Wednesday, December 5, 2012

December-January Outlook

December-January Outlook: Cliff Notes by      TradeTheNews

A thumbnail sketch of the global economy portrays some genuine risk appetite building, with equity and commodity markets looking reasonably healthy, thanks to a series of stimulus measures and rescue plans that have played out over the last four years. In the latest round, both the Fed and ECB have followed through on promises for unprecedented stimulus programs, each launching its own version of unlimited quantitative easing: attending to its employment mandate the Fed will buy mortgage backed securities at an initial rate of $40B a month, while the ECB is containing sovereign spreads with its pledge to buy government bonds in the secondary market in tandem with the ESM backstop fund. Greece appears to be out of danger, and Spain has handled its bank recapitalization while quietly pondering a broader bailout. Meanwhile Japan is steering toward open ended stimulus and China appears to be ready for more targeted measures to help its economy after cutting some key rates earlier this year.

Swimming in all of this stimulus, it makes sense that markets generally floated higher this year, but a deeper look shows that the underlying global economy is still not doing well. Europe has officially re-entered recession and faces continued political uncertainties, US GDP growth continues to stagnate at a meager 2% which could be erased by the Fiscal Cliff, Japan's short growth spurt has ended, and Chinese GDP has settled at around the official growth target of 7.5% with no signs of being reinvigorated by a generational leadership change in Beijing.

The short version of the economic story for the next few months may look like a neat and tidy conclusion to a cluster of long complex political negotiations. But the full version of the story could send markets through some new gyrations as sparring political leaders scramble to finally address issues that have lingered for the last few years.

Hills and Valleys

Equity markets have been a good barometer of the level of economic uncertainty generated by the central political and economic questions being faced this year. Though many issues are still unsettled across all the major economies, there has been progress this year, and the ongoing injections of central bank stimulus and the process of stabilizing Europe has yielded some pretty healthy gains in stocks. Notably the main French and German stock indices have just hit 52-week highs as the Greece crisis has been all but resolved. The last few months have been rockier for US equity markets as Washington paused for the election results before getting on with tackling fiscal matters.

Publically traded companies are not waiting around for the politicians to get their work done. Its assumed that firms reliant on large government contracts have already been hedging their bets as they await the resolution of the automatic budget cuts required by the "sequester", adjustments that will invariably impact corporate results in the first half of 2013, no matter what the outcome in Washington.

Another consequence creating some market distortions is that nonfinancial companies sold a record $100B in bonds in November, in part to fund special dividend payouts. Corporate boards have been busy issuing a rash of special dividends ahead of tax reform that could include higher capital gains tax rates next year. So far over 100 companies have declared significant special dividends in Q4, about four times the normal rate. Other firms, most notably WalMart, are accelerating their regular quarterly dividends, making them payable in Q4 rather than in January. With the window about to close on dividend declarations for 2012, such special dividend announcements will probably accelerate in the next week. Every company sitting on a big pile of cash is seen as a candidate for an extraordinary dividend announcement. Some of the more likely names expected to go this route are Visa, Costco, and Wynn, while more speculative minds dream of Apple or Google announcing special distributions. Shareholders are also hedging their bets by selling off equity winners, especially big dividend paying stocks, which has contributed to the Q4 volatility as investors took profits.

In the New Year, it is not clear if any firms will risk the reputational hit of cutting their dividend in favor of share buybacks in response to higher tax rates making dividends a less efficient means of returning capital to shareholders, but it cannot be ruled out as a strategy for 2013. Already, in one extreme case, Oracle has taken the unprecedented step of accelerating all of its remaining fiscal '13 dividend payments into this December. Depending on the final deal in Congress, dividend tax rates could more than double from the current 15% rate, which may lead to significant outflows from the steady dividend payers that were at the heart of many investment strategies in 2012. MLP's may also end up a big loser if their favorable tax status is stripped away in the budget negotiations.

Pulled Away from the Brink

Despite good returns in the stock market, the European economy remains troubled. Double dips in Spain and the UK have spread to the core states as Europe officially entered another recession in Q3. Forecasters are expecting the recession to deepen in coming quarters before a modest recovery in 2014. The deterioration of economic growth will stir some Europeans to renew calls for a more balanced fiscal consolidation that doesn't rely too heavily on budget cuts. The leader in this cause has been the new Socialist President of France, Francois Hollande, but he has been punished for drifting away from stronger austerity measures.

In November, Moody's became the second of the big three ratings agencies to downgrade France, citing France's lack of serious fiscal consolidation efforts. Markets took the ratings cut in stride - French bond spreads barely budged - but it could present problems for the European Stability Mechanism (ESM) bailout fund that relies on the ratings of Europe's strongest economies for its own bond ratings. France is Europe's second largest economy and was one of the few remaining Aaa-rated nations supporting the ESM's own Aaa rating. Moody's followed up the French sovereign action with a downgrade of the ESM and its predecessor the EFSF, which could drive up the funding costs for the mechanism that was meant to help contain widening sovereign spreads. This crack in one of the pillars holding up the Euro Zone comes as the EMU is trying to finalize bailout agreements for Greece and Cyprus, and considers one for Spain.

Greece appears to be on its way to getting the funding it needs after a year-long renegotiation of its bailout structure. The last potential stumbling block for Greece is a €10B voluntary bond buyback program that carries a 60-70% haircut. The Eurogroup will pore over the results of the buyback at a December 13 meeting, but if it fails to reach the desired targets, the Eurogroup may require a few additional conclaves to sort out Greece.

Although it is acknowledged universally that Greece was a special case with unique terms, the other program nations-namely Portugal and Ireland-have made noises about getting some concessions after the extraordinary lengths the EMU went to in order to keep Greece in the fold. Though Portugal and Ireland remain on track to return to normal market funding next year, their "bailout envy" could become a sore spot if Spain gets more favorable terms, too.

Even as Greece and Cyprus get their bailout funds, the case for a Spanish sovereign bailout has become trickier. Spain, which has accepted recapitalization funds for its banking sector, has yet to request a sovereign bailout, and expectations are that the government wants to wait until early next year before giving into the pressure to take a full bailout. This delay has already scuttled a German plan to push all three bailouts (Greece, Cyprus, Spain) through its parliament at once, and now Chancellor Merkel may have a much more difficult time getting approval of a Spanish bailout from a Bundestag weary of paying its neighbors debts. Notably the Greek bailout proposal passed through the German lower house by a wide margin, but it required the help of pro-Euro opposition parties to offset defectors from the ruling coalition. This may be a bad omen for a potential Spanish bailout that would dwarf the Greek deal in size and scope.

At the Cliff's Edge

Progress in the US has been even slower than in Europe as a year of kicking the can down the road has led to a last minute scramble to avoid the Fiscal Cliff. Washington will get a two or three week grace period after Thanksgiving to get a deal together before markets get nervous again, but the politicians have already wasted the first week on ideological posturing, summarized by Speaker Boehner saying "we have gotten nowhere." Most observers still expect the Fiscal Cliff will be avoided, but many analysts, including those at S&P, are now shifting their expectations toward an eleventh hour deal, perhaps as late as December 31. The initial sticking point in the negotiations has been that both sides are demanding the other be the first to publically declare their specific spending cut and tax raising plans.

As a starting point, the White House put forward a Democratic wish list that GOP leaders branded as "not serious," as it essentially asked Republicans to give up all of their bargaining chips. The proposal includes a one year extension of the payroll tax credit and unemployment benefits, and a permanent rolling increase in debt limit. It also asks for $1.6T in tax increases and over $50B in new stimulus spending, offset by only $400B in entitlement cuts and a one year postponement of the defense spending cuts triggered by the 'sequester'. The plan is far less generous to conservatives than the outline of last year's failed grand bargain (which involved three dollars of cuts for each new dollar of revenue), and led Republicans leaders to suggest that many Democrats are willing to go over the Fiscal Cliff.

After stewing over the White House proposal for over a week, Boehner's team announced the broad strokes of a counterproposal including $1.4T in new spending cuts, and $800B in new revenue achieved by closing tax loopholes. The White House responded that the plan does not meet the "balance test." This essentially leaves the two parties back to where they were at the start of the budget negotiations last year, with irreconcilable core demands and with no granular details from either side.

Some reports indicate that House Republicans may be more willing to negotiate than they have let on, given their concerns that they make get hung with the blame for going over the Fiscal Cliff. Yet so far the strong rhetoric continues from both sides: the Speaker has demanded that any debt ceiling agreement will involve additional concessions to reducing spending, and that a re-litigation of Obamacare should be on the table; and the President has hammered his ultimatum that the election showed the people agree that rich people should pay higher tax rates.

Since the income tax cuts can be retroactively reinstated (2013 taxes aren't collected until April 2014), the focus of the talks in Washington will likely shift toward the automatic budget cuts required by the "sequester" that were enacted to force action now when politicians were unable to reach a compromise last year. Ultimately, the most likely outcome of the talks is seen as a partial resolution of the Fiscal Cliff focused on delaying sequestration, which would have the most immediate impact on the economy, with tax reform hashed out during 2013. If a grand bargain like the one framed during the 2011 debate could actually be reached, markets would react very favorably. But with the same cast of characters in Washington currently going through the same motions as a year ago, the chances for a grand bargain this time appear slim, though they could arrive at a more modest bargain with more tax reform to come next year.

Breaking the Fall

Politics have also been at play in China, as it began its once-a-decade leadership transition by appointing Xi Jinping head of the Chinese Communist Party, as expected. His predecessor Premier Hu, who will turn over the top political post next year, gave Mr. Xi an additional vote of confidence by immediately ceding the chairmanship of the military to him, which should give the new leader a stronger hand to consolidate his power in this delicate transition period.

The shift to fresh leadership had no immediate salubrious effect on the Chinese economy: the Shanghai Composite added to its dismal performance for the year by losing another 4% in the month of November and economic growth appears to be puttering along near the target rate of 7.5% as no new stimulus efforts have emerged from the government. Mr. Xi's government may have learned a lesson from the huge spending program launched in response to the 2008 global crisis, which ended up stoking inflation and led to wasteful spending on unnecessary construction projects. Analysts anticipate that the new leadership will proceed cautiously, favoring smaller targeted stimulus efforts over massive investments. For example, in late November central economic planners approved $12B of transportation projects, creating sales opportunities for Chinese rail firms. This fine-tuning strategy will likely lead to a gradual recovery for China rather than a sharp rebound.

The news from China isn't all bad, however, as some signs of stabilization are cropping up. After contracting for a solid year, November manufacturing PMI readings for China hit multi-month highs and showed a return to expansion (a reading above 50 on the PMI scale), with notable improvement in new orders. Copper prices are another indicator that the Chinese economy may have bottomed out. A vigorous rebound in copper prices in recent weeks could be indicating that China is stockpiling the industrial metal for new building projects.

Sometimes overlooked in China's growing shadow, Japan's economic situation is also being tested lately. After some post-tsunami reconstruction related growth over the last few quarters, the Japanese economy has seen some signs of a slowdown lately. The preliminary Q3 GDP reading showed its first contraction in five quarters and it will post the finalized reading on December 9. Industrial production figures have also been flagging in recent months, though there was a surprise upturn in the initial October reading. The Bank of Japan has cut its economic assessment, stating the pick-up in the economy has paused and predicting that the domestic economy will level off for a while before returning to mild recovery. To ensure the economy doesn't slip further the BOJ has been expanding its asset purchase program, which now stands at ¥80T, and has indicated it can do more to offset weak exports to its struggling trading partners.

A major difficulty in resetting the Japanese economy to a growth path has been the constant churn in government leadership. The country has gone through six leaders in as many years, and the current PM, Mr. Noda, has called a snap election for December 16, eight months before it was required. The policies of Noda's DPJ have not found popular support and his party has fallen to third place in the polls. Though Noda and his opponents are both calling for a more activist BOJ, they have notable policy differences, particularly on Japanese militarism. The opposition LDP led by Shinzo Abe is polling in first place but may not be able to seize a clear majority in a polity that has become more factious in the last decade. Thus the LDP may have to throw in with the upstart nationalist Japan Restoration Party which is now running second in the polls. This would push the LDP, which is already running on the principles of greater national security and collective self-defense even further to the right, ratcheting up Sino-Japan tensions that are already at their worst level in years. An LDP/Restoration Party coalition would also give Restoration Party leader Shintaro Ishihara an opportunity to run for the PM spot against Abe, and on the outside chance Ishihara won, the People's Republic would react badly.

If elected to the top spot, Abe has pledged to take bold action to get Japan out of its two-decade funk and avert the threat of deflation. His plan includes pushing the central bank toward setting a 2 or 3% inflation target driven by unlimited monetary easing, and to compel the BOJ to purchase government construction bonds used to fund public works programs. Such radical ideas may win over a public that has been aching for a cure for Japan's long economic malaise, though other such efforts have failed to snap the country out of it in years past.

Staring into the Abyss

Ever since the Fed described economic models of the consequences of a bank collapse in 2008 that frightened Congress into passing the emergency TARP fund, central bankers around the world have been staring into the abyss. They staved off a great depression with trillions of dollars in stimulus that has only just begun to yield tenuous economic stability after four years. As the BOJ heads toward open ended stimulus, the Fed is preparing to make the first adjustment in its own unlimited quantitative easing program.

The Fed has been running its flexible QE3 program for a couple of months at the initial rate of $40B/month in MBS purchases, but the first course correction will have to come in December. At that time the Operation Twist maturity extension program will have run its course, taking $45B in monthly purchases of longer dated treasuries out of the equation. If Twist was left to expire with no replacement, it would be seen as a rollback of some fiscal accommodation, so the Fed is expected to expand the open ended QE3 program with a similar monthly purchase of treasuries in addition to the $40B in MBS. The natural time frame for this announcement would be the December FOMC meeting (Dec. 11-12) which is the next one that includes a press conference and economic revisions. Alternatively, the Fed could further extend Twist for another six months or a year. Any deviation from providing a full replacement for Twist would be a shock to the markets.

Once the flexible nature of the QE3 program is tested and put into action in January, the FOMC meetings will become more about the communication policy than ever. With an eye toward the eventual withdrawal of stimulus, a refined communication strategy will be key, and the Fed is moving steadily toward replacing the calendar based guidance with forward guidance based on economic outcomes. Multiple Fed governors and Presidents have already indicated that they would like to see some economic triggers for rate policy, particularly an employment threshold that could signal the start of the unwinding of accommodation. Chicago Fed President Charles Evans, for example, has suggested that the central bank should maintain near-zero rates until unemployment falls to 6.5% and as long as inflation stays below 2.5%. The FOMC minutes and public speeches show there is still significant debate over what those targets should be, so it appears the Fed will not be ready to roll out the new forward guidance format at the December meeting. The next two meetings after that will be in late January (Jan 29-30) and then in March, which will include a quarterly press conference.

Another consideration for 2013 will be the make-up of the FOMC voting membership. Richmond Fed President Jeffrey Lacker, who has been a consistent dissenter this year, will rotate out of the voting membership and be replaced by a slightly more dovish slate of Fed Presidents. The most hawkish voice on the FOMC in 2013 will be St. Louis Fed President Bullard, who, unlike Lacker, is not likely to dissent against QE3 now that it is in place, though he did not initially support it on concerns it may trigger premature inflation. Bullard has shown he will instead question the details of the doves' plans. In his most recent statements, Bullard suggested the thresholds for rate policy changes should be based on payroll growth rather than unemployment, and that $25B in QE3 treasury purchases per month would be equivalent to the Twist operations (which involve both $45B in buying and $38B in selling operations), about half of what the Fed doves are proposing.

The Abyss Stares Back

The central bank stimulus programs have bought some time for fiscal authorities to get their budgets in order, which is still a work in progress in Europe and especially the US. All the stimulus money poured into the effort has yielded middling results, with data still mixed.

The US housing market, which was improving even before the launch of QE3, got another shot in the arm from the Fed returning to MBS purchases. Demand for homes in the US has climbed while supply remains tight, and home prices have risen for six consecutive months. This could create a wealth effect for some homeowners who have been waiting for price appreciation to return, and also benefit homeowners who have been underwater on their mortgages. Given the healing going on in the housing market, its not entirely surprising to see US consumer confidence at a 4 year high.

Industrial data have been more mixed lately. Improvements in durable goods orders indicate that so far companies are not completely hunkered down on Fiscal Cliff worries. The November ISM manufacturing reading was very concerning, however, as it fell into contraction and hit its worst level in over two years. In fact, the last time this index hit this level, unemployment was above 9%.

Unemployment crept below 8% in the last two monthly readings, which in part helped propel President Obama to a second term, but concerns about the Fiscal Cliff and temporary impacts from Hurricane Sandy may cause the jobless rate to head north again. The next employment report, due out on December 7, will reflect the temporary layoffs caused by the "superstorm," whose impact was already measured in the poor November same store sales posted by chain retailers. Temporary factors can only be blamed for so long before elevated unemployment will start eroding confidence readings again.

In Europe, the economy faces record high unemployment rates. The worst of it is in the peripheral nations where joblessness is as high as 25%, but the core nations have their problems too, with France unemployment above 10%, its worst level in over a decade. European industrial production readings also continue to be dismal, exhibiting contraction for much of 2012. Even the strongest of the Euro Zone economies, Germany, is starting to feel the ill effects of the debt crisis. German PMI manufacturing has experienced nine straight months of contraction, with exports hurt by persistent strength in the euro, and confidence readings are also running low.

The Arab Cliff

Uncertainty is also rampant in the Middle East. Crude oil prices experienced more volatility in late November as Israel's conflict with Hamas flared up, and some Arab league nations called for using oil as a weapon against Israel. If the tentative ceasefire is broken, oil supplies could be pinched. This may be a hot topic for OPEC delegates holding their semi-annual meeting in Vienna on December 12, especially if Israel's skirmish with Hamas was only a prelude to action against their sponsors in Iran.

The escalating Syrian civil war and the renewed mass protests in Egypt also bear close attention. Europe appears to be growing more inclined to intervene in Syria as the humanitarian crisis grows and NATO ally Turkey expresses deep concerns about the conflict spilling over its border or emboldening Kurdish rebels to escalate their own efforts for sovereignty. The latest US statement on Syria declared that the Assad regime unleashing chemical weapons on its people would be a "red line" though the State Department declined to detail what response it would trigger. Meanwhile a return to chaotic street protests in Cairo could upset oil markets and raise concerns about the security of the key Suez shipping lane as it did during the outset of the Arab Spring.

Another wildcard to be considered in the region is the failing health of the Saudi ruler King Abdullah. The King, now 88, was reportedly placed on life support for some time after undergoing spinal surgery in November. In the event of his death, Crown Prince Salman, 76, will assume the throne, and could possibly be the last son of the founder of the modern kingdom to do so. After Salman, who replaced two of his brothers who died of old age in the crown price post, the third generation of princes may be called upon to rule. Either of these transitions could be the spark that finally brings the Arab Spring to Saudi Arabia, potentially destabilizing the world's biggest oil exporter.

The Short Version

As the US economy stagnates in the grip of uncertainty about fiscal policy and Europe slips back into recession as it tries to balance its own policy, emerging markets are sputtering along waiting for their trading partners to recover. Still, after four difficult years, global markets are leaning toward a recovery bias supported by massive accommodation.

If Greece and Cyprus can be squared away this month, Europe may experience a brief period of equanimity, and the ECB will be dormant until the Spanish sovereign issue comes to a head. Other difficult matters are still looming in the background for Europe, including the deadlock on the EU budget and the implementation of banking supervision and capitalization rules that have been punted to next year.

In Washington , the long awaited election left the status quo. Congressional leaders and the President don't want to throttle a nascent recovery, but the question is just how they will go about defusing the Fiscal Cliff bomb. If a bargain is not struck until the final days of December, markets might not wait to react negatively. Markets may also frown upon another "kick the can" solution, which contributed to the S&P sovereign downgrade last year. The framework of any deal also has to be firm enough to preclude Congress from dismantling or weakening the deal in the years ahead (Boehner is said to have proposed such a binding legal framework).

With US treasuries and German bunds running near record low yields, the "cleanest dirty shirts" aren't as attractive as they were earlier this year. As Europe copes with its problems, investors are warming to peripheral sovereign debt, helping to narrow sovereign spreads in Italy and Spain to their best level in two years. With stocks cheap by comparison, US and European bourses have notched solid gains, and the Chinese stock market may get some renewed attention next year as investors recalibrate for slower but still enviable growth.

Forex markets will be keyed in on the post-Greece bailout euro and the post-election yen. If the Greek debt buyback goes off without a hitch, current market short positioning in the EUR suggests it could follow its typical strengthening pattern in December, a month during which the euro has averaged over 1.7% in gains against the dollar in the last 12 years. The 1.3170 area is the critical resistance in the EUR/USD during the month. The yen has already weakened 3.5% since LDP opposition leader Abe stated that, if elected PM, he would force the BOJ into aggressive monetary easing. On a technical basis the upside for the USD/JPY has upside legs as long as 80.30/70 area holds, and analysts suggest any sustained break of the 85 level opens the door for momentum to carry the pair to 92 by early 2014 shepherded by more open handed monetary policy.

Headed into year end, if the global economy manages to stay perched on the cliff where its situated, it will have a good vantage point for the climb back up the peak from which it slid. In short, year five of the global crisis may be waypoint on the trek back toward more normal market conditions. Just don't look down.