensions

also feeds into this. Michael mckebl and brig International Economics and Quality correspondent in Washington, d C. Come on in here and talk a little bit about how that thawing backdropped. The increase in stimulus from the PBOC in China may

complicate the issue for the Federal Reserve right now. Well, one of the Feds lines over the last year or the last couple of months, But it that way in terms of the idea of being on hold, is that economic conditions around the world have slowed, and therefore that puts a break on US economic growth possibilities. We're seeing some signs that maybe we're getting a little bit of a pickup in Europe, and then China has been flooding

its economy with stimulus. If that works, and if you're picks up, then we're going to see additional growth in the United States. And uh, that's another factor they have to take into account. What it really comes down to is a question of timing. The FED believes that the economy is going to pick up and that will generate more inflation, but when does it do that and how

does it signal it. Ordinarily, the FED, or up to this point, the Fed has wanted to be ahead of the economic developments, ahead of the idea of inflation, but now they're sort of having to wait because Wall Street doesn't trust them to do that. Although and Carl may want to weigh in on this, we are seeing break even start to rise, so there is a little bit of inflation being priced into the markets that kind of hasn't been reflected in sentiment yet. Mike makes a very

good point there. Rather, the FED doesn't want to be leading the way. That's always good love with Mike McKee. Uh, but the FED tried to lead a little too hard back in December, and we saw what the market outcome was. So now the FED has been chastened by that experience. Uh. And now I was going to let the market kind of beg for rate increases and the Fed will not be overly concerned about being perceived as being behind the curve and then happily delivering what the market is asking for,

and that will be far less disruptive. I do think we could see that start to materialize in the back half of the year. Mark you'll be in the news conference. Lights A first question for Chairman Pal from you, what is it? Well? It depends on what they say, But basically you'll be looking for what is that what would

make them change their patient strategy? A lot of different ways you can ask that question, but is there something that they're looking at that the market can look at to get an idea of what the FED reaction function is going to be? Basically, you don't want to give away your your secret sauce, right, You're not going to give away your question. Um, you kind of gotta know what they're gonna do before you ask what they do.

It's all freaking save Carl. What would be the question you'd want to ask I Pepperham on the issue of what would get the FED back into play, because it's a pretty subtle change and forecast that has shifted them from a world where they were looking for two rate hikes this year and one rate hike next year to

a world where they're on perma pause. And really that's the difference of GDP growth shifting from two and a half to two, inflation shifting from something just above two down to two, unemployment rate shifting from three and a half up to four for their outlook. So it's not going to take a lot in the change mild upward surprise in the economy, but to really get them back to the type of forecasts they were looking at in September and December of last year, when they in fact,

we're expecting additional rate hikes. The one thing I would highlight here right the real Fed funds rate, the inflation adjusted interest rate is about point three right now. Uh. The economy has never rolled over with real interest rates so low. So we're still a long way from the Fed actually stepping on the brake pedal. Grant to catch out with you always now that you'll be a busy man a little bit lights bloom Bug Economics Chief US Economists now from Washington, d c Um. He's not really.

He enjoys this. This is leisure time. So if you enjoy you're not busy. He goes. He goes to work about ten minutes ago. Are you going to thank Michael interrupting make from Washington. He's busy already. He's working. Michael McKay, International Economics and Policy correspondent because he hates this calin Mike Grant to catch up. Well, one place where you are seeing real stimulus is China, where the PBOC has doubled back and is adding to what what they had

been cutting back on. It was interesting to me. Yesterday Bloomberg reported the Canada's biggest pension is actually considering opening an office in Beijing over the next year as they try to expand their holdings in the region, joining US now. Teresa Kong, Matthew's Asia head of fixed Income and portfolio man aagement here in our Bloomberg Interactive up Brokers Studios. Teresa, do you think that this is a good time to

be plowing into in particular China. Absolutely. I think it's a very strategic decision on the part of the largest pension fund in Canada. I think there are several catalysts. First, there will be inclusion of China into the global agg which I think it's going to be transformative for bond investing. As we all know, ms C I will be adding China as well in in actually greater steps than had previously announced. So I think CPP and I'm guessing is

CPPC is ding ding ding ding. Um will in fact, you know, be looking back at this ten years from now and congratulating themselves in terms of being very fort looking. Let's talk about how you're managing your exposure to Asian markets at the moment, what do you do when you have this really strong rally and global markets but there's very little sign and stability and the fundamentals, how do you reconcile the two things at the moment. Well, I think what the market is doing right now is pricing

out a lot of potential tail risks. So for example, first let's start with the FED. As you had already mentioned, most people are expecting that the FED is more likely to actually cut as opposed to raise rates. I think the European Central Bank has also been quite clear that growth is not there, and therefore they're also going to be, you know, continued to provide stimulus. So those are two

big teril risks out. And then, last but not least, certainly, everyone's looking at the trade talks and hoping for some type of resolution, even if it's a short term trade resolution without a long term resolution on all the other areas like intellectual property. I do think that the market will really be breathing a sign of relief even with that.

You know, it's interesting because when people say that they're they're going into China and buying assets right now, I have to wonder how the recent uptake and defaults corporate defaults plays into this. The fact that the PBOC they that China is allowing companies and even some local governments to actually start to fail to pay their bills, and I'm wondering how does that factor into how you invest

in the region. That's a great point, you know, to be sure defaults in China will continue to slowly increase. The important point to take away here is that defaults are necessary evil in all developed markets. Spreads price in the default risk, and arguably China is actually not completely pricing in the expect of future default risk. So this is what we call the credit spread. So I think it's really important to realize that, you know, these defaults

will continue to slowly take up um. The other thing I just want to mention is that, you know, China is really the only country where I constantly hear headlines about the total notional amount of defaults. Nowhere else in the world we talk about notional defaults. So if you're actually put in a denominator, and if you actually take out all of the government debt and all the policy bank con debt, so which you know are arguably truly

sovereign risk. But if you could include everything else, the actual default range China when we measure it with that denominator, is about zero point six, which is still substantially below where the rest of the world is, which is, you know, about hovering between when I have two. That's a good point. I think that the fear is that this is the tip of the iceberg. Number one, because the defaults are just starting to pick up and and then the government

is just allowing them to actually happen. That's number one. But number two, the amount of corporate debt, especially given the shadow banking system in China, is materially larger than some of the official numbers are stating, and there is concern, especially given the fact that the PBOTC itself was ratcheting back at stimulus because they were concerned about the growth and leverage. The fact that they are backtracking and re levering is also a concern. Is that a problem for you?

I think it's really important to continue to monitor the state of monetary policy as well as fiscal policy to sure you know, China has taken one step forward and one step back with respect to de leveraging, and it's certainly true that that defaults ticking up has an impact on what we do, but arguably what we've actually been looking forward to our actual corporate spreads to actually widen

to take into account this future default risk. I would also like to make the distinction between the different types of debt. You know, a lot of times people talk about China in one big breath, but it's really important to point out that there are corporates completely private health enterprises where we do think the faults will certainly pick up because of access to capital. As yet pointed out,

there's the what I call gray area. A lot of this state owned enterprises are really part of the mixed economy privately health somewhat, um state owned somewhat, but also you know, some of these are actually have have public

trade of stock. And then, last, but not least, there are the what I call muni slash l g F s look government bonds with respect to the s o s. This is where real credit analysis really needs to take place, because a company that is strategically very important at the national level should not be priced the same as a municipal as a excuse me, as a as a company that is doing let's say some type of natural resource extraction that could be detrimental to the future of the

environmental policies of China. And then, last, but not least, I do think that local government debt might trigger technical defaults. But until a legal framework is in place whereby there's a bankruptcy remoteness to the municipalities, I don't really see that area actually picking up in terms of defaults. To reason, great to catch up with you, really insightful stuff to Raisakung their Matthew's Asia head of Fixed income and Portfolio Manages.

Let's get the view from London, shall we? Bloomberg opinion columnists Theresa Raphael joining us now on the phone from London to get us up to speed. The Prime Minister wants to take this to the thirtie June. Will the

EU say okay? So the EU has a decision to make, and that is which risk they think is worth, a risk of no deal Brexit happening, or the risk of Britain being part of massy European parliamentary elections that uh would be even staying in the European Union for a longer period of time and um, you know, impossibly complicating the way EU policy works. I think the European Dan is likely to grant the short extension. I think that's that we can pretty much assume it's going to happen.

The question is what conditions they'll put on it and whether they will do out a longer extension if made deal doesn't get through Parliament, which he intends to resubmit, if not next week again later this month. So I'm looking at the pound right now. It did fall to session lows after this came out that Theresa May was just looking for a three month extension. Why do you think, why? Why is this a bearish sign for for the Sterling

right because it creates a new edge. So just last week, um, we're all believed to hear that the Parliament voted against having a no Deal exit. They voted in no uncertain terms, but that didn't really take no Deal off the table because it's on the statute book. And what what Mason forced to do is against to Will, is to ask for only a short extension and not a longer extension.

So that creates another cliss edge at the end of June if if the European Union he doesn't agree to extend the extension or if Parliament doesn't pass for you know, we still are faced with the possibility that Britain needs uh with no deal at all, and and you know that's a very bearis sign Now the caveat here is Parliament could step in and try to take some call.

They could try to pass an amendment to her motion the next time she submits her deal that says, you know, um, we have voted not to leave without a deal, and therefore uh, you know, they could pass a vote of their confidence. They could try to vote in favor of second referendum. So it doesn't mean automatically no deal what happened at the end of view, but it clearly leaves that as a possibility. Another layer of complexity to all of this the leader of the opposition party, Labor's Jeremy

Corbyn demanding a confirmation referendum on a Brexit deal. Terres What is that. Well, Corbyn has been um, you know, officially in favor of a second referendum as his party's position if they couldn't get a general election. Personally, he hates the idea. He would like to keep brefit happen. He would like to see this governments fall to a conservation referendum sort of splits the difference. It says, well, you know, whatever, if the deal gets through, will support

for deals. But then we wanted to put it to the people and that's going to be hugely controversial because hardline conservatives who uh pro Brexit, who even want to see a no deal Brexit, are going to be opposed to a reference and that allows remain to be an option, which is what Corbin is basically suggesting. So terres, how does John Berkow fit fit into this? The idea that he was holding up another vote on a procedural issue,

does that matter anymore? Well, I mean, Burka has but a hugely important figure throughout this whole um, you know, the whole Brexit saw that, because he's the one who decides, you know, what amendments get selected. Um. He recused, uh, while cited a a seventeenth century consum to tell me that she couldn't submit her her deal to Parliament unless it's substantially change. It's still important because it's Burka that

decides what what constitutes substantially. She might say, okay, well we've change the end date, so that's a that's it's now into agreement it will we leave on do party and not March twenty nine. And he could come back and say well that's not substantial enough. So he's still a key figure, a controversial figure. Um and uh, you know it will be hint decide really when her her deal comes back before Parliament. To Rights always great to

catch you up with you to get your insight. To Rights Rafael, that Bloomberg opinion columnist bringing us some much needed clarity on the Brexit situation. Thanks for listening to the Bloomberg Surveillance podcast. Subscribe and listen to interviews on Apple Podcasts, SoundCloud, or whichever podcast platform you prefer. I'm on Twitter at Tom Keane before the podcast. You can always catch us worldwide. I'm Bloomberg Radio