Wednesday, December 18, 2013

Market Outlook for Dec 2013-Feb 2014: Holiday Cheer  Market Outlook for Dec 2013-Feb 2014: Holiday Cheer

A sense of peace has overtaken the markets in recent months. After five years, the global financial crisis seems to have been tamed and there is a genuine feeling that the economy is on the mend. Political flashpoints have cooled, economic indicators have improved, and financial markets have calmed if not normalized.

Each global region still has its problems to contend with, but they don't seem as daunting as they did a few years ago. The proverbial light at the end of the tunnel is visible and forward looking markets have been galloping toward it. This winter season is expected to bring more good tidings of economic recovery which could presage a move away from the new normal of anemic growth back to the old normal.

We may finally turn a new page in 2014 and it seems there are fewer and fewer obstacles toward that goal. This seems to be one of the rare moments in recent history when there is no looming crisis that could topple the modest economic progress that has been made over the past few years. Barring the unlikely flare up of a Great Recession era problem, it seems only an unexpected shock can derail the New Year from showing the promise that markets have predicted for it with their movements this year.

Tis the be Tapering

The tense political situation in Washington that has been a fiscal drag on the economy in the last year seems to finally be easing. The mini budget deal reached in recent days will provide some relief from the Sequesters automatic cuts but it didn't touch on more the difficult issues of entitlements or tax reform. Still if it gets through both houses of Congress with bipartisan support from the centrists it will serve as a hopeful sign that Washington can get back to governing after five years of political cock-fighting. That should help assuage the ratings agency Fitch, which is expected to resolve its ratings watch on the US AAA sovereign rating by the end of March, having threatened to cut the rating if the brinkmanship in Washington continued unabated. By the time President Obama delivers The State of the Union Address on January 28th, he may be able to claim Washington is working again, though still under the threat of another debt ceiling battle.

The budget deal under consideration will keep the government funded for two years, averting another shutdown in January, but it does not include provisions for raising the debt ceiling, which the Treasury has forecast will be hit sometime between March and June. Thus the door is still open for another dust up in Washington over the debt limit in the spring. Despite the dtente brought by the budget compromise, partisanship still simmers in the wake of Senate Democrats stripping the minority party of some filibuster powers and as the GOP continues to hammer the bungled Obamacare roll out.

This potential turbulence in Washington could be problematic for Janet Yellen's Fed. Yellen is expected to be confirmed as the next Chairman of the Fed in the week before Christmas the same week the FOMC is set to hold its next two-day policy meeting (Dec 17-18). There has been some speculation that once she is confirmed by the full Senate, Bernanke could immediately step aside and allow Yellen to chair the January meeting, leaving the next policy steps in her hands. Though the leadership under Yellen may be slightly more dovish than under Bernanke, the rotating FOMC voting membership will become decidedly more hawkish in 2014. Dallas Fed President Fisher and Philadelphia Fed President Plosser will both rotate into the voting membership at the FOMC and carry more weight for the hawkish camp, pushing Yellens toward the rhetorical center as she represents the full views of the collegial committee.

Foremost on everyone's mind these days is when the Fed will finally begin tapering its quantitative easing program (QE3). The central bank appeared to abort the tapering mission in September because of storm clouds in Washington, and looked pretty shrewd when Congress justified the Feds fears with a two week government shutdown.

After that, expectations for tapering were pushed back to the spring, but recent US economic data has emerged unscathed by the shutdown, leading many market participants to start hedging their bets that the taper could actually start this year after all, sending treasury yields a bit higher and taking some steam out of equities. It could be a close call as indicated by Fed moderates chiming in that the start of tapering is indeed on the table for the upcoming FOMC meeting.

Still the central bank is a cautious institution and more often than not it takes a wait and see stance in the absence of certainty. Many experts are still forecasting the Fed will take its time reacting to improving data, predicting the central bank will hold off on tapering until after Bernanke's "lame duck" period through January, when the Fed will be definitively under the direction of Janet Yellen. Having waited years to declare the economy is moving toward self-sustaining status, the Fed can stand wait a few more months.

Yellen is expected to put even greater emphasis on clear and transparent communications. To that end, an alternative for the December meeting would be adding some policy language that sets the table for tapering by indicating how rapidly it might take place and in what increments before actually pulling the trigger in 2014. This would give the markets another six weeks to digest the mechanics of the process before it started in the New Year.

The other communication issue that has been debated lately at the Fed is whether it might be proper to move the unemployment threshold for rate tightening action from 6.5% given that unemployment is falling faster than Fed forecasts, having reached 7.0% in the last month. An argument has been made for lowering the threshold to as low as 5.5%, but to-date the consensus at the Fed seems to be it would come off looking wishy-washy, doing more harm than good. After all, the Fed has just spent the better part of a year trying convincing markets that tapering is not a prelude to tightening and that the unemployment threshold is not a trigger, and the markets seem to be finally accepting that.

A Winter Wondering-Land

Even Europe, which has been the epicenter of the economic crisis for the last couple of years, has achieved a basic level of stability both politically and economically. The Euro Zone should emerge from recession in 2014, reducing its dampening effect on global economic growth, and Ireland has just become the first bailout program country to successfully exit its support program.

Alas, there are still some questions about Europes health. The ECB surprised markets in early November by cutting its main refi rate in half to 0.25%, characterizing it as a preemptive action against low inflation that should allow the bank to avoid more rate cuts in the future. Euro Zone CPI has slipped below 1.0%, and German month-over-month PPI data has been negative eight out of the last nine months, giving the central bank good reason to act. The stated reason for the rate cut, heading off any potential for deflation, means the monthly inflation data in Europe will be watched closely to confirm that this preemptive move by the ECB successfully staved off uncomfortably low inflation.

Another, unstated, reason for the rate cut may be that the ECB has some concerns about lingering infirmities at European banks as they prepare to undergo a major new Asset Quality Review (AQR) that is a prerequisite for the ECB taking over bank supervision and for providing those banks with direct aid from the European Stability Mechanism, the euro areas bailout fund. The AQR to be conducted in the next few months is meant to affirm the stability of European banks before they are swept under the aegis of the Single Supervisory Mechanism (SSM), one of the two pillars of the banking union intended to create more Europe. The second pillar, the Single Resolution Mechanism (SRM) is now in the final stages of negotiation and a tentative structure is expected to be announced by year end.

Despite this progress on strengthening the unity of European institutions, the continent is still struggling with the unevenness of its recovery, and is leaning more heavily on the central bank than ever. For its part, the ECB is promising that it can take more action if necessary. For months central bank officials have stated that they are technically prepared for taking deposit rates negative. They have also said they could launch another LTRO, this time revamped to encourage banks to push more of the funds into the real economy than they have from prior long term refi operations. Neither option is particularly attractive as the ECB looks on at other central banks starting to discuss the process of weaning their economies off of central bank assistance.

Meanwhile, the Bank of England, similar to the Fed, is starting to look ahead to a time in the next few years when it can unwind accommodative policy. In its forward guidance on conditions for tightening rate policy, the BOE recently took the dramatic step of moving up its expectation for reaching its 7% unemployment threshold by a full year to Q3 of 2015, and said it might even be reached by the end of 2014. The BOE also bumped up its growth forecast for next year. Further revisions to the BOEs forward guidance are unlikely in the next few months but it certainly serves as a bright spot for Europe.

Happy (Lunar) New Year!

Like other regions Asia seems to have settled in for a quiet winter. China has had an uneventful transition of power to its next generation leader, and Japans maverick PM has produced concrete results with his economic plan, though there are signs his honeymoon period could soon end.

In China, this summers concerns about the nation missing its annual growth target have melted away. After some slippage in PMI readings and other economic indicators mid-year, there were some questions about whether China might miss its official GDP growth target, despite having been eased already from the near double digits expectations of the last decade. In recent months, however, PMI numbers have returned to steady growth and China has chalked up strong trade data, alleviating concerns.

Over the last few weeks, China has held a series of high-level conclaves to set the economic policy tone of Mr. Xis government. The state controlled media declared the Communist Party plenum in November as the most important party event since the 1978 plenum that began the post-Mao era of reforms, which started the countrys economic ascendancy. The final communiquof last months plenum set out more ambitious economic reforms, for the first time calling for markets to play a decisive role in the allocation of resources. The annual Central Economic Work Conference this month maintained Chinas proactive fiscal policy and prudent monetary policy, but also promised to deepen reforms on all fronts. These efforts will include continuing Yuan exchange rate reform, addressing local government debt problems, and reducing industrial overcapacity in sectors like the steel industry. This will be a multi-year process, but the proof will be in how the government addresses rising social concerns (like pollution and working conditions) while still posting up growth figures that promise the economic miracle endures. The Q4 GDP data is due on January 8th, and should see a result solidly above the 7.5% official annual target after rebounding to 7.8% growth in Q3. After that, things should be fairly quiet out of China headed into its second New Year, the lunar celebration and Spring Festival week from January 30th through February 5th.

In Japan, PM Abe has avoided the rapid turnover in public sentiment that brought a quick end to the last several governments in Tokyo, though the latest polls show his governments popularity has slipped from over 70% earlier this year to below 50% in December. The bloom may be off the rose as more Abenomics policies come off the drawing board and face real world implementation. For example, there is some unease about tax changes, headlined by a bump in the consumption tax that starts with the new fiscal year in April. The government has sold this as a necessary part of its economic plan, raising funds to chip away at the countrys debt burden, but it may still sour many Japanese consumers if the mix of partially offsetting tax breaks isnt right.

At the same time, Tokyo is loosening some long-standing strictures on the investments made by the government pension fund (GPIF), allowing managers to diversity portfolios into more aggressive investments. There are reports that the GPIF is eyeing investments in overseas infrastructure as one new area of focus. The laxer rules for the GPIF are expected to be mirrored by other Japanese pension funds which could lead to some large fund flows in the months ahead.

With so many moving parts in Japan, its no wonder that analysts are expecting some more stimulus from the BOJ to help keep things settled. Surveys show a majority of experts now see the BOJ stepping in with additional easing in the first half of 2014 and many expect it as soon as Q1.

A few geo-political questions are wildcard risks for the Asian theater. Tensions have been ratcheted up in the regions hottest territorial dispute after China unilaterally extended its air defense zone over the East China Sea. The struggle for jurisdiction over the resource rich Senakaku Island region reached a new level as Japan and its US ally deliberately sent military aircraft through the zone in defiance of China. A military confrontation is still remote, but the more aggressive posture that China has taken has increased the chances of an accidental incident escalating into a crisis. Elsewhere in the region, North Koreas neophyte leader Kim Jong-Un reportedly arrested and summarily executed Jang Song Thaek, his uncle, mentor, and number two man for committing criminal acts of corruption. This surprise purge is said to have unsettled even North Koreas patrons in China and may be a prelude to more rash actions if the young dictator has decided to disregard (and do away with) his most senior advisors.

Holiday Surprises

The big overhangs of the last year seem to be gone: Greece is holding together and other program countries are emerging from their bailouts, Italys government has stabilized, deflation risk is being headed off by the ECB, Washington found a compromise to reduce fiscal drag, the Fed has mostly ameliorated taper fears, China has proved its resilience again, and Abenomics has jolted Japans economy back to life.

The unbalanced contour of the global recovery is still a concern. Indeed, we are at a point where some central banks are ready to cautiously declare victory and start mapping out a deliberate process for unwinding extraordinary policy accommodation, while other contemplate more stimulus. The Fed is preparing to stop growing its nearly $4 trillion balance sheet, and the BOE has accelerated its forward guidance for rate action by a full year. In contrast, the BOJ and ECB may be forced to dig even deeper into their bag of tricks early next year.

In recent weeks some traders appear to be setting up for another possible taper tantrum, taking some profits into the end of the year, but US and European stock indices are still up double digits for the year, and Japans Nikkei Index has tacked on more than 50%. The S&P500 hasnt suffered a 10% correction since August 2011 (28 months ago) as the Feds easy money policy is keeping retrenchments at bay. Corrections occur every 30 months, on average, but there have been multiyear stretches without a correction in each of the last two decades (March 2003 to October 2007, and October 1990 to October 1997, the longest ever correction-free run stretching 1,767 trading days). January will usher in a new earnings season, and even though the consensus is that stocks are fairly valued, they may have some difficultly advancing after a 25% run in 2013 with earnings up only 5%. A lot may depend on holiday shopping results, and early tallies from November same store sales were mixed at best, with this years post Thanksgiving shopping season having six fewer days than last year.

The improving data that is steering the Fed toward tapering has led to higher treasury yields in recent months as the bond market contemplates normalization. If rates continue to inch higher, markets should be able to absorb it, but a sudden jump could spook some investors, particularly when the benchmark 10-year treasury moves across the psychological barrier of 3.00%. The notion of higher rates could dampen the housing market recovery and hurt banks as homebuyers pause to recalculate the cost of a mortgage.

In energy markets the risk is to the downside. Its not Peace on Earth but the intractable issues of the Middle East have made some small headway lately. The US dodged getting drawn into a military conflict in Syria and the chemical weapons in that country are being secured. Meanwhile, Iran has come to the bargaining table looking for relief from the economic pressure of massive sanctions. With these developments oil prices have eased lower, and WTI crude is solidly below $100. Libya may help further reduce oil prices in coming months if the countrys various factions can agree on fairly sharing the oil wealth and resume full scale production and shipping of its prized sweet crude.

Forex may be the biggest market lever in the New Year. With the euro looking to end the year at its highs against the dollar near 1.38, euro strength may force the ECB to go beyond more lip service and take significant new policy action in 2014. The first six weeks of the New Year generally set either the upper or lower bound for the year in the EUR/USD, so the early 2014 range bears watching. Meanwhile, the strengthening trend in the US economy, in conjunction with the prospect of the BOJ laying on more stimulus, could revive interest in the yen carry trade. In recent surveys, analysts have predicted that the Japanese Yen could depreciate to as high as 115 against the dollar in 2014 (Deutsche Bank specifically) which may be taken as a disorderly move, and could draw a scolding from Japans G20 partners, and perhaps even reignite currency war talk.

Thus, the calm washing over the markets, bordering on complacency, may last for some months to come, but room always has to be made for surprises. The peace will eventually be broken by an unexpected event (remember Fukushima?), but until then cautious optimism will prevail.



16: Euro Zone CPI
17: UK CPI and PPI; US CPI
18: UK Unemployment; German Zew Sentiment Index; US Housing Starts and Building Permits; FOMC Policy Statement and press conference
19: UK Retail Sales; UK Q3 Final GDP; US Existing Home Sales; Philadelphia Fed Manufacturing; Japan Trade Balance; BOJ Policy Statement(tentative); China HSBC Flash Manufacturing PMI
20: Various Euro Zone flash Manufacturing and Services PMIs; German Ifo Business Climate; US Final Q3 GDP
23: US Personal Spending
24: US Durable Goods Orders; US Consumer Confidence; US New Home Sales
25: BOJ policy minutes; Christmas Day
26: Japan Retail Sales
27: German Retail Sales; German Unemployment; UofM Final Consumer Confidence
30: US Pending Home Sales; Japan Household Spending
31: Chicago PMI; China Manufacturing PMI

1: New Years Day
2: Various EU and Euro Zone PMI manufacturing readings
3: China non-manufacturing PMI

6: China HSBC manufacturing PMI; Euro Zone services PMI; US Factory Orders; US ISM non-manufacturing PMI
7: Euro Zone CPI and PPI; US Trade Balance
8: China CPI and PPI; China Q4 GDP; China Trade Balance; China Industrial Production; Japan Consumer Confidence; German Trade Balance and Factory Orders; FOMC Minutes
9: German Industrial Production; BOE policy decision; ECB policy decision
10: Euro Zone Q4 prelim GDP; US Payrolls and Unemployment

15: October 2013 US government funding deal expires (unless new budget deal passes Dec 17th)
17: UofM Prelim Consumer Confidence
20: MLK Birthday Holiday (US)
22: BOJ policy decision; BOE minutes

26: BOJ minutes
28: UK Q4 prelim GDP; US State of the Union Address
29: FOMC policy decision
30: US Q3 GDP (final); China Spring Festival/Lunar New Year through Feb 5

6: BOE policy decision; ECB policy decision
7: US Payrolls and Unemployment

11: Japan Q4 GDP
12: BOE quarterly inflation report
14: Euro Zone Q4 GDP

17: Presidents Day (US)
18: BOJ policy decision
19: BOE minutes
20: US CPI; BOJ minutes
21: European Commission economic growth forecasts

26: UK Q4 GDP
28: US Advance Q4 GDP (1st reading)