Friday, June 1, 2012

June-July 2012 Market Outlook

This summer we fully expect to see a market that evokes one of baseball personality Yogi Berra's greatest lines: "It's deja vu all over again." The next few months are shaping up to be a rehash of the dogs days of 2011. Greece is still the boogeyman of the euro zone, threatening to start a domino effect that could tear apart the common currency. Politicians on both sides of the Atlantic are butting heads over the balance between austerity and growth policies once again. Beijing continues to give assurances it can manage a soft landing for the Chinese economy, even as many indicators are souring faster than expected.

The potential for a replay of last year's issues has once again unsettled markets that were off to strong start earlier in 2012. Equity markets had a blockbuster first quarter, but the US and Chinese indices are now well off their highs and European stock markets are largely in the red for 2012 (the Greek market hit a 22-year low). The flight to safety has pushed 10-year government bonds in the US and northern Europe toward record low yields, trumping gold as a safe haven play - this year the precious metal has failed to regain traction as a store of wealth after nearly reaching $2,000 at the height of last year's crisis. That is due in part to the strengthening of the dollar index, which has also helped tame the price of oil, despite an impending embargo of Iranian supply. The euro, which has remained surprisingly strong throughout the EMU crisis, has finally begun to erode against the dollar as the Greek tragedy heads into its third act.

Uncertainty remains the watch word for the global economy in this environment. Market forecasters are still predicting more stimulus from in the form of a third three-year LTRO and QE3, but officials at the Fed and ECB have been held off on more accommodation so far. Despite unprecedented transparency from central bankers, it's still unclear how much worse the global economy has to get before they will swing into action again.

Leaders in Washington are deadlocked over looming budgetary problems (the so-called "fiscal cliff"), Europe is reliving a situation in Greece that was supposed to have been resolved by the PSI debt swap, and there are fears that China's gradual slowdown will be bumpier than its leadership, now in transition to the next generation, can manage.

"When you come to a fork in the road, take it"

European leaders, struggling with severe austerity plans, have recently tacked toward trying to have it both ways by exploring growth measures alongside austerity. The election of Francois Hollande as the new president of France prompted an immediate shift toward growth measures to balance the austerity that was the foundation of the plan forged over the last year. Within a week of the French vote, German Chancellor Merkel and the EU's top brass conceded that austerity alone won't work. Mr. Hollande also pushed hard to revive the idea of common euro bonds at the recent informal EU summit. Germany and the rest of northern Europe have continued to reject the idea, noting common bonds would unfairly raise their own borrowing costs, but have also appeared to be more open to smaller steps toward burden sharing. The idea of creating an FDIC-style bank deposit insurance for the euro zone seems to be gaining traction - with talk of a 1 percent levy on bank deposits to fund a resolution reserve - and leaders appear ready to grant Greece some small growth oriented concessions on its bailout/austerity agreement.

There are hopes that some decisions will be made at the formal EU leaders summit on June 28-29. European leaders raised expectations for impactful decisions at the upcoming summit after cautioning that May's "informal" summit was just a brain storming session to set the table for an action plan in June.

Europe is in a holding pattern until Greece conducts new elections on June 16. The recent EU gathering discussed a variety of additional support measure that could be offered to a compliant Athens, but the euro zone needs to confirm that Greece will remain a member before any new decisions can be made on the future of the group. Polls suggest that the Greek people overwhelmingly want to remain in the EMU, but sentiment is much less favorable when it comes to the design of the bailout agreement, which the rest of the EMU insists must be abided by. The anti-bailout Syriza party is looking to play spoiler again and is running neck and neck with the conservative New Democracy party. Syriza is attempting to use contagion as a lever to pry bailout concessions from Europe. If Syriza wins outright (garnering 50 bonus seats granted to the biggest vote-getter in the 300-seat parliament) or runs a strong second as it did in the last round of inconclusive elections it could herald a rapid and messy Greek exit from the euro zone. On the other hand, if New Democracy and its pro-euro coalition partners in the socialist Pasok party manage to squeeze out a majority, then Greece will likely remain in the common currency, at least long enough to make an orderly exit.

In the meantime, European leaders will be watching for other warning signs that their actions may not be rapid enough. Their worst nightmare would be a series of bank runs in the peripheral nations that cause the financial system to lock up again. Alarm bells went off in the days after Greece failed to form a new government when it was revealed that the slow bleed of deposits in Greek banks had accelerated considerably. This immediately raised concerns about the Spanish banking system, which is saddled with doubts raised by the Bankia's request for a €19B bailout. There have been no immediate signs of a potential bank run in Spain, but about 4 percent of its bank deposits have been transferred out to stronger EMU economies over the last year.

If Greece is cast out of the euro zone, Spain is poised to be the next battleground. Aside from the threat of Greek contagion and the deep problems within its banking system, Spain's economy is laboring under record high unemployment rates (above 24 percent, triple the pre-crisis level), and budgetary problems that extend to its regional governments. The President of Catalonia, the wealthiest of the Spanish regions, accounting for about a fifth of the nation's GDP, recently told reporters that his government will need assistance making debt payments if they can't find a way to raise more funding. He said the option of funding via patriot bonds (paying 4-5 percent) has been exhausted with a quarter of Catalan savings already pledged, and implied that taking short term loans from the market at 7 percent as some other regions have resorted to is unsustainable. Catalan officials later backed away from the executive's statement and said they were not seeking a bailout, but made it clear that some sort of debt mutualization was desired.

Spain also has to develop a bank bailout plan that is acceptable to its EMU partners. Initially the Spanish government floated the idea of recapitalizing Bankia by directly injecting €19B in government debt into its parent BFA, amounting to an IOU that the bank could deposit with the ECB in return for liquidity at the central bank's three month refinancing window. Subsequent reports said that the ECB shunned this scheme as it might blur the distinction between these IOUs and the ECB's normal liquidity operations and set a dangerous precedent for other euro zone nations that are seeking to recapitalize their banks without going to international sources for bailout funds.

As European officials insist over and over, Spain is not Greece. Its economy has more breadth and its debt problems are not as acute. Spain has a lower debt-to-GDP ratio than Greece and has already issued debt for more than half of its financing needs this year. Yet with its banking system and regional finances under a cloud, the Spanish 10-year yield has edged back above 6.5 percent, not far from the 7 percent threshold that pushed Greece, Ireland, and Portugal toward seeking bailouts (and near a spread that will likely move LCH.Clearnet to increase margin requirements on the sovereign debt). On top of that, another quarter of GDP contraction is expected in Q2.

If the ECB remains unwilling to bend its charter to become the lender of last resort for sovereigns, Spain will need to need to look at other options. One alternative might be modeling a bank resolution law on those in German and the UK that allow for restructuring failed banks and boosting equity by writing down creditors rather than using taxpayer funds. A more controversial strategy that has been resisted by EMU officials would be to wipe out shareholders and convert their debt to equity. Rumor has it that Spanish regulators are also considering reinstating a short selling ban on financial stocks. Meanwhile, the IMF is said to be working on standard contingency plans in the event a Spanish bailout becomes necessary, though both the fund and Madrid deny any dialogue about a bailout has taken place.

The bond market appears ready to put Spain to the test as its 10-year yield has crept back above levels it saw after the launch of the LTRO that stabilized European debt markets earlier this year. A Spanish scare could be exacerbated by the banks that used the cheap money from the LTRO to load up on more sovereign debt. All of this has put renewed pressure on the euro currency.

"A nickel isn't worth a dime today"

The action in government bond markets indicates that the declining strength of the euro has been precipitated by the weakness of the peripheral nations. Cash is pouring into the German 10-year government bond, which has hit fresh all time lows around 1.2%, and record lows have been established in other northern European 10-year bonds as well (Netherlands, UK, Finland, Denmark). These bonds are definitely not cheap at this point, and these flows are strong indicator of mounting concerns that the worldwide recovery could be tripped up if southern Europe stumbles again.

The euro has tumbled to 2-year lows below 1.237 against the greenback as the shearing forces hitting the currency zone exacerbate the divergences between its member economies. As the forex market awaits the latest master plan out of Europe, the euro could next probe the psychological support at 1.2000 and test its 2010 low (and 1999 launch level) of 1.1874. This seems quite plausible as the price action this year has seen the fourth instance of the Euro breaching a January high and low since the launch of the common currency (in all but those four years the January trading range has tended to mark either the high or low for the Euro for the remainder of the trading year).

The weakness in the euro could have a silver lining: A 10 percent drop in the euro's trade weighted value should boost economic growth by about half a percentage point. But the impact would not be felt equally across the zone. The weakening euro could boost exports for the continent's strongest industrial economies, like Germany and the Netherlands, but it will be of little help to the weaker peripheral economies, only increasing the imbalances within the zone.

Meanwhile the firmer greenback has weighed on dollar-denominated commodities, helping ease some inflation concerns. In May WTI crude had its biggest drop in over three years, falling 15 percent and dipping below the $90 mark even as the US summer vacation driving season begins.

As the dollar index strengthens in the absence of good alternatives, US treasuries(what PIMCO has dubbed "the least dirty shirt") have continued to attract risk averse money. The 10-year treasury yield has been pushed back to near record lows around 1.70%. The Fed keeping the prospect for QE3 alive has helped suppress rates, though the end Operation Twist, the program to extend the average maturity of its portfolio, could lead to a modest reversal, steepening the yield curve.

"You can observe a lot just by watching"

The Federal Reserve has used its greater transparency to strongly indicate that it remains in 'wait and see' mode. At the last FOMC meeting, stimulus addicted markets were hoping for a better indication of shape and timing of the next quantitative easing package, but Chairman Bernanke folded his arms and merely reiterated that more [unspecified] action will be taken if needed. Fed watchers believe that QE3 would most likely focus on adding MBS to the Fed's portfolio, but FOMC officials have doggedly avoided fueling speculation about any new program. Instead they have largely tried to downplay expectations for a new round of quantitative easing, exemplified by Dallas Fed President Fisher commenting that he is perplexed by Wall Street's fixation on the subject and that QE3 would only come if the economy takes a "dire" turn. The Fed has also indicated that Operation Twist will conclude on June 30th as scheduled with no extension or renewal, and has taken pains to assert its end does not amount to tightening and will have no ill effects even though a successor program was not announced. The final FOMC policy meeting before the end of the Twist comes on June 20.

The ECB has been even quieter than the Fed on the prospects for more accommodation. Since the launch of the two LTROs, President Draghi has noted the calming effects it had on European markets, and in the next breath urges political leaders to use this respite to forge ahead with fiscal consolidation efforts. Yet market pundits are still anticipating more extraordinary measures from the ECB.

For both central banks the incoming data will be crucial to their efforts to manage expectations of more easing. The euro zone eluded a technical recession after Germany posted solid Q1 growth, but most of the EMU is still struggling. In total, the euro zone is now experiencing its highest unemployment rate since its inception in 1999, with joblessness near 11 percent. Even with the German machine humming along, the latest euro zone PMI reading was at its lowest since June 2009, showing significant contraction (at 45, below the break even 50 level). The recent drop in energy prices, a weaker euro aiding exports, and more political will to consider growth measures may help retard this slide, and could even bring a snap back later this year. But it's a dangerous waiting game with restless populations worried about their economic future.

For the Fed, economic prospects are a little better, with US growth slow but steady, and unemployment improving a little faster than expected, even if the underlying reasons why aren't entirely clear. Inflation is under control, and since maximum employment is the other half of the mandate, the payroll numbers are of paramount importance to the Fed at this point. After three straight months of nonfarm payrolls topping 200 thousand, the last two readings have slipped well below that level, prompting concerns the jobs rebound is losing momentum. To counteract these worries several Fed officials have recently taken to the podium to reiterate that one or two data points do not make a trend. Fresh US employment data on June 1st will shed more light on whether a downward trend is emerging. Washington partisans await the data with baited breath.

"We made too many wrong mistakes"

It has become clear that the biggest drawback of the extraordinary interventions by the Fed and ECB is the loss of a sense of urgency among the political class. That is to say, the stabilization created by the QEs and LTROs has to some extent lulled the US and Europe into a certain amount of complacency. In Europe, some leaders are questioning the extent of planned austerity programs and starting to discuss "balancing" austerity measures with growth programs (even ECB President Draghi addressed this head on, saying fiscal consolidation and growth are not mutually exclusive). Europe is also making slow progress on passage of its fiscal compact which decrees stricter budgetary monitoring and sanctions to prevent another debt debacle like the one in Greece. Seven national parliaments have already ratified the compact (with some of those still awaiting a presidential signature), and Ireland is expected to follow via its referendum. By design the agreement should be relatively easy to enact as only 12 of 25 participating nations need to adopt the treaty to make it binding but it must be ratified by January 2013 (the other two EU states, the UK and Czech Republic, opted out).

In the US, which has yet to honestly broach the subject of fiscal consolidation, the Fed is locked into extraordinary stimulus programs through 2014 because it is compensating for the failure of fiscal authorities to take action. Congress and the Administration appear to have entered a cold war agreement to wait for the November election to determine the course for the future. This timeframe may be entirely impractical however as the US heads toward the $500B "fiscal cliff" at the end of 2013, when the extension of the Bush tax cuts are set to expire, the automatic across-the-board budget cuts forced by the "sequester" kick in, and the debt ceiling will again be reached. Chairman Bernanke has made it crystal clear that there is no way that monetary policy could offset the sizeable the impact of such a confluence of fiscal events, so Congress must act. Washington has made some noises about addressing these issues, but the two parties appear to be digging in for the election battle.

Another event due in June with vast political implication is the US Supreme Court decision on the national healthcare reform law ('Obamacare'). The justices grilled government lawyers for three days in March, and swing vote Anthony Kennedy appeared to lean toward the conservative side of the court looking to strike down the legislation. Yet the high court is often unpredictable in close cases so the outcome is still in doubt. The lynchpin of the decision will be whether the individual mandate is constitutional under the Commerce Clause. Justice Kennedy called the individual mandate an "unprecedented" change in the relationship of the individual to the government, and questioned whether Congress can "create commerce in order to regulate it."

The healthcare industry may soon have more clarity, but the banking sector is a different matter. The US banks that the Fed regulates have been limping along in the aftermath of the 2008 financial crisis and the subsequent EMU debt crisis. Delays in the setting the final rules for the principles set out by the Dodd-Frank law are compounding the banks' difficulties by prolonging uncertainty about the new regulatory framework. The Volcker Rule, mandating the separation of banking from proprietary trading and hedge fund operations, was supposed to go into effect on July 21, but the Fed Chairman has stated that regulators will not meet that deadline.

"If the world were perfect, it wouldn't be"

The next two months will also see a bevy of global gatherings that could impact markets. The G20 heads of government meet in Mexico June 18-19 to approve the final comminque on agreements related to finance, growth, employment, and trade that have been carefully constructed in ministerial level meetings earlier this year. In April, ministers tentatively agreed on boosting IMF resources by over $400B, a little less than the IMF sought, but still bringing its lending capacity above $1T. There are still some details to be worked out on how much each country will pledge after the BRICS nations were reluctant give specifics until Europe works out its debt crisis.

The G20 meetings may overshadow a concurrent session in Baghdad as the major powers (P5+1) hold a follow-up meeting with Iran on the nuclear issue. With just weeks until the European embargo on Iranian oil goes into full effect it remains to be seen how many concessions Iran is willing to give. Both sides said the last round of meetings in May were constructive, but pressure is still on Iran with the embargo set to start on July 1st and likely to deal a crippling blow to the country's economy. The Iranian delegation played politics as much as it could, making an effort to flatter the new socialist French President, but even its traditional supporters Russia and China appear to be losing patience. So far the major powers appear to be resolute that Iran has to open up all of its facilities, civilian and military, to inspection, and that it must halt uranium enrichment beyond the levels normally used for civilian purposes.

With its production already down 12 percent in the first quarter, reports indicate that Iran is now storing large quantities of excess oil production in tankers sitting offshore. The nation has a fleet of about 40 tankers with 80M barrels of storage capacity, less than a month of production at current levels (though Chinese shipyards are scheduled to deliver one 'very large crude carrier' to Iran by the end of May as part of an order for 12 new VLCCs). It appears the country will quickly run out of storage capacity when the embargo hits and force some production to be idled which can permanently damage oil wells, reducing future capacity.

Just before the Iran dialog takes place, OPEC will hold its 161st ordinary meeting on June 14th in Vienna to set production quotas. The OPEC conclave holds less meaning than it has in the past since the meeting last June when some delegates stormed out of the session after Saudi Arabia declared it would unilaterally boosts its production level to compensate for disruption caused by Libya's civil war. Since then OPEC oil ministers have generally indicated that they believe oil at $80-100 per barrel is appropriate.

OPEC holds almost all of the world's spare oil production capacity, which is at its lowest level in four years at about 2.4M bpd, down from 3.7M bpd a year ago. That's less than 3 percent of total world crude oil consumption, with Saudi Arabia still in control of most of the spare capacity. Recent reports indicate that the Saudis have agreed to keep production elevated in the event of an SPR release, which the G8 discussed as a potential reaction to any price spike precipitated by the Iran oil embargo. Also of note for the energy market (and insurance), the Atlantic hurricane season starts on June 1.

Last but not least on the global events calendar are the Games of the XXX Olympiad hosted by London (July 27-Aug 12). With the world watching, the Olympics are always deemed a tempting terrorist target, and London is still recovering from the memory of the attack on its subway system just seven years ago.

"I ain't in no slump. I just ain't hitting."

Meanwhile, the concerns about China remain the same as they have since they hosted the 2008 Olympic Games: the slowing pace of the nation's dazzling economic boom from double digits to high single digits to the current official target of 7.5 percent. Outside forecasters have been trimming their targets for China GDP this year to the low 8 percent range, still above that official government forecast, but reflecting a clear slowdown seen in the data. China PMI data has contracted for seven straight months and bank lending has slowed to a crawl. This slowdown has already prompted rampant speculation about what the Chinese government will do to reinvigorate its economy.

China's control-capitalism has the advantage of allowing the central government to take action quickly if deemed necessary. Expectations are that the government will enact more reserve requirement ratio (RRR) cuts for its banks to spur sputtering lending, and the latest word is that a new stimulus package of up to 2T yuan (about half the size of the 2009 China stimulus package) is being prepared. Beijing has officially denied this talk, but the record shows the government is not going to stand by idly if things deteriorate much farther.

According to recent reports documenting the slowdown in Chinese lending, banks in China may miss their loan targets in 2012 for the first time in seven years as the economic slowdown curbs demand. Declines in lending activity in the last two months have put banks on a trajectory for 2012 loans of 7T yuan, significantly below the government target of 8.0-8.5T yuan.

The most recent RRR cut in early May, however, appears to have been ineffective in shifting this trend leading to speculation about what other actions might be taken on this front. With inflation now in check, in part helped by a slower economy, an interest rate cut may now be a more practical solution for China after a rate tightening cycle last year. The Chinese inflation rate is down to around 3.5 percent, about equal to the deposit rate and the lending rate stands at 6.57 percent. The PBoC typically moves both interest rates in tandem, but it could instead choose to enact an asymmetrical rate cut, reducing the lending rate while maintaining the deposit rate steady which might spur lending where the last RRR cut has failed. This scheme would of course depend on the inflation rate stabilizing at the current level or lower.

The global malaise could also undo years of Chinese promises to appreciate its currency. China recently widened its trading band to 1 percent as it edges towards floating rates, but as the month of May ended, the yuan declined by over 0.9 percent m/m against the USD, its largest monthly decline ever.

A slower economy in China naturally dampens the prospects for the rest of the region as well, particularly raw material suppliers like Australia. Three straight months of subpar Australian export data appear to confirm the softening Chinese industrial data. Australian PMI has also seen a two straight months of contraction, another bad sign for the region. The Indian economy also appears to have hit a roadblock with its latest GDP reading well below expectations and industrial production readings flagging.

In Japan, downside pressure on the yen has been further capped by the undersubscribed Bank of Japan purchase program earlier this month, which effectively undermined the likelihood of additional policy easing. In response, BOJ has taken a decisively more "glass-half-full" approach, turning a blind eye to the slow progress of achieving its 1 percent inflation target. The latest BOJ decision was slightly more positive on the domestic economy, while the government's Cabinet Office went as far as upgrading its assessment of economy for the first time in 9 months. Analysts suggest the BOJ is waiting on the outcome of the Greek elections in June while keeping some easing powder dry. The extent to which credit rating agencies focus on the sustainability of Japan's fiscal state may be the only factor keeping the yen from strengthening markedly, especially considering PM Noda's consumption tax hike initiative is being met with resistance from the DPJ's once-again politically-relevant Ozawa camp. Mr. Noda has warned he may have to extend the Diet session beyond June 21st in order to pass the consumption tax legislation. Meanwhile, Fitch cut Japan's sovereign rating two notches earlier this month amid concerns about the nation's rising public debt ratios, and Moody's warned the Diet that the failing to enact the fiscal reform bill would be a credit negative.

The yen currency has retraced most of its early 2012 weakness as dealers ponder what more the BOJ could do to get the yen reflect its fundamentals given the background noise from European contagion concerns. The ripple effect from Europe could eventually push the USD/JPY below the 70 handle, but in the short term the pair will likely consolidate in the 78 neighborhood.

"It ain't over till it's over"

With the EMU periphery in crisis, growth slowing after a promising start and politicians putting partisanship first, this summer could be a replay of last year with one big exception: the central banks have used up all of their surprises. Quantitative easing, dollar swaps, Operation Twist, and the LTROs each provided timely relief. It appears at this point that central banks could launch another round of what has already been tried, but they would surely see diminishing returns. Markets may remain strained this summer as the European crisis assails more peripherals and the China economy slows, while US indicators are expected to pick up only modestly. Yet we may not see the same kind of market tumult as last year with the 'Bernanke put' firmly in place and expectations that the ECB would step up to the plate again with another LTRO if the European situation becomes dire.

Euro zone officials have made it clear that the next Greek election is going to be a referendum on EMU membership, and though the Greek resolution is again the center of attention, it is not the endgame. A "Grexit" appears to be built in to most forecasters' models, and some even believe that excising the EMU's weakest member could spark a rally, but the wider implications for the rest of the zone are coming to the forefront. If Greece is able to depart from the euro zone, an action that is not provisioned within the legal structures of the EMU, it means that other troubled members are not immune from being shown the door. Thus, the latest market convulsions over Greece are really a barometer for Italy and Spain, the third and fourth largest economies in the single currency.

Spain is up against the dual risks of sputtering regional finances and shaky banks, leading many observers to conclude it's only a matter of time before Madrid will have to ask for a bailout package from the IMF and its euro partners. A credible plan to recapitalize its banks could buy enough time for Spain to benefit from a more overarching plan for bank supports emerging from the next European summit, but Spain's plans are still amorphous.

The US and China have been the backbone of the nascent global recovery, but now face renewed difficulties at home. If not dealt with, the year-end fiscal cliff could be a recession trigger for the US economy, and the rising tide of campaign rhetoric will only complicate these efforts. The Fed has QE3 in reserve but has made it clear to Congress that monetary policy alone cannot fix the economy. In China, not much action has been taken yet, but speculation is rampant that a new layer of stimulus measures is in the offing. As in the US, a leadership transition is underway in China which can create complications even in a one party system.

Indeed it may be a rocky summer for the markets as a global leadership in transition tries to hold hands and find solutions beyond the rhetoric. Can the efforts of politicians and policy makers in the G20 stabilize the global recovery before it slides back into recession? As the wordsmith Yogi Berra put it, "I wish I had an answer to that, because I'm tired of answering that question."