Tuesday, July 31, 2012

August-September 2012 Outlook

August-September 2012 Outlook: Let the Games Begin
Tue, 31 Jul 2012 17:27 PM EST

Last year the economic recovery failed to gain traction because of a series of unfortunate events-the Japan tsunami, the US debt ceiling fiasco, and the Greek sovereign crisis all collaborated to trip up the nascent recovery. The threat of this pattern repeating is weighing on markets as the first half of 2012 played out like an echo of the prior year. The events are different-Asia is dealing with a Chinese slowdown, US politicking growing more rabid in an election year, and the contagion threat in Europe has shifted from Greece to the more substantial economies of Spain and Italy-but the consequences are the same uncertainties as last year.

Forecasters around the globe have been cutting GDP predictions as the recovery has slowed to a crawl and economic indicators have turned sour in the developed and developing economies alike. Equity markets in Europe and China have been battered, while money flows have continued toward the safety of select government bonds, such as US treasury bonds and German bunds. US stocks are seen as relatively cheap, but uncertain investors remain on the sidelines and the Q2 earnings season has not been pretty.

In the face of these troubling indicators, the spirit of the Olympic season may lead things in another direction. Tradition holds that during the Olympiad a truce is called among all warring factions, and as the world comes together in London, there is hope that the Olympic spirit has infected leaders on the continent, steering them to a grand plan to get ahead of markets once and for all and restore confidence in the euro zone. The "hope" trade is back, but this time it will need substantive new political compromises if there is any hope for "hope" to last beyond the closing ceremonies of the Games.

Opening Ceremonies

During the spring, the "hope" trade was tarnished by bad data but it still has its adherents who believe that where politicians and consumers may fail, the central banks will provide. That is to say, many market watchers believe that the 'Bernanke put' will continue to keep a floor set in equity markets, with QE3 loaded and ready should it become necessary. This same camp has also leaned toward the expectation that if the euro zone situation gets dire enough, then Germany and the ECB will relent in their opposition to bending the central bank charter toward becoming the lender of last resort for sovereigns, even if it requires some creative fund transfers or treaty changes to circumvent the current prohibition against the ECB lending directly to individual governments. Alongside the quantitative easing taken by the Fed and BOE, the ECB has now set the precedent that it will take direct action if necessary (e.g. LTROs). This safety net under the markets drove back the bond market vigilantes for a time, but each successive program has held sway for a shorter and shorter time.

A speech in late July by ECB President Draghi may have marked a new turning point; Draghi said point blank that the ECB is ready to do whatever is necessary within its mandate to preserve the euro zone "and believe me, it will be enough." Subsequent press reports said that Draghi was holding meetings with the conservative wing of the ECB council to seek consensus for a grand plan to quiet euro skeptics for good. Reports indicate that the central bank chief might propose a multi-pronged effort to shore up the European sovereign market, including additional rate cuts, another LTRO lending program, authorizing more sovereign debt purchases and even eventually granting a banking license to the ESM bailout fund. The latter would give the ESM access to ECB funds, facilitating a coordinated bond purchase program with the central bank (ESM in the primary market, and ECB in the secondary market) that would demonstrate the euro zone's willingness to essentially commit unlimited funds to support the sovereigns. There is even speculation by market watchers that the ECB could peg the yield for peripheral nations so they don't have to pay unsustainable rates above 7 percent. Germany, which in the past has thrown cold water on this type of grand speculation, has been unusually closed lipped about this latest report, with the vacationing Chancellor issuing a brief statement in support of safeguarding the euro zone.

On Your Mark...

As Olympic glory shines on the athletes in London, the economic tone of the next several weeks may be set in early August by major central bank meetings clustered at the beginning of the month. For some time now Fed Chairman Bernanke has been indicating the Fed has more QE to give if the economy worsens considerably, and after four straight months of subpar jobs data and shriveling consumer confidence, many pundits are looking for the Fed to pull the trigger. His next opportunity will be at the August 1 FOMC meeting. ECB and BOE policy meetings will be held the day after, which may lead some conspiracy theorists to hope for at least the appearance of global central bank coordination. A Fed QE3 followed by a bazooka shell of ECB support programs could send market sentiment soaring like Olympic doves.

It is unclear at this point if the FOMC is going to sprint toward QE3 if it will be a marathon. Many market watchers may be disappointed if the program isn't launched in August but team Bernanke may have reason to hold off a little longer. Twenty-two out of thirty indicators for June have surprised on the downside, including payrolls, the ISM, and retail sales data, while US and University of Michigan confidence readings have just hit their lows for the year. However, Fed officials of every stripe are quick to note that a few months of data does not make a trend, and FOMC voters may want another month of reports to confirm the recovery is stalled. A slightly better than expected advance Q2 GDP reading at 1.5 percent may have given the Fed enough of an excuse to keep its powder dry at the August meeting. There is also some speculation that Bernanke is attempting to avoid claims of political interference by waiting until September to launch QE3. By that time the impact of the program would not be felt in the economic data until after the election and thus the Chairman would not be seen as showing favoritism to the President that reappointed him (other commentators will deem any more QE this year as political). Thus the odds are that Bernanke will hold off, and use his keynote at the Jackson Hole Symposium in late August (24-25th) to set the table for QE3 in September when the Fed meeting includes more detailed economic forecasts and a press conference where the Chairman can fully explain the decision. Intervening data could also surprise to the upside, perhaps allowing the QE3 timetable to slip indefinitely.

Those seeking immediate gratification from the ECB could also be disappointed this month. The ECB President may need additional time to shepherd his more hawkish colleagues into a grand easing scheme, so there's no guarantee an unveiling will be forthcoming at the August 2 council meeting. It is also still unclear if political leaders have signed off on the reported details of Draghi's plan or if it will lead to a confrontation over the extent and flexibility of the ECB mandate. If Chancellor Merkel decides to throw her weight behind the plan, her coalition government may fall apart as her partners run for cover. Also Draghi's assurance that "it will be enough" does not necessarily mean it will be immediate. The August ECB meeting may ultimately feature additional verbal intervention in the form of a more elaborate explanation of Draghi's provocative statement.

The Beijing Games

Policy planners in Beijing have also been on the move, continuing to coax the cooling Chinese economy toward a soft landing. Reacting to weakening economic data, the PBoC has cut the reserve ratio requirement (RRR) by 150 basis points between last November and May, and cut the key 1-year benchmark rates in each of the last two months. The HSBC manufacturing PMI has been in contraction for nine straight months, while the official Chinese government PMI reading has sagged to seven month lows just above the 50 level that separates growth from contraction. More tepid growth data like this in Q3 could necessitate more policy action.

Recently a senior Chinese government statistician forecasted a "mild loosening" of monetary policy and a few reserve ratio and benchmark rate cuts in second half of the year, which suggests the PBoC is walking a line between the post-2008 crisis "moderately loose" monetary policy stance and the current "prudent" stance in place since December 2010. The same analyst suggested that there would be no need for loosening property market controls in the latter half of the year, and that Chinese growth will bottom in Q3 and find renewed strength into the year end. If that bears out, China could see a bit more of a rough patch in the next few months, but then find new footing and keep the year's GDP comfortably above the official forecast of 7.5 percent. Thus the London Olympics may herald a bottoming out for the Chinese economic dip, a suitable bookend for the Chinese market which peaked just ahead of the 2008 Beijing Games.

Not to be overlooked is the continuing transition process at the top of the Chinese government as Premier Hu prepares to transfer power to Xi Jinping over the course of the next nine months. A minor factional power struggle earlier this year accentuated the delicacy of such a transfer of power, but the situation appears to have been resolved, and Mr. Xi is on track to be named as the Party Secretary this autumn, and assume the Presidency in March. These "generational" shifts in the Chinese government can unleash pent up public angst, as seen in the Tiananmen Square protests in 1989, though Mr. Hu managed a seamless transition when he came to power a decade ago.

Passing the Torch

All of the potential central bank action that is seen ahead, could still amount to nothing if political leaders don't tend to necessary fiscal policy measures. Europe has been working on fiscal consolidation for the last two years, with mixed results, as evidenced by the fiasco in Greece. The ECB has given political leaders some breathing room with its LTROs and may do so again if the Draghi's expanded bond buying scheme materializes. The approval of the €100B Spanish bank bailout is a testament to Europe's ability to stand together, but the reaction to it shows that markets are fed up with the incremental approach to the problem. Just days after the bank loan plan was unveiled, Spanish borrowing rates were higher than they were before the agreement, with the 10-year rate surging back above 7%, the level that forced Ireland, Portugal and Greece to seek international bailouts.

Though the German government did little to walk back the reports of Draghi's grand scheme, it has yet to endorse this escalation. Thus far, Germany and other core EMU nations have been content to take slow deliberate steps to match the carrot of new support programs with stick of greater fiscal integration. Politicians in the states footing the bill for support programs have been reluctant to take any bold steps given the growing unease of their constituents back home who fear they are been drained by the euro zone periphery.

If the reports about Draghi's grand scheme are true and he gets the blessing of the EMU core leaders it would be a dramatic shift in the euro zone landscape, demonstrating the euro experiment is truly at a point of no return and that the core will trust the periphery to pay their markers in the end without first getting political collateral. Yet if a grand plan is in the works, a sense of urgency is lacking as European leaders including the German and French heads of state are following the norm of taking extended summer vacations. Perhaps they fear creating a new crisis atmosphere by cutting vacation time short, but it seems unlikely that Draghi would be allowed to bring out the bazooka while Merkel and Hollande sat in beach chairs. However, if the Germans throw up opposition to Mr. Draghi's plans, the ECB President's reputation may be severely damaged for overpromising and under-delivering.

Meanwhile, political uncertainty remains the biggest potential threat to the US economic recovery. US economic indicators have slipped in the last several months on uncertainties about tax policy, rulemaking under Dodd-Frank, as well as the politicization of debt ceiling. The so-called "fiscal cliff," the pending expiration of the Bush tax cut extension and the enforcement of the budget 'sequester' required by the failure of last year's Congressional Supercommittee, could result in a 4 percent hit to 2013 GDP. The Fed Chairman has already warned Congress that there is no way that central bank monetary policy can offset such a big drop in GDP and that legislators need to act.

Even with such dire forecasts, Congress seems intent on continuing its partisan brinkmanship into the Presidential election in November. The GOP controlled House continues to pass non-starter legislation including bills seeking to repeal Obamacare and to extend all of the Bush tax cuts, while the Democratic Senate has moved only on its agenda for an extension of the tax cuts for families with annual incomes under $250 thousand and pushing for the strictest rulemaking under Dodd-Frank. If no compromise can be reached in the next few months, and legislators refuse to even lay the groundwork for a bipartisan plan, then that would leave only the brief lame-duck period in the last eight weeks of the year to resolve these complex issues. That scenario would undoubtedly cause serious market gyrations, and it is unpredictable when markets will latch onto "fiscal cliff" fears as a catalyst. One positive note recently came from a senior Treasury official who indicated that the current debt ceiling will hold until early 2013, so it seems unlikely that the skirmish that triggered the downgrade of the US sovereign rating last year will have to be refought this year.

Going For Gold

Another sign of market expectations for intervention is in the energy futures, which have come roaring back in the last month despite a stronger dollar. In June, WTI crude dipped below $80/barrel and Brent below $90/barrel, prompting some noises about an emergency OPEC meeting, but prices have since rebounded to healthier levels, with Brent above the key $100 mark that the cartel wants to defend. So far the energy market has taken the expanded Iran embargo in stride, though it is keeping a close watch on Tehran's response to the sanctions. Iran has done some scimitar-rattling, claiming it has contingency plans to close the Straights of Hormuz if it feels threatened. Meanwhile, Israel has laid the blame for several international terrorist plots on the regime, but barring a military incident with Iran, the risk on trade in the oil market seems to have run its course, so the price may stabilize or drift lower from here.

Gold has lost some of its luster in recent months. Even with the Fed tiptoeing toward QE3, gold futures have continued to deteriorate as the fears of an all out euro break up have subsided. Precious metals will likely remain subdued for the rest of the year unless European contagion or fears of the US fiscal cliff flare up again.

In currency markets the focus will continue to be on the euro as the ECB drama unfolds. Concerns about Spain helped drive the euro down to near 1.20 against the dollar, which, if prolonged, could actually be a boon for euro zone exporters. Talk of the "Draghi put" helped equity markets rebound, but the forex market has been more skeptical, giving the euro only limited relief as it awaits concrete action. At a bare minimum, currency traders would like to see a reactivation of the ECB's government bond buying program (SMP). Worth noting is that September is usually the most the volatile month of the year in forex trading, often driven by historic market events (the Plaza accord in 1985, Soros breaking the BOE's back in 1992, Sept 11th terror attack in 2001, and the Lehman bankruptcy in 2008). On September 12, the German Constitutional Court decision on the legality of German participation in the ESM and fiscal compact could become one of those historic inflection points.

The Mettle Round

It appears that central bankers have heard the trumpets blaring, calling them to play the hero and save the economy and markets. ECB President Mario Draghi has joined Fed Chairman Ben Bernanke in taking strides toward the promise of more extraordinary policy action in the absence of timely action by sluggish fiscal policy makers. If the central bank chiefs announce new support programs in a semi-coordinated fashion, it could be the starting gun for a dash into the risk on trade. However, if one or both of the central banks fails to follow through with action after the recent verbal interventions, the risk on trade could stumble out of the blocks on a false start.

Central banks have made it very clear that in the end their extraordinary policies are temporary and fiscal authorities cannot avoid political compromise and budget consolidation indefinitely. Yet with that said, central bankers now appear poised to throw up another round of extraordinary easing. Political leaders have been less clear about their intentions. If they fail to use the breathing room provided by central banks to get fiscal policy in order, all of the bankers' efforts could be for naught. A skeptical public watching these political contestants can only hope that they are up to this Olympic-sized task.

30: Italy 10Y auction
31: Euro Zone Unemployment; China Manufacturing PMI

1: FOMC policy decision; ISM Manufacturing PMI
2: ECB and BOE policy decisions
3: US payrolls and unemployment

7: Germany Factory Orders; UK Manufacturing
8: BOE inflation report; China CPI and PPI; BOJ policy decision; Germany Industrial Production
10: UK PPI; China Trade Balance

14: UK CPI; Germany Zew; US Retail Sales and PPI
15: US CPI and Industrial Production
16: US Housing Starts and Building Permits; Philly Fed Manufacturing Index
17: University of Michigan Consumer Sentiment; Germany PPI

21: FOMC minutes
22: Germany IFO Business Climate; US Existing Home Sales; China HSBC Flash Manufacturing PMI
23: German and other Europe Flash PMI readings; UK GDP revision; US New Home Sales
23-25: Fed Jackson Hole Symposium
24: US Durable Goods

28: US Consumer Confidence
29: US Q2 GDP revision; US Pending Home Sales
31: Chicago PMI; Euro Zone Unemployment

2: China Manufacturing PMI and final HSBC Manufacturing PMI
3: UK Manufacturing PMI; US ISM Manufacturing PMI
5: UK Services PMI; US ISM Non-Manufacturing PMI
6: ECB and BOE policy decisions
7: US payrolls and unemployment; China Trade Balance

10: China CPI and Industrial Production
11: US Trade Balance; UK Manufacturing Production
12: German Constitutional Court ruling on constitutionality of ESM
13: FOMC policy decision; US PPI
14: US CPI; US Retail Sales; Univ of Michigan Consumer Sentiment

16: ECOFIN meeting
18: UK CPI; German Zew Economic Sentiment; BOJ policy statement (tentative)
19: German IFO Business Climate; US Housing Starts and Building Permits and Existing Home Sales; China HSBC Flash Manufacturing PMI
20: German Flash Manufacturing PMI; Philly Fed Manufacturing

25: US Consumer Confidence
26: US New Home Sales
27: US Durable Goods; US Pending Home Sales; US Final Q2 GDP
28: Chicago PMI; Final Univ of Michigan Consumer Sentiment

30: China Manufacturing PMI; China HSBC Final Manufacturing PMI