Tuesday, February 7, 2012

TTN February-March 2012 Outlook

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.


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