Wednesday, April 3, 2013

April - May 2013 Outlook  THIS Time It's Different…

The next two months will be about whether 2013 can break some of the patterns seen in the last few years. 2011 and 2012 both began with great optimism, getting off to strong starts with improving economic indicators, only to falter in the second quarter. Hope springs eternal and expectations are that this year will break that pattern and avoid the spring slump. The US economy is showing particularly good signs -employment trends are on a better than expected trajectory and confidence indicators are largely on the rise. Japan, where the tsunami disaster derailed recovery hopes in March 2011, is now riding high on hopes that an unprecedented stimulus program will move its economy into a higher orbit after a two decade stall. Neighboring China is entering a more subdued phase for its economy as a new government seeks to put its imprimatur on the world's second largest economy. Europe has tamed its crisis in the last year, though events in Cyprus last month made it clear there's more work to do, and economic stagnation is worsening in some parts of the continent.

One key difference this year is that central banks are more active than ever. As the fiscal authorities continue to struggle with right-sizing their austerity programs, the economic recovery clearly rests on a cushion of monetary stimulus. Central bankers in the US, Japan, England, and the Euro Zone have all committed to record stimulus programs and some are ready to take it even further.

Japan Takes a Different Tack

April starts off with a bang as Japan's fiscal year begins, and the BOJ holds its first policy setting meeting under new management. At the April 3-4 BOJ policy meeting, newly minted governor Kuroda is expected to set his plan in motion, which could include pooling monthly bond purchases and the asset purchase fund, and using the funds to buy more longer dated debt. He may also accelerate the start date of open ended asset purchases that are currently slated to begin next January.

Kuroda has built up big expectations, vowing to do "whatever it takes" to end 15 years of deflation and reach the 2% inflation target within two years. Some respected Japanese economists, including advocates of greater stimulus, are casting doubts on whether a more active BOJ can achieve that aggressive goal so rapidly, with some suggesting it may take 5 years or more to get to the 2% inflation target, especially in light of higher sales taxes set to kick in over the next two years which are expected to crimp consumer spending. The sales tax will double in two stages from the current 5%, to 8% next year and then 10% in October 2015, so the BOJ stimulus plan will have to be grand enough to offset that drag.

With the yen already weakening and Japanese stocks rising in anticipation of the BOJ moves, failure to go big or to act swiftly on some of these measures could risk disappointment in the markets. Speaking to that point, Prime Minister Abe recently hedged his bets, saying it is possible that the 2% inflation target may not be achieved within two years, and that he is not calling on the BOJ to act recklessly just to meet that timetable.

Europe: "Differently Abled"

After the BOJ makes its fateful decisions on bolstering stimulus, next up is the European Central Bank. The ECB has two main issues to contend with - policy missteps that have fanned the coals of the crisis and euro zone states that are unable to shake off anemic economic data.

The troika's ham-handed bailout of Cyprus shook the notion that the euro zone crisis was fully contained. Fearing a string of sovereign bailouts threaten to turn the EMU into a "transfer union," northern European states pushed for a "bail in" component that would ensure weaker nations pay their dues for any future bailout package. In Cyprus this translated into the ill-conceived initial agreement that would levy a tax on all bank account holders, even those below the sacrosanct deposit insurance threshold of 100 thousand euros. Even though the levy was ultimately shifted to larger depositors, the Cyprus plan has created the threat of instant bank runs at the first whiff of trouble. For example, should Spain give the slightest hint of considering a full bailout program (as it seemed to a year ago before opting for a bank-focused recap fund), Spanish depositors would rush to secure their savings to avoid losing them to a potential "bail in."

A barrage of weak data has plagued much of the euro zone. For the EMU as a whole, unemployment has climbed from 10% a year ago to 12%, and PMI has been in contraction for over a year. Northern states have been faring better, but the southern nations, including France have been forced to trim GDP forecasts and delay expectations for returning deficit to GDP ratios back below 3%. If these data trends don't improve soon, Europe's woes could drag down the global recovery and force the ECB into more action.

Political instability has also been an enemy to economic recovery. Italy's government has been in limbo since inconclusive elections over a month ago. Three major blocks split most of the vote about equally, including the 5-Star Party's protest vote garnering 25%, and have been unwilling to join each other in a broad coalition government. It now appears likely that President Napolitano will have to call another election, perhaps in June, though it's unclear if the result would end the deadlock. Italy may eventually have to opt for another technocratic regime, but until a working government is formed uncertainty will run high in Italy.

These pressures have led the ECB toward considering another unprecedented action, namely cutting rates to zero or lower. In recent press conferences, ECB President Draghi has indicated that the bank has discussed the possibility of cutting its key rate below 0.25%, is operationally ready to do so, and could even consider negative interest rates. As the issue has been contemplated over the last year, most ECB officials seem to agree that a zero rate could create beneficial flows from fiscally sound countries with excess cash to peripheral nations whose troubled banks could borrow the funds, but that resorting to negative deposit rates might create unintended consequences including damaging Europe's 1.1 trillion euro money market industry. The ECB is also said to be looking at easing collateral rules, though it raises concerns about further weakening the central bank's balance sheet.

On a smaller scale, the BOE is struggling with poor economic indicators in the UK, which haven't been helped by the government's latest budget reaffirming austerity as its guiding principle. How the tightening purse strings play out in the UK economy may set the tone for the rest of Europe which has been shrinking away from its initial fiscal consolidation plans on fears it will extend recession. So far, readings of industrial production and manufacturing in the UK have not been promising, which is a flashing green light for more quantitative easing. The BOE could add another £25 billion to its existing £375 billion QE program as early as its April 4 meeting. Governor King, who will be replaced in July by current BOC chief Carney, has called for an additional £25 billion in QE at each of the last two policy setting meetings.

A Little Fed Makes All the Difference

With the BOJ, ECB and BOE on the verge of building on to their already unprecedented stimulus programs, the Fed seems content with the status quo after it opened the taps fully with "QE-infinity" late last year. Shifting to economic thresholds instead of calendar based forecasts successfully moved market focus back to economic data and expectations rather than fixating on a specific end date for accommodation. The Fed has made it clear as well that the thresholds are not automatic triggers for a policy change, and at his last press conference Chairman Bernanke even suggested that the thresholds could be shifted as a way to create more stimulus if necessary (e.g. lowering the unemployment threshold from 6.5%).

Thus the jobs outlook is more important than ever. In the last couple months unemployment data has become demonstrably better, enough to cause the Fed to trim its forecast for the central tendency of 2013 unemployment. One month of much better than expected payrolls data in the early March report created expectations that net new jobs will start rolling in at over 200 thousand a month on a consistent basis. The three month average of the last three months is still below the strong reports posted in Q1 of 2012, however, so market watchers may be putting the cart before the horse. Two more readings above that key 200 thousand level in early April and May could convince skeptics that the spring swoon will not repeat this year and put us on track for a better second half of 2013.

Differential Equations

The successful return of the DJIA and S&P500 to record levels seems to support the revival of the trope that global markets may be decoupling. The reanimation of the euro zone crisis caused by the mishandling of the Cyprus bailout only seemed to reinforce the idea that the US is a safer place to invest than Europe. Many analysts are now making the case that the global economy is in a unique phase that could allow the US economy to start hitting on all cylinders while Asia sputters and Europe is stalled.

At least temporarily, the political temperature on Washington has cooled. Partisans have accepted the sequester cuts in stride and are perpetuating them while Democrats and Republicans work on a longer term budget agreement. The truce centers on another round of "kicking-the-can" - Congress passed a continuing resolution that provides funding through the end of the fiscal year, September 30, averting a government shutdown. The GOP still has the option of turning up the rhetoric around the debt ceiling, which was suspended until May 19 as part of the last kicked-can, but they may be unwilling to risk another sovereign rating warning that may result from this tactic.

In this relatively calm political environment, US equity markets have fallen into a complacent melt-up mode undergirded by the Fed's QE3 program. There appear to be no good alternatives to stocks - cash has eroding value, gold has fallen along with crisis fears, and bond yields are miniscule. The VIX volatility index has dropped to multi-year lows, and shows no signs of concerns even in futures contracts ranging out to late 2013.

Not to be forgotten, another earning season is upon us. Companies will have to demonstrate they deserve expanding multiples by putting up solid results despite the global malaise and incremental setbacks like the loss of some government funding because of the sequestration (which is now set to continue through September unless a grand budget deal is forged).

A few warning signs are emerging in the metals market, including a potential glut in copper production. Copper futures are near one-year lows, a concerning indicator for industry. The weakness in copper is reflective of weaker than expected manufacturing data in China, the top consumer of copper. Meanwhile silver futures have just officially entered a bear market, dropping 20% off of September highs, a bad omen for gold, which has been slumping for six months and has fallen more than 10% in that period. In the energy complex, the price of oil probably won't garner much attention unless WTI returns to $100 per barrel, a level that could be seen as a hindrance to economic expansion. As always, a surprise escalation in Iran or North Korea could play havoc with the commodity markets.

Split the Difference

As the spring quarter opens, every corner of the global economy is faced with difficult questions. Will the sequestration begin to bite harder in the US and will the D.C. pugilists at least keep their gloves on? Can Europe withstand economic data getting any worse even as it helplessly watches the Italian political fiasco? Can the new Japanese regime stir together the right recipe to reinvigorate the country's economy, a feat that has eluded leaders for two decades, inducing governments in Toyko to change almost as often as the seasons? Will a disappointing string of data, another unexpected macro event, or even the "sell in May" platitude trigger yet another spring swoon?

Three months into 2013, these questions have yet to be answered, but things seem to be a little better than the last two springs. Equity markets continue to attract money flows though the anticipated "great rotation" out of bonds and into stocks has yet to begin in earnest as retail investors still fear getting burned again. Treasury yields in the most favored nations are still extraordinarily low, but there's no obvious catalyst yet to prick the "bubble" of the 20 year bond rally. History favors stocks in the short term - over the last six decades, April has been has been the best performing month of the year for the DJIA with an average gain of 2%, and the Industrials haven't registered a decline in any of the last seven Aprils. The expectation that the BOJ will open the flood gates for stimulus has buoyed the Nikkei Index for several months, and any perceived shortcomings in the actual BOJ policy announcement will only steer investment dollars back toward the US stocks.

The biggest note of caution for the next few months may lie in the central banks being victims of their own success. If economic data start to turn dramatically better, monetary policy efforts will get most of the credit. But too much success could have a stiff price as the markets start to recalibrate the timing of the eventual unwinding of accommodative policy. Central banks do not appear to be in a hurry to stop what they are doing, and some are just starting to go full tilt, but if they get a burst of faster than expected positive results, much of that progress could be lost as markets try to anticipate the pivot toward the exit strategy. Ultimately better data would be a positive, but the perception that it all rides on the back of extraordinary stimulus that will eventually be withdrawn makes all the difference.



1: US ISM Manufacturing PMI
3: US ISM Non-manufacturing PMI; BOJ Policy Statement
4: ECB policy statement; BOE rate statement; Bernanke and 3 other FOMC members speak
5: US unemployment and payrolls; US trade balance
5-6: Next round of Iran nuclear talks in Almaty, Kazakhstan

7: Japan Current Account
8: China CPI and PPI
10: China trade balance: US FOMC meeting minutes
12: US retail sales; US PPI

14: China Q1 GDP
16: BOE inflation letter and UK CPI data; US housing starts and building permits; US CPI
17: BOE minutes; German ZEW economic sentiment
18: US Philly Fed Manufacturing Index

22: US existing home sales; China HSBC flash manufacturing PMI
23: Euro Zone flash PMI readings; US new home sales
24: German Ifo business climate index; US durable goods orders
25: UK prelim Q1 GDP; BOJ policy statement (tentative)
26: US advance Q1 GDP

29: US personal spending
30: Euro Zone unemployment; US consumer confidence; China manufacturing PMI
1: US ISM Manufacturing PMI; FOMC policy statement
2: ECB policy statement; US trade balance
3: US unemployment and payrolls; US ISM non-manufacturing PMI

6: Japan prelim Q1 GDP
7: China CPI and PPI; German factory orders
9: BOE policy statement; Japan current account
10: China trade balance

13: US retail sales
15: German ZEW economic sentiment; BOE inflation report; US PPI
16: US housing starts and building permits; US Philly Fed Manufacturing Index
17: US preliminary University of Michigan consumer sentiment

21: BOJ policy statement (tentative)
22: BOE minutes; FOMC minutes; US existing home sales; China HSBC flash manufacturing PMI
23: Euro Zone flash PMI readings; UK Q1 GDP 2nd reading; US new home sales
24: German Ifo business climate index; US durable goods orders

26: BOJ minutes
28: US consumer confidence
30: US Q1 GDP 2nd reading
31: China Manufacturing PMI