The New Year has started with a much more positive tone than 2012, though world leaders are still struggling to find balance between policies that promote economic recovery and those that might inflate new and dangerous bubbles. Europe's patchwork of rescue measures has dramatically eased sovereign yields off their peak levels. Meanwhile, Washington set the table for a positive January, establishing some certainty for businesses and households with the agreement to preserve middle class tax cuts, but kicked the can down the road again on the debt ceiling debate and the budget cuts demanded by the sequester. The notion of a "currency war" got some new life as the US Fed launched its open ended quantitative easing program and Japan's new government pushed the BOJ to promise a similar policy in 2014. As central banks tipped toward even more open handed policy and politicians continue to wrestle with the new fiscal realities, the global economy has quietly gotten back on its feet, looking steadier albeit at a slower "new normal" growth rate.
Equity markets appear to be setting up for a break out if a few final political roadblocks can be overcome in the months ahead. Major US and European equity indices are at five-year highs, while Hong Kong stocks and Japan's Nikkei are near two-year highs. Companies have spent the last few years getting leaner and hopes abound that these more efficient firms can expand earnings multiples now that the economic turnaround is starting to take hold. The latest earnings season is showing mixed results in this regard, with some long time favorites like Apple losing favor but investment dollars finding a home in other stocks. The net result is equities continue to rise, and are now testing an inflection point exemplified by the S&P 500 testing a range above 1,500, within striking distance of all-time highs (1,565).
With stocks on the verge of a break out, murmurs about a reversal in the nearly uninterrupted 20 year-long rally in bonds are becoming more pronounced. Many analysts now describe the action in the bond market as a bubble, brought on by historically easy base rates at global central banks coupled with ongoing economic uncertainty that leave no alternative to the relative safety of government bonds. Years of record low government bond yields have worn on investors, however, leading to the beginnings of what some prognosticators says will be a "Great Rotation" back into stocks. Recently the US 10-year yield hit 2% for first time since April 2012, but that merely got it back to the level that marked the low yield during the outset of the 2008 crisis. By almost any measure, stocks appear to be a better value than bonds, yet uncertainty is still holding that Great Rotation at bay for the time being. If some of the final hurdles of uncertainty can be cleared, it could trigger the surge to new highs that stock market watchers are clamoring for, and money draining out of treasuries could set bond yields on a trajectory back toward historical norms.
The Economic Steeplechase
The fallow years of the crisis have dented investor confidence to the extent that market participants are still reluctant to fully adopt the risk-on bias they are leaning towards. The anemic growth being achieved by most of the world's major economies is particularly troubling to the want-to-be bulls.
Of all the global regions, Europe has the most questionable growth outlook. Just recently, the UK delivered a preliminary Q4 GDP reading that was worse than expected and back in contraction, after Q3 growth finally broke a streak of three straight quarters of contraction. If the final revision set to be released on February 27 digs the hole even deeper, it could magnify concerns that Prime Minister Cameron's government may have pushed austerity measures too hard and tilted the UK back toward its third official recession in four years.
German GDP isn't much better, with six quarters in a row of growth below one percent and more of the same expected from the preliminary reading (Feb 14). The German Economic Ministry also made it clear in its latest forecast that this suboptimal growth will continue indefinitely, cutting its forecast for 2013 GDP to 0.4% from 1.0% prior. Measures of factory orders have come in below expectations in three of the last four months as well, a problematic sign for industrial Germany, though it has been offset somewhat by recent improvements in the Ifo and Zew business sentiment surveys.
The advance reading of US Q4 GDP surprised to the downside with a -0.1% reading, which was largely attributable to slower federal government spending. Markets shook off the poor reading, anticipating that the more complete revisions of the GDP data (due out on February 28 and March 28), will correct back to growth territory. Data watchers are also pleased with the trend in US payrolls. After a hiccup in mid-2012, payrolls have been trending higher, with upward revisions almost every month. The last revision brought both December nonfarm and private payrolls close to the key 200 thousand level that is essential for taking unemployment lower from here.
Growth measures in China seem to be stabilizing at the new normal of high single digit growth. The latest data on China showed 2012 growth at 7.8%, its lowest annual pace since 1999, but still comfortably above the new target rate of 7.5%. Though some skeptics don't trust Chinese government data, other measures of economic activity are confirming this solid growth rate. The official China manufacturing PMI has seen four straight months of expansion, though it has been tending to come in below analyst estimates, while HSBC's PMI measure just hit a two year high and has exceeded estimates for four months. In its survey, HSBC polls more small and medium sized businesses that have a tougher time getting credit in a slow economy, so the case can be made that it's a better cyclical signal that the government reading. China trade data has also improved lately, with the January trade balance showing a surprising jump in exports above 14%, the highest year over year rise in seven months. Imports were also higher than expected, another indicator that China's economy is on the rebound. Still the readings of February data may be artificially subdued by the 'Golden Week' celebration of the lunar New Year starting February 10, during which Chinese industry will be largely idled for the spring festival transitioning from the Year of the Dragon to the Year of the Snake.
Political Hurdles
China completes its generational political hand off at the meeting of the National People's Congress in early March. There Xi Jinping is expected to be named President of the country, succeeding Hu Jintao, whom he replaced as head of the Communist Party in November. Mr. Xi is not expected to rock the boat as he takes power; so far the transition has been focused on maximizing stability.
As it has been for the last several months, Washington is still the epicenter of political uncertainty. For the time being, however, a more conciliatory tone has been struck in the capital. As a damage control effort for the reputation of a Congress that appears to the world to be losing its ability to govern effectively, Republicans agreed to delay the debt ceiling fight for three more months (to May 19) and to tighten up filibuster rules in the Senate that have nearly ground legislation to a halt in that body. Congress managed to avert the Fiscal Cliff at the last moment, thanks largely to the personal working relationship between VP Joe Biden and his former Senate colleague minority leader Mitch McConnell, but the New Year's Eve compromise only dealt with half of the problem, leaving the hardest issues to be tackled in the weeks ahead.
The 'sequester,' set to begin March 1 unless a new agreement is hammered out, will cut the discretionary part of the federal budget by nearly 10%, split evenly between defense and non-defense spending. It was designed to be painful enough to both parties to force them into making hard choices and compromises on more targeted cuts. Some Republican leaders are now suggesting that the sequester cuts might be inevitable since further negotiations may require more tax compromises, and some Democrats favor allowing the sequester to happen because it's the only way the defense budget will ever be included in discretionary cuts.
President Obama won't likely be sending a dear Valentine message to Congress in his State of the Union address tentatively scheduled for February 12. If a sequester deal is not being shaped by that time, the speech may include heavy doses of the President scolding congressmen for creating another political cliffhanger (immigration reform and gun violence will be the other big topics).
After the sequester is dealt with one way or another, the next line in the sand will be coming up fast. At the end of March, Congress has to authorize a spending plan, and the GOP has made noises that it will use this as another political football to leverage additional spending cuts. If the appropriations bill is held up, it could force the federal government to furlough workers and suspend non-essential services. This would be a political risk, however, after a similar maneuver to force a government shutdown in 1995 backfired on Republicans.
Europe is also experiencing more political turmoil. Spanish Prime Minister Rajoy is embroiled in graft scandal that might threaten his government. He and other leading members of the Popular Party are accused of receiving kickbacks from a party slush fund during the boom years that lasted until 2008, allegations that are particularly damaging in this time of austerity. Two junior members of Rajoy's party have already quit the government in protest, and the attorney general has determined the allegations warrant an investigation. If the scandal cannot be put to rest quickly, it could destabilize the government and threaten its ability to successfully navigate out of Spain's fiscal and financial system problems, and may even force a snap election.
Uncertain times are also being seen in Italy as it returns to a fully political government after the steady technocratic rule of Prime Minister Monti. With the euro zone the crisis ebbing, political machinations abruptly ended Monti's term late last year and new parliamentary elections on February 24-25 will determine what's next for the country. The Democratic Party (PD) is leading in the polls, following the trend across Europe during the recent crisis years of throwing out conservative governments in favor of socialist leaders (a worrisome trend for German Chancellor Merkel who will face the polls this autumn). If the PD takes power it will likely add to the chorus of the more left-leaning leadership in Europe calling for added programmatic spending to balance the austerity measures that were enacted in the name of fiscal stability. This is a concern for many officials, including those at the upper echelons of the ECB, who worry that the perception of the crisis easing should not be used as an excuse to turn back on fiscal consolidation efforts.
Banks Vaulting
Beyond these political concerns, Europe is also facing currency imbalances eroding its exports and persistent high unemployment rates sapping consumer confidence, yet there have been some recent signs that stabilization has taken hold. Since ECB President Draghi's July 2012 declaration to do "whatever necessary" to preserve the euro, sovereign debt tensions have dissipated and the currency zone has found some economic stability. The situation in Greece has been patched, talk of an impending full Spanish sovereign bailout has all but vanished, and the other bailout program states - Portugal and Ireland - are making strides toward normalizing their debt markets.
At the last ECB policy meeting Draghi shifted expectations away from a cut to negative deposit rates, indicating that it was no longer being advocated by anyone on the council in January. Another surprise development was the revelation that the stronger European banks have begun returning Longer-Term Refinancing Operation (LTRO) funds faster than expected - the ECB announced in late January that banks would repay €137.2 billion of LTRO funds in the first week, much more than the €100 billion expected. This seems to indicate that banking sector liquidity is better than believed, though the truth of this will become clearer over time as banks schedule the return of over one trillion euros in 3-year LTRO loans up until their expiration in 2015. One risk associated with this process is that it may create the appearance of a two tiered financial systems, between healthy banks eager to return the funds quickly and less robust institutions that are reluctant to repay the LTROs expeditiously.
Despite this good news, Europe is still putting out fires in the banking system, and even in core countries. Just days ago the Netherlands was forced to nationalize SNS Reaal NV, the country's fourth largest bank, to save it from collapsing under the weight of a bad real estate loan portfolio which endangered the entire Dutch banking system. There were concerns that Italy might have make a similar move with its third largest bank, Monte Paschi, after the bank uncovered €700 million in losses from a complex derivatives deal. Ultimately the Bank of Italy approved €3.9 billion in bailout bonds to stabilize the bank, but the incident raised unsettling questions about how managers at the bank were able to avoid setting off red flags sooner despite the expectation of tighter controls after the 2008 financial meltdown.
The plan to create a new cadre of regulators at the ECB to oversee the continent's largest banks helped quiet the turmoil in Europe late last year, but upon closer scrutiny the plan is now being panned by many experts. The terms of the banking union give the ECB direct supervision over the largest 200 banks, those with more than €30 billion in assets, and less defined role of pointing out problems at smaller banks that are under the supervision of their home country's regulators. Critics say that this failed to address the two cornerstones of a banking union, a joint deposit insurance scheme and a single resolution fund to clean up failed banks. As it stands now, the European Stability Mechanism (ESM) rescue fund can only be applied to viable banks, not the "bad banks" that nations have set up to wind down problem assets, which are the banks most likely to incur losses and need external support. So if the ECB demands a failed bank be wound down, the home nation will have to foot the bill, putting renewed stress on the sovereign. Thus, critics say, the inadequate bank resolution regime has failed to deal with the toxic link between weak sovereigns and weak banks. Bank failures and bailouts like those just seen in the Netherlands and Italy could rekindle the European crisis.
Meanwhile US banks are starting to look healthier, at least by comparison to Europe. US banks have trimmed down their collective balance sheets to about 78% of US GDP (compared to Euro Zone banks at 357% of GDP and Japan banks at 174%), making the financial system less of a threat if banks are put to the test again.
On March 7, the Fed will release results of the annual supervisory stress tests conducted accordance with the Dodd-Frank Act, and a week later it will announce the results from the Comprehensive Capital Analysis and Review (CCAR) of "too big to fail" banks. Last year some banks, notably Bank of America and Citigroup, failed parts of the review based on their plans for dividend distributions and stock repurchases, which was publicly embarrassing. This time around none of the big banks are expected to fail the stress test and CCAR, and many will be given a green light to pursue more ambitious capital plans than in the last few years, which could be a real catalyst for bank stocks headed into the spring.
An area of continued uncertainty for US banks is the implementation of bulk of the Dodd-Frank rules, which were initially slated to be in place in the summer of 2012. Regulators missed that deadline and have continued efforts to write rules, and now appear to be putting the finishing touches on the specific regulations to support Dodd-Frank. That may make 2013 the year for implementation which could lead to some surprises as stricter rules hamper some of the old business practices on Wall Street, and unintended consequences of the new rules shake out.
The Fed, which is among the regulators working to finish the Dodd-Frank rules, has had most of its attention taken by new policy innovations and the launch of a fresh quantitative easing program. After making its first "QE-infinity" policy tweak in December by replacing the Operation Twist maturity extension program with more outright Treasury purchases, the Fed will probably keep a lower profile in the next few months. The committee is expected to continue to stress the communication function of the Fed, reemphasizing that the new data thresholds for rate policy are not triggers but merely guideposts. The Fed will take great pains to point on that the 6.5% unemployment threshold in particular will not automatically trigger a rate hike, nor will its approach preclude other preparations for exiting accommodation schemes.
Each new sign of economic improvement is now being considered as to how it will impact the timetable of the Fed's eventual unwind of accommodation. Surveys suggest that the market expects conditions will improve enough in the months ahead to cause the Fed to trim back its current $85 billion per month quantitative easing program to a more modest monthly amount in the third or fourth quarter. The full FOMC will not openly discuss potential exit strategies in early 2013, but in the interest of the transparency that has been the hallmark of the Bernanke era, some members may float trial balloons in their periodic speeches. One Fed official has already suggested that the unwinding process will begin with raising interest on excess reserves (IOER). Notably the FOMC voters will shift to a slightly more dovish slate in its 2013 rotation, with the leading dissenters of the last few years out of the voting membership, so Bernanke should be able to start the accommodation endgame on his own terms.
Currency Leapfrog
The Fed and their global central bank counterparts will be facing more questions about the so-called "currency war" in the months ahead. Japan has become the front line in the currency war since the country elected its fifth new Prime Minister in five years on the promise of breaking a twenty year economic malaise. So far, newly installed PM Shinzo Abe has followed through on his plan to jumpstart the country's economy by pressuring the central bank into a joint statement with the government setting an official 2% inflation target and promising the BOJ will pursue open-ended asset purchases. This action had the desired effect of further weakening the yen and extending gains in the Nikkei, but it has some disagreeable side effects. Abe's plan may have eroded the independence of the BOJ and it has drawn criticism from other countries worried about competitive devaluation. The opened ended BOJ QE program also had a strange caveat: the program will not begin until January of 2014. This odd one year delay may be targeted at keeping the "jawboning" effect alive for longer, but it sets up the BOJ program to begin when other global central banks will probably be in the midst of winding down their own extraordinary programs.
That timeframe could change, however, when Mr. Abe names his hand-picked replacement for outgoing BOJ governor Shirakawa, who steps down in April. A new BOJ chief who is vocal about aggressive easing could signal a spring offensive in the currency war. Reports say the short list of candidates has been narrowed to four names: Asian Development Bank President Haruhiko Kuroda, former finance ministry official Takatoshi Ito, and two former BOJ Deputy Governors, Kazumasa Iwata and Toshiro Muto. Kuroda once advocated in a paper that the BOJ should set a 3% inflation target, while Muto recently stated that stopping deflation is a top priority and a policy of monetary easing is justified. Iwata and Ito have both proposed that the BOJ should buy foreign-currency bonds to reverse exchange-rate appreciation, with Iwata elaborating that the central bank should double its balance sheet to achieve the 2% inflation target by 2014.
The Japanese press is already speculating that Abe's choice to lead the BOJ could initiate the new easing program as he takes office in April, particularly if incoming data support immediate action. It's clear that the new government is anxious for action, with one senior economy ministry official suggesting openly that the yen would only become problematic in the 110-120 per dollar range, though his boss, economy minister Amari, later backtracked from that statement as unseemly. Other senior Japanese officials and advisors have indicated that a yen range of 95-100 is an appropriate level.
Euro Zone officials don't appear to be ready to take up arms to fight a currency war, but some senior officials have begun to strike a note of alarm. At the global forum in Davos this January, one ECB official was quoted as saying the central bank is "not very happy" with a step toward competitive devaluation in Japan, given the massive quantitative easing programs already being implemented in the US and UK. French President Hollande put a happier spin on euro strength, saying it shows investor confidence in Europe is returning, though he still noted that the euro is now at a "very significant" level which could be problematic.
The issue of competitive currency devaluations is certain to be a hot topic on the sidelines of the G20 meeting in February (Feb 25-26). Senior officials across the globe have already taken note. For example, a Bank of Korea economist recently said "it is not an exaggeration that the global economy will face a currency warTrade protectionism is spreading." The Taiwan central bank has said outright that it will step into the currency market if necessary, and German industrial groups have registered their concerns that the new BOJ policy may cause a devaluation race.
Clearing the Wall of Worry
For the stock market, January's performance is usually a strong indicator for the entire year. With US stocks seeing their best four week start in twenty years, and bonds yields still depressed, equity markets may gain a lot of ground later this year if economic confidence is not tripped up by the hurdles presented this spring in Washington or Europe.
Signs of a strengthening economy in the US could shake the expectation that the Fed will keep up the current $85 billino per month in QE until the second half of the year. But that would require consistent payroll growth over 200 thousand per month and unemployment starting to head down closer to the 6.5% policy threshold. It remains to be seen if and when the "Great Rotation" toward risk assets will be knocked off kilter by concerns about the "Great Unwind" of unprecedented central bank accommodation that looks to start this year.
It is also yet to be seen if the rising talk of a currency war will materialize in a race to devalue currencies or if it's an overstated problem, making too much of standard skirmishes. Despite the griping of other finance and monetary officials, the BOJ plan to boost asset purchases and restart inflation does not appear to be all that radical in the era of fiat currencies of the last 40 years. The Euro Zone appears to be ready to sit out the currency war, despite the euro experiencing the greatest appreciation from it, though the ECB may still hurl some verbal volleys at other central banks if competitive devaluation campaigns continue.
In terms of the dollar weakness, signs are pointing to at least some near term reversal. One top analyst noted that real money US dollar selling has hit an extreme level in recent days (near two standard deviations), signaling dollar weakness is set for a near term reversal, which would erode some of the strength in risk assets. This, coupled with the extreme complacency in the VIX volatility index, suggest as least a short term reversal in the risk-on gusto seen in January.
A short term retrenchment may be a healthy development, creating a base to build off if 2013 is indeed the year the crisis mentality ends. As always, however, this path could be diverted by political blunders or more surprising revelations from the too-big-to-fail banks that triggered the financial crisis.
CALENDAR
FEBRUARY
1: US Payrolls and Unemployment; US ISM Manufacturing
4: US Factory Order
5: US Non-Manufacturing PMI
6: German Factory Orders
7: ECB and BOE rate decisions; Fed releases annual bank stress tests results; China CPI
8: US Trade Balance; China Trade Balance (tentative)
11-15: China Spring Festival Golden Week holiday
12: BOE Inflation Letter and UK CPI; US State of the Union speech
13: US Retail Sales; BOJ rate decision
14: Europe Q4 preliminary GDP; Fed releases Comprehensive Capital Analysis and Review (CCAR) for banks
15: US Final University of Michigan Confidence; UK Retail Sales
18: China HSBC flash Manufacturing PMI
19: Europe Flash Services and Manufacturing PMI readings
20: BOE Minutes; German ZEW Economic Sentiment; US Housing Starts and Building Permits ; US PPI; FOMC Minutes
21: US CPI; US Existing Home Sales; US Philadelphia Fed Manufacturing
22: German Ifo Business Climate; Europe CPI
24 (Sunday): Italy Parliamentary Election begins
25: Italy Parliamentary Election concludes; G20 meetings start (tentative)
26: US New Home Sales; US Consumer Confidence; G20 meetings
27: UK Q4 GDP (2nd reading); US Durable Goods Orders
28: US Q4 Preliminary GDP (2nd reading); China Manufacturing PMI; China HSBC final Manufacturing PMI
MARCH
Early March: China National People's Congress (Xi to be named President)
1: US ISM Manufacturing PMI; 'Sequester' budget cuts scheduled to begin (unless revised or delayed again)
5: US ISM Non-Manufacturing PMI
6: BOJ rate decision
7: ECB and BOE rate decisions; US Trade Balance; China CPI
8: US Payrolls and Unemployment; China Trade Balance
11: BOJ Minutes
13: US Retail Sales
14: US PPI
15: US CPI; US Preliminary University of Michigan Confidence
19: US Housing Starts and Building Permits
20: German ZEW Economic Sentiment; BOE minutes; FOMC rate decision, projections and press conference
21: US Existing Home Sales; US Philadelphia Fed Manufacturing; China HSBC preliminary Manufacturing PMI
22: Europe flash Services PMI; German Ifo Business Climate
26: US Durable Goods Orders; US Consumer Confidence; US New Home Sales
28: US Final GDP (3rd reading)
31: China Manufacturing PMI
