Stimulus Addiction
The first quarter of 2012 saw some dramatic changes in market sentiment as Europe found its equilibrium, the US showed signs of a sustainable recovery, and the Chinese economy officially downshifted. Global political forces finally regained the upper hand on contagion and bond market vigilantes, stabilizing European bond spreads, easing overstretched foreign exchange rates, and restoring some confidence in the stock market.
The first quarter centered on the questions of whether Europe could keep its unity, China could manage a soft landing, and politicians could restrain themselves from spoiling the economic recovery. The questions for the next few months remain the same, but we now have a few more answers. Europe threw up enough stabilizing measures to take Greece through an orderly default process. The continent still faces a looming recession and more political turnover, but it may be able to limit the impacts of these factors following the successful effort to save Greece. The Chinese miracle is entering a natural slower phase, and so far Beijing's planners have shown a steady hand. On the political front, Europe's leaders are tentatively forging ahead with plans for greater fiscal unity, Washington has called an uneasy truce until the presidential campaign begins in earnest, and the world community appears ready to tackle the thorny crises in Iran and Syria.
In this environment, equity markets got off to a blistering start in 2012, as some of the mountain of cash that fled into the bond market last year started to reallocate to stocks in light of an improving economy. The recent 10 percent drop in the price of gold could indicate a return of confidence, although the forex market still shows a muddled picture as the "currency wars" continue.
The sentiment shift is underpinned by central bank programs, namely the ECB's LTRO and the prospect for the Fed to launch QE3. These programs may be the final injections of extraordinary stimulus that central bankers will deal out, so it may be time for the markets to consider how to handle the withdrawal symptoms once the stimulus drains from its veins. Central bank chiefs appear to be wearied by the extraordinary lengths they have had to go to during this crisis, and are ready to plan exit strategies to gently break the market addiction.
Europe on the Patch
The question was raised last week at the ECB press conference, where President Draghi was quick to reply that banks are not addicted to cheap money. But how true is that statement? The situation in Europe has been shored up for the time being by the Greek debt swap arrangement, pledges of fiscal consolidation from EU governments, a dollar swap arrangement between central banks, and an "adequate" firewall agreement. Sentiment did not really turn, however, until the ECB was finally drawn into the fray with its innovative Long Term Refinancing Operations. The two LTROs greased the wheels of lending which indirectly helped prop up the sagging European peripheral sovereign market, easing Spanish and Italian 10-year debt yields back below 7 percent. The program bought Europe some time to enact its austerity measures and to work on improving "competitiveness" in the region.
Now it is up to individual governments to make good on their vows to create more lean and efficient economies in the time that's been given them. The jury is still out on whether southern Europe can follow through. Despite praise for the steps they've taken so far, Italy and Spain have a long way to go before they are in the clear. Spain could be the nexus of the next crisis as it has already admitted it can't meet 2012 fiscal targets in the face of an economy stagnated by crippling unemployment rates, especially among youths. Already Spain has seen unruly demonstrations reminiscent of the scenes in Greece a few months ago, and labor unions are launching spot strikes across much of the EU in protest of austerity measures and the relaxation of labor laws. For example, a trucking strike in Italy protesting higher fuel taxes has been disastrous for the auto industry, with Fiat posting its worst March sales in three decades.
Greece will also lurk in the background. Though its contagion has been contained after a year of hit-or-miss negotiations, the new government that will take power in Greece after early May elections has a monumental task ahead of it to reach its fiscal consolidation targets. Any cavalier statements from the next PM, likely the New Democracy Party leader Samaras, could restart the rumblings about his country needing yet another rescue in the years ahead, further fraying the fabric of the Euro Zone. It was just in February that Samaras was quoted as saying he might seek to "renegotiate and change the current policy" after he is elected PM, prompting Euro Zone leaders to demand he and other Greek party chiefs sign a written pledge to stick to the bailout agreement.
The revised firewall agreement amounted to €800B, higher than Germany wanted to concede but lower than the trillion plus that non-European governments were said to be pushing for. The plan is meant to be a sign of good faith that Europe will take care of its own business, and as a marker to induce global treasuries to agree to boost the IMF's capacity to help out. Ultimately the firewall was built for show, and the agreed-upon size would not be enough to support the world's 8th or 12th largest economy (Italy and Spain together account for over 20% of Euro Zone GDP) should they get into real trouble. Indeed, Italian and Spanish yields have crept higher in recent weeks as the debt market reminds everyone that it is keeping a watchful eye on the situation.
The core European states have had their problems too. The UK could slip into recession with a negative Q1 GDP print, though survey data are tilting toward signs of growth. France says it has narrowly avoided a recession, expecting a modicum of growth for Q1 after a negative reading in the prior quarter. Even powerhouse Germany has had its issues, with its most recent manufacturing PMI reading showing contraction. These core states still have broad differences on the right way forward for Europe -- for example, there is little agreement on the idea of a financial transaction tax. The first hurdle for the fiscal unity track (which the UK and Czech Republic have already opted out of) will be seen in an Irish referendum to be held on May 31. Polls show Ireland is ready to support the proposal, but it could be only the first of many nervous moments for the fiscal unity plan as successive national governments take up approval measures.
France also faces political changes at the top as the national election process is set to start on April 22. Battling a high disapproval rating, President Sarkozy has managed to narrow the gap against his main rival Franois Hollande of the Socialist Party. Mr. Holland has consistently led in the opinion polls and seems primed to win in a run-off election against Sarkozy on May 6. While he has stated he will seek to work within the framework created by "Merkozy" for Europe, Holland may seek to ease austerity measures enacted by his predecessor, pleasing the electorate but potentially upsetting markets.
Dow Jonesing for Stimulus
With the European crisis contained for the time being, risk aversion and volatility have ebbed and money managers have found that the best value lies in the US equity market. As a result, the DJIA had its best Q1 percentage gain since 1998 (+8.1%), and the S&P 500 turned in its best quarter since Q3 2009 (+12%) and its biggest Q1 point performance ever (+151). After running up to levels not seen since before the 2008 global financial crisis, equities may be more sensitive than usual to the upcoming earnings season. This post-holiday period is usually the time for sales and inventory clearance and same store sales data are indicating a fairly robust quarter for retailers. In this segment, unseasonably warm weather during Q1 in the US may have artificially boosted retail sales, "stealing" sales from the Spring months which may suffer worse than expected results after the early strength this year. This tale will play out in Q2 guidance.
Meanwhile the tech sector is showing signs of the long-awaited IT refresh cycle kicking in. If the last remnants of the supply chain disruptions from the flooding in Thailand and the tsunami in Japan can be overcome, high tech firms could be well positioned for the rest of 2012. The breathtaking performance of Apple's stock has been emblematic of the huge run in tech shares after solid results for many marquee names last quarter. Yet the fourth quarter earnings season did turn up some red flags indicating that the first half of 2012 could show slower growth than some expectations. Business technology stalwart Oracle, which almost always manages to show results in line or slightly ahead of expectations, came up short in its most recent quarter, raising questions about the near future. Any backsliding from the business world could shake up models for solid 2012 growth and start a reevaluation of multiples.
The IPO for social media giant Facebook appears to be on track for liftoff in May, which could give the tech market even more juice, or it could signal a short term top in the market. The old market adage "sell in May and go away" has been valid advice the last few years as stock markets off to a good early start languished during the summer months, as seen last year when the Greek debt crisis exploded in August.
Chasing the Dragon
The Chinese stock market has not gone along for the ride with other global equity markets. The Shanghai index slid throughout March on poor industrial production numbers and concerning export data, which fanned the ever-present worries that China will not be able achieve a soft landing. State-tabulated PMI data paints a rosier picture, and rumors have swirled for weeks that the government is ready to renew easing actions with a cut to the Reserve Requirement Ratio (RRR) for banks.
Along with the economic challenge of managing a more moderate growth rate, China's government is heading into a transition period when the next generation of leadership will take power. This impending transition recently spawned rumors of a power struggle between the presumed next premier, Xi Jinping, and the leader of another faction in the Communist Party, Bo Xilai. The government was quick to dismiss this chatter, but not before it was escalated to a "coup" by the rumor mill. Incidentally, Mr. Bo and some of his allies have been unceremoniously removed from their party posts.
With the Chinese government managing its economy (and some say its economic data) it may be wise to watch China's trade partners to get a clearer idea of how the economy is fairing in the People's Republic. In Australia two months of soft export data have raised some eyebrows. Australia's raw materials have been feeding the Chinese growth phenomenon so any continued slowing of Aussie export figures (May 7) could be a warning sign for China.
The biggest wildcard in Asia remains Iran. The net of economic sanctions continues to tighten around Tehran, and will be cinched with a European embargo of Iranian oil starting in July. A fresh round of talks between Tehran and the major powers will begin in the weeks ahead, but Western leaders have warned that the diplomatic window is narrowing. The sanctions are said to already be taking a toll, and should Iran become backed into a corner, the Supreme Leader may make the rash decision to militarize the Straights of Hormuz, harassing tankers or even mining the waterway.
This might be the year that the pundits' perennial predictions of a military strike against Iran actually materialize, though such action might create as many problems as it solves. Bombing Iran's multiple nuclear related facilities, especially if carried out by Israel, could generate a backlash among muslin states, creating destabilizing ripples in areas like eastern Saudi Arabia where there is some sympathy for the Persian regime. That said, the regular OPEC meeting in June could be the most contentious one to date. For the time being, crude appears to be range bound between $100-110/barrel as Iran tensions are partly offset by chatter that western powers could release oil stocks from strategic petroleum reserves and that Saudi will continue to produce at elevated levels even if the SPRs are tapped.
Market Methadone
Elevated energy prices are one of the many factors central bankers are now weighing as they consider whether to keep feeding the markets more stimulus. If energy inflation persists for longer than expected, the Fed may find its two mandates working against each other. Price stability may demand a stronger dollar, but the promise of more extraordinary easing to foster job creation will continue to weigh on the dollar.
To avoid this dilemma the Fed will be hoping for better payrolls data in the months ahead. Monthly payrolls had been rising at a 200 thousand per month clip for three months, until the March data released on April 6 blunted the trend. One bad month could be an anomaly revised away in the April payrolls data, or it could be the start of a new soft patch that will leave markets begging for more stimulus. The housing market also had a good three-month stretch, with starts and permits seeing their highest levels since the global financial crisis began. Future housing data could help confirm the trends in evolving in the labor market.
The big turn in sentiment that started late last year largely came courtesy of central banks. After arranging a credit easing dollar swap with other global central banks, the ECB stepped in again with its LTRO, which finally stabilized the European situation. Meanwhile in the US, the four-month market reversal has been predicated on the so-called "Bernanke put" -- that is, if things don't improve the Fed will refresh its accommodation efforts with a third round of quantitative easing.
With Operation Twist expiring in June, and the Presidential race heating up, the Fed will likely want to act sooner rather than later to lay the groundwork for any new program (despite the Fed's claims it won't let the political calendar influence its decisions). Expectations are that the central bank will give some indication of its next potential QE move at the April FOMC meeting which is a two day meeting culminating is a press conference hosted by the Chairman.
Market watchers see the Fed having three options for additional easing measures: more QE, a "sterilized" QE, or an extension of Operation Twist. More outright quantitative easing (QE3) may be the least likely option at this point since the Fed has already tried it twice and Bernanke is on the record as saying each QE effort has diminishing returns. Press reports last month said that the Fed has discussed sterilized bond purchases, achieved by borrowing back money used to buy Treasuries or MBS at low interest rates, with the intent of easing concerns the newly printed money could increase future inflation pressure. However, Fed officials have subsequently denied any such discussions (Fisher on 3/19 and Plosser on 3/29).
The more open and transparent Fed that Bernanke has promoted could make his job more complicated in the months ahead. Bernanke, a student of the Great Depression, has indicated that he will not take his foot off the pedal for fear of squelching a nascent recovery before it can sustain itself. Countering this position, the hawks have made it clear they see no need for more stimulus from the Fed unless the economy takes a dire turn. The standard bearer for the hawks this year is Richmond Fed President Lacker who established himself as the new dissenter by voting against a set date for the low rate pledge. The new rate path predictions begun this year have made it clear that there is a broad spectrum of opinions on when the tightening cycle should begin. Steering this more public than ever debate at the Fed will be Bernanke's biggest challenge in a Washington that has managed to politicize ever other facet of government (witness the Supreme Court decision on 'Obamacare' that could come down to a 5-4 vote). The rate path forecasts will get their first revision at the April 25 FOMC meeting, and because of its novelty any shift in the predictions this time out could be lent more weight than deserved as a signal that the central tendency of policy has shifted.
As of now, the majority of forecasters still include more Fed quantitative easing in their models. Until now, Bernanke has been stressing the downside risks, apparently determined to keep the promise of QE3 alive. Improving data trends and some of the most recent Fed commentary have created some doubts about more QE, however. In Congressional testimony in late March, the chairman made no reference at all to QE3 and minutes of the March 13 FOMC meeting suggested little discussion of the topic. It seems the Fed is now in a wait and see stance, and any indication that it might waive off QE3 might be a strong signal that the Fed feels the threat has passed, but this could have a perverse effect on markets that have become addicted to open handed stimulus.
Kicking the Habit
Markets have become hooked on central bank stimulus. The artificial accommodation provided by central banks has created market distortions, mostly for the good so far. But the government banks rightly fear that if it goes on much longer, the medicinal effect will turn to addiction which will make the withdrawal period that much harder.
Publically, central bankers have insisted this is not a concern -- the Fed has indicated extraordinarily low rates will continue for two more years and QE3 is not off the table, while ECB President Draghi has said outright that banks are "not addicted" to the LTRO. In their inner deliberations, monetary policy councils seem more worried about the addiction issue. Concerns about the consequences of pushing more stimulus through markets have led to a shift in central bank speak. The ECB has vowed that the LTRO will not be used again and the Fed has shown some signs it may withhold QE3 unless things get worse.
Signs of fading momentum in the US jobs market, significantly slower growth in China, or stumbles in fiscal consolidation in the EU could all prompt more policy intervention. While global growth is expected to slow this year, it is unclear whether it will slow enough to crimp the sentiment change that came in with the New Year. The three largest world economies -- the US, China, and Japan -- are all expected to report good growth in 2012, even if the European region drags down the global average with a mild recession. But if these forecasts don't meet expectations, the currency market, where the dollar has made only small inroads against other reserve currencies despite the US strength, is indicating the punters are betting that the Fed is still the most likely to intervene again. Meanwhile the bond market appears ready to put Spain to the test as its 10-year yield creeps higher again, and a Spanish scare could be exacerbated by the banks that used the cheap money from the LTRO to load up on more sovereign debt.
In Asia, China's economic rulers may be poised to deliver another analgesic rate cut. In Europe, events in Spain and Italy will be watched closely in the months ahead, as any further slippage from fiscal consolidation targets could trigger another tumult in the debt and credit markets, and draw the ECB back in. In the US, the Fed will have to decide within the next month whether it wants to replace Operation Twist or leave its final adrenaline shot in reserve. Central banks don't want to turn the stimulus drip off prematurely, but are looking toward a time when they can start unwinding extraordinary accommodation. The stimulus put in place this year has pushed off the withdrawal date to at least 2013, but the next task for central banks will be how to manage those expectations so that removing accommodation is perceived as a vote of confidence for the health of the market and not a reason for a relapse.
