TradeTheNews.com August-September 2013 Outlook: Summer’s End
The Goldilocks environment has persisted into the summer, with central banks further augmenting their dovish talk as tepid data showed the slightest improving trend, not too hot, not too cold. Markets saw a bit volatility in June as Treasury rates popped after some hand wringing about the Feds QE tapering plan, but the worries quickly subsided as the Fed and other central banks went to new lengths to demonstrate that they are still in control. A parade of Fed officials stressed that the end of QE would not constitute tightening and was not a prelude to rate hikes. The ECB took up the banner of accommodation by providing forward guidance for the first time ever, indicating that rates will be at current levels or lower for an extended period of time. Similarly the BOEs new chief has promised to throw his own forward guidance on the stimulus bon fire in August. The BOJ has already impacted markets with its fresh accommodative policy, and there is some speculation that the Chinese central bank could offer up some new stimulus if China's economic growth slips any further.
It is becoming clear that the global recovery will be a long, slow, and multi-speed one, which will make the eventual unwind of extraordinary monetary easing extremely complex and fraught with peril. But for at least another couple months, markets will likely continue to ignore the longer term issue of exit policy, and enjoy the modest improvement in the economy as it faces only some moderately sized potential pitfalls, mostly on the political front.
Finally, Europe Gets Some Sun
Europe is getting more attention as its economy appears to have stopped getting worse, thanks largely to central bank interventions. At its July meeting, the ECB initiated forward guidance for the first time to further leverage its verbal intervention. This, combined with the promise of the OMT program (which has been enacted but never actually used), is just about the last line of verbal defense from the ECB. If economic data starts to deteriorate again, the central bank may have to raise the prospect of negative deposit rates again, which Draghi has said they are technically ready to implement, though the policy could have serious unintended consequences. First, negative rates could further squeeze the lending margins of banks, particularly in the weakened peripheral nations. Second, it may be seen as the last tool available to the ECB, and just the perception that its bag of tricks is empty may be enough to cause some market jitters on the notion that the central bank has nothing left to give if another crisis hits. If more economic weakness forces the ECB to take the plunge into negative rates, analysts believe they would have to make it a significant move, cutting rates as much as one percentage point to give the policy enough oomph to be impactful.
As the ECB waded into providing forward guidance, the BOE also stepped in to say that it will delineate a rate path this month. The details of the forward guidance are set to be released alongside the August 7 Inflation Report, as newly minted BOE Governor Carney starts to put his stamp on monetary policy. In future meetings Carney could also move to increase the banks asset purchase program again, as his predecessor advocated.
There are emerging signs that the European economy has finally hit bottom. The latest EMU unemployment reading ticked slightly lower to 12.1%, the first decline in almost two-and-a-half years, and Euro Zone July PMI Manufacturing edged above 50, the first growth reading in 24 months. There are still deep problems in the peripheral countries for example, the IMF just downgraded its forecasts for Spains unemployment, predicting it will remain above 25% for the next five years but on the whole it seem that the euro zone has seen its worst days. With the light at the end of the tunnel starting to become visible, the EMU has to do its best to stay true to the path of greater integration, despite a bevy of political challenges across the zone.
The European political scene has still has many potential flash points that could refuel the Euro Zone crisis. In recent weeks Greece was shepherded through the necessary steps to get its next bailout tranche, but there are still some questions about a future funding gap, while in Portugal the government survived a tiff between coalition members over fiscal strategy. Spanish PM Rajoy is comfortable enough with the path to economic recovery to asset that the recession is being left behind and the danger of a bailout has gone, but continues to contend with the taint of a government slush fund scandal. Perhaps the most troubling situation is in Italy, where former PM Berlusconi is prodding his party to threaten to break up the fragile coalition government that took weeks to form after an inconclusive election in April. If President Napolitano refuses to grant Berlusconi a pardon from a one year sentence that was recently affirmed by the high court, the government could fall apart.
The biggest planned political event of the next few months will be the German federal elections on September 22. Chancellor Merkel has treaded through the minefield of the Euro Zone crisis with extreme caution in an effort to avoid the fate of many of her former peers: more than half of Euro Zone governments have been tossed out and replaced by the opposition during the last four years. Because of a collapse in support for its junior coalition partner (the FDP party), Merkels current coalition government does not have a clear edge in the polls over the opposition coalition. Merkel is, however, polling far ahead of Peer Steinbruck as the preferred Chancellor candidate, and seems likely to retain her post, though it may require forming a grand coalition with Steinbrucks center-left SPD party.
Elections in the heart of Europe have changed the course of Euro Zone policy already. For example, shortly after France elected a Socialist leader for the first time in nearly two decades, President Hollande redirected continental policy toward growth measures to counterbalance strict austerity programs that had been focus of the crisis recovery plan until then. Once the German election has been settled, Merkel will be free to exercise a more muscular agenda in Europe, including working on the structures and institutions that will build more Europe as she likes to say.
One hurdle to clear will be the German Constitutional court decision due out this fall on the legality of participation in the European Stability Mechanism (ESM) and the European Central Bank's bond-buying program (OMT). Last September the court gave a preliminary verdict that participating in the ESM was permissible, though it insisted on the German Parliament retaining veto rights. The court has a track record of bowing to German government authority when it comes to issues of European policy, and in hearings this June the court president indicated that the ECB's conditionality on OMT could help draw the line between fiscal and monetary policy distinctly enough for it to be a good middle way.
Leaders in the Middle Kingdom are also looking for a middle way that would allow them to keep growth near target levels without significant new stimulus efforts as the economy has gotten soggy. To that end Chinese leaders have given a lot of lip service to the official economic forecast. Within the last month China Premier Li Keqiang has acknowledged that the official 7.5% GDP forecast may be vulnerable, but vowed that the government would not allow growth to fall below 7% this year, while Finance Minister Lou has stated that there will not be major fiscal stimulus this year, but only some fine tuning of policy. Indeed, in the early days of August the PBoC resumed reverse repo operations for the first time in six months, which the Chinese press deemed a form of mini stimulus aimed at stabilizing growth.
Recent data has given Chinese leaders some relief. The latest official non-manufacturing PMI put in its 17th straight month of expansion and the manufacturing PMI is still showing growth. Outside measures are not as favorable, however, as the July HSBC manufacturing reading hit an 11-month low, raising more questions about whether the official government data is wholly reliable.
The dampening Chinese economy is impacting trading partners, especially Australia, which has long benefited as supply line for the Chinese economic miracle. Even as Chinas demand for raw materials has subsided, Australia has also been sandbagged by foreign central bank policy that has led to a strengthening Aussie dollar, squeezing domestic profit margins and thus the tax base. This pressure may demand a response from the government and central banksome analysts are predicting the RBA may need to launch its own QE program and slash rates to near zero to avert a recession. The ailing economy may also lead directly to the ouster of PM Rudds Labor party in favor of the center-right opposition in the upcoming September 7th election.
Japans own upper house election, held last month, solidified Prime Minister Abes political powerbase, leading him to declare that Japan's will to change has returned, and that the revolving door of politics is over. He also used the occasion to give assurances to partners in other advanced economies that he will shift his focus to the third arrow, reform programs to achieve growth through stimulating private investment and boosting Japans economic competitiveness. Now that the PM has been given the political capital to move forward with the economic plan that bears his name, Abe must show the determination to enact deep reforms in the Japanese economic system, some which may be unpopular with his own party, including agricultural trade reforms sought for the Trans Pacific Partnership (TPP). Already Abe is hedging on a planned consumption tax increase, saying the government will study the data in the next few months to determine if the proposal to double the consumption tax over the next two years will go ahead as planned.
The BOJ is still projecting confidence. Recently Governor Kuroda stated that the BOJ has taken enough measures to achieve its 2% inflation target and is ready to make policy adjustments as necessary. Last month the central bank also raised its economic assessment for the seventh straight time, the longest streak on record. Having done its part for Abenomics, the BOJ now needs to see its monetary measures supported by fiscal policy actions.
Bernanke's Last Summer
BOJ officials might be concerned by the American example, where fiscal policy inaction has substantially hampered the economic recovery. Congress has just started a month-long recess, but before members left Washington, they previewed the debt ceiling battle which is about to restart. With the sequestration taking a bite out of economic growth and economies in Europe and Asia still shaky, Washington has an opportunity to shore up fiscal policy with a new look at a grand bargain before the US fiscal year ends on September 30. But little has changed in D.C. politics since the last time leaders kicked the can on March 1 (when the sequester took effect), and a mild improvement in the economy has given them even less urgency to reach a deal.
Congressmen may also have lost some of the sense of urgency to deal with fiscal issues because there has been little consequence for their feckless behavior. On the 2-year anniversary of S&P cutting the US sovereign rating, most US stock indices are notching record highs, despite the ongoing political gridlock that was the main impetus for the ratings downgrade. In June, thanks largely to the sequesters indiscriminate budget cuts and the Feds growing stimulus, S&P brought its outlook back to stable from negative, and now predicts a 2013 debt ceiling deal will get done at the last minute. The other ratings agencies, Fitch and Moodys, still have their AAA ratings on a negative outlook, but dont seem to be in any hurry to test the reaction to a second US sovereign downgrade, which could either be shaken off like the first, or finally trigger the sea-change in fixed income markets that some expected after the S&P downgrade.
Despite the fiscal drag and gridlock in Washington, the US economy has worked its way toward modest growth, doing better than almost every other advanced economy. The housing market has gathered strength amid tight inventories of homes for sale, and home prices have appreciated, floating many homeowners who were underwater back to the surface, which in turn has helped buoy consumer confidence readings. Prospective home buyers will be watching mortgage rates closely, as any additional spurt higher in rates could cool off the market.
Despite the housing strength, economic growth remains lackluster in the US and the jobs market is still on a very slow ascent for the fourth year of a recovery. Average payroll additions are still lagging behind the 200 thousand or so needed to match new workers in the workforce each month, and unemployment has been ticking lower largely based on a declining workforce participation rate. Many of the new jobs that are being created are in lower wage brackets, leaving many people underemployed. There is growing evidence that the unemployment problem is now largely structural, which could make any additional stimulus efforts ineffective.
The Fed may be tacitly acknowledging this by gearing up for the end of QE3. Chairman Bernanke used the June meeting to link the reduction of QE to the Feds economic forecast, indicating tapering would start in the fall and conclude in mid-2014 when unemployment will be around 7%. Thus if the taper doesnt begin by December, it would strongly imply the Feds forecast had slipped again, creating some credibility problems for the central bank. It would also open the Fed up to more potential mistakes in messaging, possibly throwing out another lead balloon like the comments that evoked the June Taper Tantrum.
Therefore, along with the economic data, the FOMC calendar now plays into forecasting the potential for tapering QE. The next FOMC meeting, on September 18, includes a press conference that would allow Bernanke to explain in detail any decision to taper. If the data are still too languid to begin slowing QE in September, then the mid-December meeting would offer Bernanke his last opportunity to launch the taper at a regularly scheduled press conference. Otherwise the entire unwinding of extraordinary stimulus will be left up to Bernankes successor.
Speculation about succession at the Fed will likely become a growing distraction in the weeks ahead, as the Fed will have to devote more attention to giving assurances that the next Chairman will not rock the boat and can handle the implementation of the exit strategy. But as Mr. Bernanke noted himself, he is not the only person in the world who can manage the exit.
Vice-Chairman Janet Yellen may cement her frontrunner status for the top job at the Jackson Hole symposium in late August, where she is scheduled to moderate a panel especially if her remarks offer up additional policy guidance. Its expected that Yellen would follow Bernankes approach closely, and possibly be even more dovish than Helicopter Ben, which would please most stimulus-addicted Wall Street denizens, though some fear she might be slow to react if inflation reared its head. The other top candidate is former Treasury Secretary Larry Summers who is a friend of the White House but seen as somewhat abrasive for the collegial style of the FOMC and may be a more unsettling choice for market participants. Two other former Fed Vice-Chairs, Donald Kohn and Roger Ferguson, are seen as dark horse candidates who could get a second look if the intense press speculation and political lobbying around Yellen and Summers end up hurting their candidacies.
Into the Fall
While many of the pressing issues mentioned above will be discussed by leaders at the G20 summit in Russia on September 5-6, a change in the tenor of the global outlook may not become clear until October. By then, Germany will have settled its election (as will Australia), Japan will have let fly the third arrow of its recovery plan, the new US fiscal year will start with a debt deal or another frustrating kick-the-can extension, and we may even know the name of the next Fed Chairman (the last time around Bernanke was re-nominated by Obama in late August 2009).
Economic data across the globe could be better, but for the first time in four years theres a sense that things are improving or at least stabilizing in most regions. Europe has arrested its fall, though its political tests will continue, and if the euro creeps back towards 1.35, the ECB may reintroduce negative rate-talk. In Japan, PM Abe now has full control of the government and now must put up or shut up, with the knowledge that the uncomfortably rapid rise in the 10-year JGB interest rate in mid-May could be only a small taste of whats to come if the government loses control of its experimental recovery plan. China has to prove its capable of hitting its economic growth target, even as it carps about losing its edge due to Yuan appreciation. While in the US, the next test for markets will be how treasury rates react to the impending curtailment of QE3, and how much of that is already factored in. Historically August and September have been two of the worst months for stocks over the last thirty years, but money keeps flowing into equities, and analysts keep ratcheting up their targets (Piper just raised forecasts for the S&P500 to reach 1,850 by year end and 2,000 next year).
Central banks have created a period of stability with a vast cushion of monetary largesse to support the global economy. But four years into the recovery process, if the data dont start showing a more summery aspect, markets could lose some confidence, and fall into the fall.
5: US ISM Non-Manufacturing PMI
6: US Trade Balance; Japan Prelim GDP
7: BOE Inflation Report; German Trade Balance and Industrial Production; China CPI/PPI
8: China Industrial Production; China New Loans; Japan Current Account; BOJ policy statement
9: China Trade Balance
13: US Retail Sales; UK CPI
14: German, French, Italian prelim GDP; German ZEW; US PPI
15: UK Retail Sales; US CPI; Philly Fed Index
16: US Housing Starts and Building Permits; Prelim University of Michigan Sentiment
19: Japan Trade Balance
21: US Existing Home Sales; FOMC Minutes
22: German Ifo Business Sentiment; China HSBC Flash Manufacturing PMI
23: German and French PMI readings; UK GDP 2nd reading; US New Home Sales
24: G20 ministerial meetings
26: US Durable Goods Orders
27: US Consumer Confidence
28: US Pending Home Sales; Fed Jackson Hole Symposium begins
29: US Prelim GDP
30: Euro Zone Unemployment; US Chicago PMI
31: China Manufacturing PMI
1: China final HSBC Manufacturing PMI
2: US ISM Manufacturing PMI; China Non-Manufacturing PMI
4: US Trade Balance; US ISM Non-Manufacturing PMI
5: ECB and BOE policy statements; Japan final GDP; G20 Leaders in St. Petersburg (Sept 5-6)
6: US Unemployment and Payrolls; tentative release date for US Treasury currency report
7: China CPI/PPI; Australia Parliamentary election
8: China Industrial Production; China New Loans
9: German Industrial Production; BOJ policy statement; Japan Current Account
10: China Trade Balance
13: US Retail Sales; US PPI; Prelim U of M Consumer Confidence
16: US Industrial Production
17: US CPI
18: German ZEW; BOE Inflation Letter; US Housing Starts and Building Permits; FOMC policy statement and Press Conference
19: US Existing Home Sales; Philly Fed Index; Japan Trade Balance
22: German federal election
23: German Ifo Business Sentiment; China HSBC Flash Manufacturing PMI
24: European Flash Manufacturing PMI readings; US Consumer Confidence
25: US Durable Goods Orders; US New Home Sales
26: UK final GDP; US final GDP; US Pending Home Sales; Japan Industrial Production
27: U of M final Consumer Sentiment
30: US Chicago PMI; China Manufacturing PMI; China HSBC final Manufacturing PMI; End of US Government FY13