Wednesday, October 3, 2012

October-November 2012 Outlook: Trick or Treat

TradeTheNews October-November 2012 Outlook: Trick or Treat

In the last two months, central banks have delivered on promises of new stimulus, acting even more aggressively than some expectations. European Central Bank President Draghi managed to convince nearly all of his colleagues to support a new sovereign bond buying program (OMT) that skates along the edge of the ECB mandate, and Fed Chairman Bernanke has unleashed a third quantitative easing program that is coming to be called QE-infinity given its open ended structure. Throw in fresh stimulus from China and Japan, and this round of stimulus may be more impressive than the emergency measures taken to staunch the 2008 financial crisis. Markets have taken the hint and the risk-on trade has plowed ahead using each successive stimulus program to take a leg higher, supported by what some observers have called a "QE competition" among central banks.

Even though the central banks have thrown everything but the kitchen sink at the problem, it is still not clear that fiscal authorities will follow through with the necessary fiscal consolidation efforts. In Europe, all eyes are now on Spain, which has pledged more austerity measures, but has had some concerns about a loss of sovereignty that might be attached to accepting more help from its partners. Meanwhile the US has not even truly broached the idea of fiscal consolidation, as the national debt runs above $16T and the two political parties still refuse to compromise during the election season. China faces its own sort of uncertainties as the leadership prepares for its once-a-decade leadership transition just as the economic miracle seems to be settling into a slower growth phase. Events over the next two months could help settle some of these jitters headed into 2013, or they could exacerbate the uncertainty that government leaders have still failed to fully put to rest.

Putting on a Brave Face

The Fed has essentially gone all in: QE3 is the final quantitative easing program that the Fed will launch in this cycle because it is essentially limitless. The open ended nature of the new program allows the Fed to adjust the size and composition of the program as they see fit without going through the handwringing of launching a fresh QE program each time. Fed chieftains agree that this policy is focused squarely on the full employment mandate of the Fed by targeting MBS which can help improve the mortgage lending market, which in turn is hoped to keep the housing market recovery on track and undergird the overall economic recovery.

The labor market focus of QE3 comes with the caveat that the inflation mandate must also be maintained. As the program continues, this may become the central question of its viability: how much inflation is the Fed willing to tolerate in order to sustain a QE program to buy mortgages that only indirectly impacts the jobs market? The Fed doves have stated they see little inflation risk from QE3 and note that inflation is currently running below the 2% target range. Aside from the inflation risk of piling more assets on to the already $3T Fed balance sheet by "printing money," another potential downside is the risk of QE3 not moving the needle. Chairman Bernanke himself has already noted the diminishing returns seen from each successive QE program, so if QE3 (and the other global central bank QE programs for that matter) doesn't achieve the desired goal, the central bank will appear impotent, shaking market confidence.

Spooky Data

Lackluster data over the last several months have helped justify the central bank moves, especially the quicker than anticipated action by the Fed last month. The data clearly shows that the economy has been flagging for the last two quarters, and there has been little improvement in the latest reports. The September Chicago PMI showed contraction for the first time since 2009, and the most recent durable goods orders dropped by double digits, the biggest decline in over three years. The Philadelphia Fed manufacturing index has been running in negative territory for five straight months and has missed analyst expectations for five of the last six. To top it all off, the final reading of US Q2 GDP was slashed by four-tenths of a percent from the preliminary reading, taking it down to a mere 1.3%. The next couple of months of data will tell if the optimism indicated by the markets is warranted, while the tepid economic activity of the third quarter will be summarized in the Q3 GDP reading out on October 26.

The Fed's renewed focus on its employment mandate will add even more weight to the weekly and monthly jobs data. Some early momentum this year in US job creation has faltered in the last few months. Nonfarm payrolls data has been stagnant for the last five months, never managing a reading above 150 thousand net new jobs, which is seen as the bare minimum for working down the unemployment rate. As a result, unemployment has barely budged, holding between 8.1-8.3% all year. The next two monthly jobs reports have a lot riding on them. The Fed will be watching to see if QE3 is working and needs future adjustments when the data comes in on October 5 and then on November 2, just days ahead of the Presidential election. The future direction of US governance is also on the line: A couple of upside surprises on the employment data could propel President Obama to four more years in the White House.

Nothing to Fear but Fear Itself

Despite the pleas from the Fed for Congress to take action on the fiscal situation, it appears that nothing will be resolved before the November elections. After a series of gaffs by his opponent, President Obama has built a small lead in key swing states like Ohio and Florida. Romney is not out of the race, but there's a growing consensus that he will need to score big points in the upcoming debates (Oct 3, 16, 22, and VP debate Oct 11).

Even after the elections are over, it is not entirely clear that the partisan cloud covering Washington will dissipate. If President Obama is reelected, he and the House Republicans may enter another game of brinksmanship like the one that led to the fiscal cliff in the first place. A Romney win may cow Senate Democrats into going along with the GOP fiscal plan, or they may mirror the obstructionist tactics the House Republicans have perfected over the past two years. In either case, the question will be can the two parties come to a reasonable compromise on taxes and spending cuts in before the end of the year? The prospects of across the board tax hikes slamming the economy and the loathing most Congressmen feel for the 'sequester' budget cuts should propel them toward a deal, but in this unprecedented partisan atmosphere its still possible the two parties will wrestle each other over the cliff.

So far the markets have largely ignored the fiscal cliff, despite the media hype, with most analysts seeing little chance that Congress will let the country go over the edge. With Congress scheduled to be in session for only a few weeks in November and December, markets may react if politicians continue to drag their feet on a compromise after the election. Even then many analysts believe legislators could resort to kicking the can down the road one more time by putting another temporary extension in place to allow negotiations to continue into the first half of 2013.

Defense contractors may see the first impact of a potential fiscal cliff scenario, and many of big the military industrial firms have already created more flexible hiring and production scheduling to allow for the possibility. These firms may feel some relief if the Republican candidate is victorious in November, but some of Romney's policy stances may cause turmoil in other markets. Political promises are a dime a dozen, but Romney has said on day one as President he would name China a currency manipulator, which could quickly ratchet up tensions with America's biggest creditor.

In a very different version of the leadership selection process, China will start its once in a decade power transition in just a few weeks. On November 8, the 18th National Congress of the Communist Party will convene to name Xi Jinping the General Secretary of the Party, the first step in his ascendance to the premiership next March.

There have already been some bumps in the road, including the rumor of a military coup in March (quickly denied), followed by the very public ouster of a Xi rival. There were also some concerns raised when Mr. Xi disappeared from public view for two weeks in September, but he has since reappeared no worse for wear. These incidents accentuate the delicacy of such a transfer of power. Past generational leadership transitions have been impeded by internal power struggles, and have even created leadership gaps that allowed public demonstrations ( e.g. the Tiananmen Square protests in 1989), but the current Premier, Hu Jintao, managed a smooth transition when he took power ten years ago, and he appears ready to ensure a similar outcome this time around. As Mr. Xi steps into the spotlight, the outgoing General Secretary still deserves attention as he will issue a formal report to the party congress that will set the political and ideological tone for his successor.

A key topic of that report will surely be managing the continued growth of the economy that has shown signs of losing its vigor. Despite recent stimulus efforts there is still a bear loose in the China shop - Chinese manufacturing PMI readings have been indicating contraction for months and the latest official industrial production reading touched a 39-month low, helping extend the drop in the Shanghai index to three year lows. This may be the greatest test of the Chinese economic miracle since this long period of expansion began, so even more stimulus may be coming, including potential rate cuts.

The Chinese central bank (PBOC) has cut its reserve requirement ratio by 150 basis points in the last ten months, essentially releasing hundreds of billions of yuan for banks to invest into the economy, but the last cut was back in early May. Since then the PBOC has held off on further RRR cuts, holding it at 20%. Meanwhile the central bank has cuts its 1-year benchmark deposit and lending rates twice, in June and July.

With the economic engine still sputtering, many analysts believe that the situation is ripe for additional rate cuts, perhaps as soon as the first week of October when mainland China shuts down for its "Golden Week." Recently, some PBOC advisors have suggested the economy may not achieve the 7.5% GDP growth goal in the latter part of the year, a potential embarrassment for outgoing leader Hu. If the growth slips further it might even warrant the drastic step of shifting the official government monetary approach back to the "moderately loose" stance put in place in November 2008 that was revised to "prudent" in December 2010 (the official fiscal policy stance has remained "proactive" since 2008).

Another fly in the ointment for China is the recent unrest emblemized by a violent protest by workers at a Foxconn plant in southern China last month. In a protest of working conditions, 2,000 workers damaged buildings on the site before police forces swept in--another embarrassing incident for the manufacturer of the iPhone 5 on its launch date.

The flare up of China's territorial dispute over a cluster of islands claimed by Japan is also crimping the regional economy, as anti-Japan protests in China have resorted to vandalizing Japanese brand cars and stores. Numerous Japanese manufacturers including Toyota and Nissan have reduced production rates as Chinese demand for their products dries up, enough for the Japanese PM Noda to acknowledge that the dispute over the Senkaku Islands could further weaken his country's economy.

For its part, Japan has taken advantage of the post-tsunami reconstruction effort to shore up its economy. Yet the latest assessment of the Bank of Japan is that the pick-up in economic activity has paused due to slowing in the economies of its trading partners, and at its September meeting the central bank expanded its asset purchase program by ¥10.0T to a total of ¥80T.

The Devil's in the Details

In Europe, the new ECB bond buying program is contingent upon a sovereign nation asking for it to be implemented. The apparent guinea pig will be Spain, which has moved at a deliberate pace toward a bailout, jumping through all of the prescribed hoops along the way. The government has agreed to a bank bailout package and as of late September bank stress tests have determined that seven of Spain's banks will need €59.3B in recapitalizations. The finance ministry has indicated that those banks should be able to raise about a third of those funds on their own and thus appears ready to request about 40% of the €100B in funds set aside for Spanish banks by the EU. During this process, sovereign spreads have reacted favorably, taking the benchmark 10-year Spanish bond yield well below the dangerous levels above 7% where it stood before the bank bailout was arranged.

The next steps for Spain will be thornier. The government just announced a 2013 budget that continues the country's austerity push, much to the chagrin of many Spaniards who fear the 25% unemployment rate will get even worse. As the government passed the budget measures, protesters swarmed outside of the parliament building, some clashing with police in a scene very reminiscent of Athens earlier this year. But the additional austerity measures in the budget plan were welcomed almost unanimously by senior European officials who seemed to signal the proposal was enough to meet the conditions for a broader Spanish sovereign bailout.

Now the pressure is on Madrid to formally request a sovereign bailout. Initially the government seemed hesitant because of the "conditionality" attached to the ESM/OMT bond buying program which some officials feared might impinge upon Spain's sovereignty. These fears seem to have been allayed, and the formal request could be made sometime in October, which happens to coincide with the period when Spain has the heaviest turnover in its long term debt needs this year. There has also been widespread speculation that PM Rajoy wants to wait until after October 21 regional elections in Galacia and the Basque Country in order to minimize the political fallout from the Regions.

Even as Spain is under pressure to accept the full bailout program, the EU and EMU are working toward greater integration of their common institutions. French President Hollande recently stated that the summit on October 18-19 would demand "key and durable" decisions that would stabilize the Euro Zone. The meetings will include a review of progress made on the implementation of the Growth Compact as well as the single European banking supervision mechanism. Failure to show a unified front and genuine progress at this summit may be deemed as a failure.

The latest reports indicate that the aggressive timetable for the banking union may need to be pushed back a bit in order to get it right. There has also been some pushback from northern European countries about the mechanics of the bailout fund. Finland led a charge against excessive leveraging of the ESM which, for now at least, will keep any leveraging of the bailout fund at modest levels. In addition, there have been indications that Chancellor Merkel wants to get any new bailouts bundled together for a single parliamentary vote rather than risking the Bundestag rejecting one of a series of bailout votes - Spain, Cyprus, Greece - out of frustration. Politicians are also feeling growing public pressure against fiscal consolidation at the heart of the integration and bailout schemes. Anti-austerity protests have been commonplace in Athens, have been flaring up in Madrid, and just recently Paris has seen marchers out in force. The European public, who in the last couple years have voted out conservative parties in favor of the socialist candidates in nearly half of the Euro Zone, are now asking for less severe cutbacks. If these protests become widespread it may be difficult for leaders to ignore them, which could further jeopardize integration timetables.

Whistling Past the Graveyard

The aggressive nature of the simultaneous new global stimulus has thrown the risk-on trade into a higher orbit. Two months ago, gold was looking lackluster, but now the prospect of unlimited central bank interventions has sent the precious metal on a course back to $2,000 and perhaps all time highs. US equity markets have hit four year highs, and European bourses have seen a solid rebound. Uncertainty is clearly still a major factor, however, as US treasuries are still attracting a significant flow of funds.

Meanwhile the oil market has seen WTI crude futures touch the $100 mark again, despite Saudi Arabia given assurances of a well supplied market and the consistent rumors of an imminent release of oil from strategic petroleum reserves. The hurricane season, which officially ends November 30, has contributed little to the rise in oil prices, as only one storm (Isaac) has had any impact on Gulf of Mexico production so far.

It appears the boycott of Iranian oil has also had only a minor impact on oil prices as the stalemate over Tehran's nuclear program continues. One wildcard event that must be weighed is an Israeli strike on Iran's nuclear program. An impassioned speech by the Israeli PM before the UN in September cemented his concept of a "red line" for Iran's nuclear program, a point that Mr. Netanyahu suggested may only be months away. It is conceivable that just after the US elections in November might be the opportune time for Israel to strike Iran, especially if Romney wins. Obama's lame duck period may be a window of opportunity for Israel to bomb Iran without the overt blessing of an American government in transition.

The commodity market action has been exaggerated by the across the board weakness in the dollar. Predictions from earlier this year of the euro dropping to parity with the dollar have fallen flat. The euro dipped to as low as $1.20 in July before ECB President Draghi famously said he would do whatever it takes to preserve the euro zone. Since that pronouncement, worries about the unraveling of the EMU have ebbed, and the anticipation and then the reality of QE3 have weakened the dollar back to $1.30 against the euro, about where it started this year. The pendulum may yet swing again, but for now it appears the weak dollar trend will continue into the year end.

A Bear in Bull's Clothing?

Now that the central banks have done everything they can to calm and stimulate markets, what's next? If the stimulus gives fiscal authorities the room they need to make sensible economic adjustments, the global economy could shake off funk that has held it back for the last four years. But if all this stimulus fails to keep markets aloft, and leaders fail to make progress on creating smarter, leaner government, uncertainty could reassert itself.

For now, the risk-on sentiment has the central bank safety net underneath it, so it appears current market trends can continue for some time, even with the upcoming third quarter earnings reporting season expected to be ugly. Yet as 2012 races toward its end, fears of all the missteps governments could make-from Congress playing chicken with the fiscal cliff, to subtle power struggles in China, to sovereignty issues unsteadying Europe's integration process-still have the potential to dent sentiment. Any such political scares could put the safety net to the test, stretching it to a point where a deeper seated concern must be considered. Namely, with the central banks now essentially all in, what more can they do if markets lose confidence again?


1: Euro Zone Unemployment Rate; US ISM Manufacturing; National Golden Week in China
3: Minutes of Sept FOMC meeting; ISM Non-Manufacturing
4: ECB policy statement; BOE policy statement; BOJ policy statement
5: US Payrolls and Unemployment

8: China GDP and CPI; German Industrial Production; Eurogroup meetings
9: China Trade Balance; ECOFIN meetings
11: US Trade Balance
12: US PPI; Prelim University of Michigan Confidence

15: US Retail Sales; BOE Inflation Letter (tentative)
16: German ZEW Sentiment; US CPI
18: Philadelphia Fed Index; EU summit (Oct 18-19)
19: US Existing Home Sales

23: China HSBC Flash PMI
24: FOMC policy statement; US New Home Sales; German Ifo Business Climate; European Flash Manufacturing PMIs
25: US Durable Goods Orders
26: US Advance Q3 GDP (1st reading); UK Q3 GDP

29: BOJ Policy Statement (tentative)
30: US Consumer Confidence; BOJ Outlook Report
31: Euro Zone Unemployment; China Manufacturing PMI

1: US ISM Manufacturing
2: US Payrolls and Unemployment

5: US ISM Non-Manufacturing
6: US Election Day; Japan Current Account; German Factory Orders
7: Euro Zone Retail Sales; China CPI
8: China National Party Congress; ECB policy statement; BOE policy statement; US Trade Balance; China Trade Balance (tentative)

11: Japan Q3 GDP
12: Minutes of the Oct FOMC meeting; Eurogroup meetings
13: German ZEW Sentiment; Eurogroup meetings
14: US Retail Sales; US PPI; BOE Inflation Report
15: US CPI; US Philadelphia Fed; Europe Prelim Q3 GDP readings (by country)
16: US UoM Prelim Confidence

19: US Existing Home Sales; Japan Policy Statement
21: German Ifo Business Climate; China HSBC Flash PMI
22: German Flash PMI

27: US Durable Goods Orders; US Consumer Confidence
28: US New Home Sales
29: US Q3 Prelim GDP (2nd reading)
30: China Manufacturing PMI