Views From the Floor

What could happen if the Federal Reserve did implement precautionary rate cuts?; and the reasons not to read too much into the UK construction PMI number.

In this week’s edition (12 Feb 2019) - we question whether the honeymoon is over in Brazil; and why crude prices look vulnerable.

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What If the Fed Did Cut Rates?

As of 3 July, the Fed funds futures curve was pricing in a 100% probability of a rate cut when the Federal Open Market Committee meets on 30-31 July.1

Previous Fed easing cycles that occurred without a looming recession were in 1995 (the Tequila crisis) and in 1998 (Asian, Russian and LTCM crises). To get a sense of what might happen in the event the Fed did implement precautionary rate cuts, we analysed the returns to factors and yield curves before and after the precautionary rate cuts, based on the net monthly returns to the MSCI World Index (Figure 1).

In both 1995 and 1998, rates ultimately went higher, yield curves steepened and the dollar rallied – perhaps exacerbated by the fact that the original crises were both in emerging markets. Value underperformed after both easing cycles, losing 7.1% and 5.6% in the 12 months after 1995 and 1998, respectively, while momentum outperformed, gaining 7.9% and 4.5%. From a defensive perspective, minimum volatility strategies struggled, losing 0.9% and 10.5% in the 12 months after the easing cycle. Quality, on the other hand, was mixed – rising 4.9% after the Tequila crisis, but falling 3.1% after 1998.

One other statistic might be of interest. The ISM manufacturing survey is often used as a proxy for growth. Over the same 12-month period, it rose from 45.9 to 48.7 in 1998, and from 53.6 to 57 in 1998.1 On this basis, it seems to us precautionary cuts do extend the economic cycle.

Figure 1: MSCI World Index Factor Returns, Yield Curve Changes and USD Strength Before and After Precautionary Rate Cuts

MSCI World Index Factor Returns, Yield Curve Changes and USD Strength Before and After Precautionary Rate Cuts

Bloomberg, Man GLG; As of 1 July, 2019

The UK’s Construction Hangover

UK construction purchasing manufacturing indices (‘PMIs’) tumbled to 43.1 in June from 48.6 in May, the worst reading since April 2009 and far below the 50 level that indicates no change from the previous month (Figure 2).

However, we would caution against reading too much into this one number: PMI data can be volatile and impacted by weather month on month, not always correlated to output data, and often fails to capture the longer-term nature of construction planning. Many commercial projects which currently feature in PMI data would have been commissioned more than 18 months ago; poor numbers today are a direct result of a lack of confidence in 2016-17.

In our view then, whilst the weakness was more broad- based than in recent readings, poor PMI data may continue to be a lasting hangover from the post-Brexit environment rather than directly indicative of the longer- term trend. The UK construction industry is still expected to be supported, in our view, by the structural need for more housing supply and the longer-term national infrastructure pipeline (albeit with the risk of short-term delays in the current political backdrop).

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Source: Markit, Bloomberg; As of June 2019

The Conditions for an Oil Rebound

We believe conditions are ripe for higher oil prices for four reasons.

First, the surplus in crude inventories has almost eroded: excess supply stood at 0.4 million barrels a day as of 31 May (Figure 3). Evident surpluses in the first quarter were the main reason for our caution earlier this year. Second, speculative long positioning is at 0.161 million contracts, close to lows. Third, tensions between Iran and the US have increased, with the prospect of renewed sanctions on the Iranian economy after the limit for Iran’s enriched uranium stockpile was breached.2 Fourth, not only has OPEC agreed to production cuts until March 2020, but Russia and nine other non-OPEC producers have also agreed to a 9-month rollover of oil supply cuts.

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As of May 2019

With contribution from: Ed Cole (Man GLG, Managing Director) and Matt Walker (Man GLG, Analyst).

1. Source: Bloomberg

2. Source: