TTN February-March 2012
Outlook
A Healthy Recovery?
In the last few months we have seen some limited positive progress out of
politicians who previously seemed determined to fail to the detriment of the
economy. The US Congress kicked the can down the road again on tax cut
extensions, while Europe has gotten closer to an orderly Greek resolution and
made some decisions on how to move forward with greater integration. The ECB
also bought them some more time by enacting a three year LTRO (long term refinancing
operation) to ease bank funding issues, an effort that has salved sovereign
markets.
The situation has also been helped by improved data in many regions, with
global PMI readings picking up, the US jobs market improving, and China
navigating a soft landing. Yet despite this, the outlook is still uncertain and
global forecasters like those at the IMF continue to cut forecasts for 2012 and
predict a double dip for Europe.
In this reality, three big unknowns will be major determining factors for the
fortunes of 2012: Politics, Europe, and China. The outcomes of elections and
other political battles, the ability of Europe to move toward greater
integration and stability, and China continuing to skillfully harness its
economy will all play into how healthy the global economy remains in the months
ahead.
Europe Takes its Medicine
Concerns about a Euro Zone implosion have been minimized through a series of
sometimes clumsy negotiations and imperfect bargains that have managed to pull
Europe away from the edge of the abyss. A systemic failure on the order of 2008
has been averted with cheap dollar lending, promises of fiscal consolidation,
and the relief provided by the ECB's LTRO.
European banks are expected to gorge themselves on the 3-year LTRO in the second
round of auctions on February 29. Press reports say that many large banks are
preparing to double or even triple their funding requests from the LTRO money
auction, after the ECB supplied €489B in its inaugural operation in December.
Some bankers are now estimating the auction will exceed €1T and could go even
higher if markets should deteriorate in the next few weeks. After the success
of the first auction many more banks are expected to participate in the second
round as well, with the potential of stigma removed and the promise of cheap
money at a tantalizing interest rate of only one percent.
The LTRO has lent some stability to the situation in Europe, which is now
expected to deteriorate at a slower pace. It appears to have had a salubrious
effect on European spreads as some of the cheap money has flowed into higher
yielding sovereign bonds, bringing down borrowing costs for the peripheral
nations (particularly in Italy where the key rate has dropped 200 basis points
from its peak). Forecasters are predicting a mild recession for Europe this
year as the continent limps along at a decrepit pace, having taken longer than
anyone expected to agree on resolution mechanisms.
Contagion Contained?
It now seems less likely that a Greek credit event will cause a tailspin across
markets this year, but the event will still have to be absorbed. Greece needs
to make a €14.4B bond payment by March 20, and many analysts are now looking to
this date as the start of an orderly default process for Greece. Talks with private
creditors to avoid a disorderly default are nearly complete, though a second
track of negotiations to trade more austerity for a second bailout package has
been thornier. Greek opposition parties and unions are decrying the notion of
more cuts, but barring any last minute Greek drama, it seems they have little
choice but to accept. The hope is that this will immunize the Euro Zone from
Greek contagion.
Europe may not be out of the woods yet, however, as troublesome symptoms have
been observed in Portugal and Hungary. The Hungarians have managed to make
their European partners queasy by threatening the sacrosanct independence of
their central bank. This has placed an IMF loan package at risk, without which
Hungary could become a new source of contagion for central Europe. In Portugal,
interest rates have continued to rise, even as other peripheral nations saw
yields ease. Speculation is swirling that the nation could need another €30B
bailout on top of the €78B it got from the IMF/ECB/EU troika last year. This
has triggered an uneasy series of statements from top EU and Portuguese
officials giving assurances that it will not need a new bailout package like
Greece. This sort of denials have foreshadowed each new stage during the
European crisis, so they tend to have the opposite effect, screaming that
Portugal may soon need to enter bailout talks. This idea that Portugal may be
succumbing to the same infirmities that sent Greece to the intensive care unit
is concerning because while Europe has been steeling itself for a Greek
default, no such preparations have been made for Portugal, and French banks in
particular may find themselves overly exposed again.
Against this tide, incremental progress is being made. The new EU treaty is set
to be signed by most of the union's members (the UK and Czech Republic opted
out, and others like Sweden may still get cold feet) in the next few weeks,
inching the continent a step closer toward fiscal union. This milestone treaty
is the point of no return for the Euro Zone as well, as more centralized power
gives Germany the political will to continue with the Euro experiment, perhaps
someday leading to real fiscal union and minting Eurobonds. Leaders have also
recently confirmed that the ESM backstop fund will launch in July 2012, but
talks are still touch and go about boosting its capacity beyond €500B.
US Getting Off its Crutches
Even as Europe struggles to right itself, economic data has been good enough in
the US to be called surprisingly strong, though much of that renewed strength
appears to be from the chronic adrenalin shots of stimulus. Most recently the
Fed extended its low rate pledge for over a year into late 2014, set an
explicit two percent inflation target, and reiterated that QE3 is ready on a
hair trigger. But stimulus is like a narcotic, the more you take the less
effect it has.
With US data yielding many upside surprises in the last few months and bond
yields pinned to extraordinarily low levels, equities have had a great start to
2012. Volatility has dropped significantly and stocks have gained steadily as
the recovery finally seems to be taking hold. Yet the surprise improvement
trends could create ever greater expectations for each successive data point,
requiring ever better data to drive markets higher. Thus, any stumble in the
economic data could be amplified as the winter months wear on.
The vital signs of the US economy have genuinely improved in recent weeks.
Non-farm Payrolls have grown for sixteen straight months and the data has shown
steady improvement over the last four months, capping it off with a resounding
243K reading last month, a twenty month high. The unemployment rate has also
yielded pleasant surprises the last two months, coming in below expectations
and falling to a nearly three year low of 8.3% in the latest reading. Measures
of growth also improved in Q4, with an improving trend in US GDP and production
indices. The second reading on US Q4 GDP will be out February 29 after the
advance reading showed sequential improvement but disappointed expectations,
while US production data has been uneven, though the most recent ISM data (both
manufacturing and non-manufacturing) had its best showing in over half a year.
With moderate economic growth, however temporary, and employment indicators
showing noticeable improvement, risk appetite has improved and the VIX
"fear" index has hit a seven month low. But the nascent economic
recovery may not be as healthy as some prognosticators believe. One key factor
will be the continuing absence of a housing recovery. The construction sector
has played a significant role in past economic recovery cycles, creating
construction jobs and perceived wealth as home prices appreciate. But this time
around, even though there have been some sporadic positive housing readings,
the housing sector is unlikely to undergird the recovery in jobs and
production.
The Fed Prescribes More Tests
Old Doctor Bernanke for one is not convinced of the health of the patient. At
his latest press conference, Bernanke made sure to emphasize that the Fed is
not out of ammunition and laid out certain conditions that might prompt them to
embark upon a third round of quantitative easing. In discussing the inflation
target the Chairman also made it clear that the Fed would not accept a moderate
rise in inflation as a trade off for more job creation.
The Fed has now taken significant new policy actions at three of the last five
FOMC meetings, which may be unintentionally adding to the politicization of the
central bank-either a hawkish or a dovish dissent has been lodged at each of
the last five meetings. Indeed the latest transparency effort, the Fed's rate
path forecasts, draw the battle lines more clearly than ever. In a Washington
DC more partisan than any time in decades, the fed essentially revealed the
weighting of hawks versus doves.
The newness of the rate path forecast may make it fashionable to lend it added
weight at the next two-day meeting of the FOMC, in late April, when these
predictions are revised. Any changes may garner extra attention, maybe more
than deserved, as a signal that the central tendency of policy has shifted.
The Fed will introduce another shock treatment in March, when it is set to
release a battery of bank stress test data. Late last year the central bank
announced that the biggest 31 US banks would undergo their severest stress
testing to date in an effort to boost confidence in the financial system. The
scenarios will include a test against a European market shock for six banks
with large trading operations (BoA, Citi, Goldman, JP Morgan, Morgan Stanley,
and Wells Fargo), and the most severe parameters will include an 8 percent GDP
contraction, unemployment at 13 percent, and a 52 percent stock market plunge.
This is the first US bank stress test since the spring of 2009, when the Fed
used it to alleviate concerns about the viability of financial institutions
after the collapse of Lehman. That test was criticized as too soft, with banks
allowed to count on direct government support, and yet 10 of the 19 firms
tested were still found to have inadequate capital (within half a year almost
all of them had taken steps to meet required capital levels).
The new round of examinations is meant to inaugurate an annual assessment of
banks creating greater transparency and confidence in the systemically
important financial institutions (SIFIs). As they examine the tougher stress
scenarios, banks will also have a harder time boosting their capital adequacy
now that the TARP program is over and that Dodd-Frank forbids any new bailout
actions. If banks that were teetering a few years ago pass this severe
scenario, it may help break the fever that has been afflicting the financial
industry. Alternatively should some banks fail this new test, plans for
addressing capital shortfalls will need to be formulated. The banks have more
than reputations on the line in these tests as the Fed has also stated that it
will use the test as a basis for approving dividend increases and other capital
distributions only for companies whose capital plans "demonstrate
sufficient financial strength to operate as successful financial intermediaries
under stressed macroeconomic and financial market scenarios."
Sick of Politics Yet?
The growing political reality of fiscal consolidation is causing uneasiness in
most world capitals as government leaders rework the balance between taxes,
entitlement programs, and deficit reduction. S&P cut the US sovereign
rating last summer after the debt ceiling debate, citing the political impasse
in Washington as the primary motivation, and the Euro Zone just went through
another round of downgrades based on the execution risk for its plans for
greater fiscal integration and economic recovery. Both regions have pledged
budget cutbacks to varying degrees, but many of these plans could unravel or
radically change in the face of looming elections.
In the US, improving data has had a bipolar effect. Each new positive data
point reduces the prospects for QE3, which has been underpinning markets, while
simultaneously improving the President's chances of reelection, to the chagrin
of big business. Obama, who not long ago seemed destined to be a one term
president, has also gotten a shot in the arm from the GOP's contest to find a
standard bearer.
Republicans have struggled to find a viable Presidential contender, and the
four still remaining show no signs of stepping aside to allow a single
challenger to emerge. After winning Florida with a media blitz, Mitt Romney is
again the front runner and he has been trying to shift his focus to the general
election and President Obama, but his stubborn Republican rivals have made life
difficult. Though Gingrich, Santorum, and Paul have boasted they have the
staying power to go all the way to the Republican convention in August, Romney's
fortunes may rise in the next month or two. After two dozen debates that the
less well funded challengers used as free advertising, the GOP debate schedule
features only one such forum in the month of February (2/22). Advantage Romney.
Also in his favor, Romney won five of the six February Primaries in 2008, and a
similar showing could position him to all but wrap up the nomination on March
6, Super Tuesday, when a slew of key states will hold their primaries. Thus the
President Obama's opponent may not be known until March or later, and then the
real mud-slinging can begin. The longer the GOP process drags on and drains the
coffers of the eventual challenger, the more likely Obama will get a leg up on
re-election.
In the White House, Mr. Obama will have his hands full as the Executive butts
heads with the other two branches of the federal government in the weeks ahead.
Another skirmish with House Republicans is likely as they maneuver for leverage
on the payroll tax cut extensions. A two month compromise deal put a ceasefire
in place at the end of last year, but terms of a deal that will extend the tax
cuts through the end of 2012 must be hammered out in the next few weeks. Given
the antics seen in Washington last year, more political gamesmanship is likely
to ensue.
Meanwhile the US Supreme Court is set to review the centerpiece of Obama's
domestic agenda, the healthcare mandate that has been labeled
"Obamacare." The high court has set an unusual three-day session
(March 26-28) to hear oral arguments on the issue and this summer will render a
decision that will impact the course of the election.
The political scene in Europe may be even more intractable. Between all of the
high level emergency meetings to lay plans for treaty changes and chart the future
of Europe, what is missing is the consent of the governed. Discontent with
European leaders has shown clearly in elections this year. With the ouster of
Greek PM Papandreou and Italian PM Berlusconi in November, seven of the 17 EMU
nations have now forced out or voted out their governments within the last
year. Elections are also looming large for the core Euro Zone states, with
French elections set for April and May of 2012 and German federal polls coming
up in 2013. Discontent in the electorate has been visible, especially evident
in German regional elections last year that punished Merkel's party for betting
ever larger pools of German money on holding the EMU together. Opinion polls
show that French President Sarkozy is currently trailing well behind the
Socialist candidate Franois Hollande, and if his lead holds it could shake up
the balance of power at the center of the Euro Zone. Though he has pledged to
keep France on a path of fiscal responsibility, Hollande is also running on a
platform affirming a commitment to the public sector which could conflict with
austerity promises. It would also be a blow to Merkel who has relied on her
partnership with Sarkozy to power through some of the more dicey moments of the
Euro Zone crisis.
Tiger Balm
The third plank of potential uncertainty is maybe the most straightforward and
non-complex. The Asian economic miracle, centered squarely in China, has been
an engine for global economic growth and recovery for the last decade as the
People's Republic rises to take its place as the world's number two economy.
Chinese central planners have so far managed to walk the path between
overheating the economy and stifling booming growth with well timed stimulus
and policy braking actions.
Inflation was the bugaboo of China in 2011 and threatened to clip its real
growth rate to uncomfortably low levels. But after running hot at over six
percent for several months last year, China CPI has ebbed to 4.1 percent in the
latest reading, a 15-month low. China's PPI has subsided at an even greater
pace, easing the grip of inflation. Meanwhile Chinese growth has slowed over
much of the last year, no longer scorching double digit returns, but still
maintaining a healthy pace in the high single digits. China can only benefit
the global economy if these trends hold up, but should they reverse again
dramatically an Asian flu could rapidly infect world markets.
One potential bright spot in Asia could be Japan as it gets back on its feet
after the tsunami disaster nearly one year ago. Supply chains have been
restored and the rebuilding of the disaster zone is seen as a potential
economic boon, though the new taxes to be put toward that effort could curtail
GDP. A surprise growth spurt from Japan this year could take some of the
pressure off of China to continue propping up global economic growth on its
own.
As the US and Europe prepare for election season, China faces its own limited
form of regime change this year as President Hu Jintao begins the transition
process of turning over power to his presumed successor Xi Jinping after ten
years in leadership. Mr. Xi's politics are still not entirely clear, but many
observers hope that as the representative of a new generation of leadership he
will continue the economic reforms of his predecessor and may even be more open
to political changes. In any case, managing China's economic ascent while
tending to the maturing needs of an increasingly affluent and economically
dynamic population will be a challenging task for the incoming leader. Thus Mr.
Xi will be under ever increasing scrutiny in the months ahead as he takes over
the post of General Secretary this fall, and then President next year.
Politics will have an outsized impact on energy markets too in the next few
months as Europe moves toward an embargo of Iranian oil by mid-year. This
latest round of sanctions targeted at the Iranian nuclear program could
decimate Iran's economy, and has provoked Iran into threatening to preemptively
cut off its supply to Europe to cause reciprocal economic damage. If Tehran
follows through on this threat or disrupts traffic in the Straight of Hormuz,
energy prices could spike which could stunt the nascent recovery seen in some
Western economies.
Lately there have also been rumblings that Israel may decide unilaterally that
the time for negotiations is over. With Iran estimated to be a year away from
potential nuclear weapons capability, the Israelis may see this as the last
chance to cripple Tehran's nuclear ambitions with a military strike before the
weapons program gains so much momentum that it becomes unstoppable. Israel
successfully destroyed a secret Syrian nuclear facility in September 2007 with
astonishingly little political fallout, and now ironically Syria may be adding
to the case for a pre-emptive strike in Iran. Syria is the biggest client state
under Iran's influence, but with the government in Damascus being challenged by
a year-long uprising, Iran would have little ability to counterstrike against
Israel through its proxy state now in turmoil and under international scrutiny.
The Iranian government has made a show of strength, with fleet maneuvers in the
Straight of Hormuz and demonstrating its ballistics expertise with a recent
satellite launch, but those will likely do little to deter Israel if it senses
an existential threat.
To Your Health
The old market adage says that, as January goes, so goes the year. If this
bears out, the steady rise in equities during the opening weeks of 2012 sets a
favorable tone for the rest of the year. The "hope" trade that
generated a stock market rebound late last year was legitimized by some recent
data points that suggest the economy is seeing a turnaround, especially in the
US. Still many skeptics are not convinced that the volatile days are all behind
us. Even if the Greek situation is contained with a bond swap and second
bailout agreement, the odds are that Greece will undergo an orderly default and
eventually slip out of the Euro Zone. While banks' direct exposure to Greek has
been largely shed or hedged, there could still be significant fallout from a
default event, particularly the risk that the dominoes could start falling
again, starting with Portugal.
Another rule of thumb is that the first five weeks sets one extreme, the high
or the low, for the EUR/USD for the rest of the year. That criterion would
suggest that either the low has been set for the year at 1.26, or the high has
been put in at 1.32. The latter scenario seems the likelier outcome for a year
where Europe is going to fall back into recession and has yet to allay all of
the concerns about the future of the unified continent.
China started this two month stretch on vacation for the Lunar New Year, with
some celebrations lasting through the first week of February. The Dragon is
said to be one of the most prosperous signs of the Chinese zodiac, and perhaps
that bodes well for the Chinese leadership as they continue their brand of
"command capitalism." If inflation remains in check, energy prices
stay stable, and solid growth continues uninterrupted, this part of the world
should pose few surprises this season. The Asian economic situation bears
watching but remains in a better state than the US or Europe.
Questions continue to mount for the western economies as they must pay the
piper for years of excess and free handed stimulus. The ECB has found a
backdoor stabilization plan in the form of the LTRO. Balance sheets in European
capitals will be improved by austerity plans, but those same plans will be a
drag on economic growth for an indefinite period. The EU has a framework
agreement for enhanced integration but extraordinary execution risks remain.
Meanwhile, the Fed deliberates teeing up yet another round of quantitative
easing and US politicians haven't even been able to define austerity as they
gamble the health of the nation on the upcoming election, rather than
considering real compromise. The Supreme Court deliberations over
"Obamacare" may become an apt symbol of the partisan politics
afflicting Washington, as the conservative leaning court may strike down the
mandate that was passed two years ago in a bitter partisan vote. The lackluster
economy, crimped in part by uncertainty over the costs of the healthcare
overhaul, will be the ultimate determining factor in the US. If the economy stumbles
again it could lead to a change in the Administration and trigger QE3. But if
the economic recovery continues President Obama can be assured of a second term
though quantitative easing will be off the table. Pick your poison.
CALENDAR
Feb 8: China CPI and PPI
Feb 9: ECB policy decision
Feb 15: European GDP data; FOMC minutes
Feb 17: German Ifo Business Climate
Feb 20-21: European finance ministers meetings
Feb 22: Europe PMI readings
Feb 25-26: G20 finance ministers meeting
February 29: ECB's 2nd LTRO money auction; US Prelim Q4 GDP (2nd reading)
March 1: US ISM Manufacturing PMI
March 1-2 - Summit of EU heads of state and government in Brussels
March 5: US ISM Non-Manufacturing PMI
March 6: "Super Tuesday" (9 GOP primaries)
March 8: ECB policy decision; China CPI and PPI
March 9: US payrolls and unemployment
March 12-13: European finance ministers meetings
March 13: FOMC policy decision
March 16: Europe PMI readings
March 20: €14.4B in Greek bond mature
March 26: German Ifo Business Climate
March 26-28: US Supreme Court hears "Obamacare" arguments
March 29: US Final Q4 GDP
April 1: China Manufacturing PMI
April 2: US ISM Manufacturing PMI
April 4: ECB policy statement, FOMC minutes, US ISM Non- Manufacturing PMI
April 9: China CPI and PPI, China GDP
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