Monday, May 5, 2014

May-June 2014 Outlook: From Russia with Love  May-June 2014 Outlook: From Russia with Love

The early part of the year has been spent digesting the outsized market moves of 2013. Equity , currency and commodity markets have mostly moved sideways, held up by slowly improving global economic data, but capped by seasonal weakness and harsh winter weather in the US, as well as headline risk from the Ukraine crisis.

Russia's annexation of the Crimea was this year's first big surprise event, and markets are still considering how to treat the situation. As Russian President Putin decides whether to further exert his influence on his neighbors, pundits are guessing at how far he will go and how much economic damage resulting sanctions will cause. So far markets have been quite stable other than the periodic knee-jerk reaction to Ukraine headlines, but if the situation escalates, it could distract from the efforts to stoke the fledgling economic recovery and to stave off deflation in developed economies.

Russian Winter or Spring Offensive?

More sanctions on Russia, not to mention the reenactment of Soviet-era imperialism, would be damaging to Europe. The continent's economic recovery is as fragile as a Faberge egg, and low single digit growth expectations could be tipped back toward contraction if Russia brushes aside western objections to territorial expansion. Even the German economic engine, which has led Europe toward recovery, could be damaged by a trade spat with Russia.

In the US, for the entire first quarter economists and companies have been blaming poor growth on the unusually harsh winter weather. Relentless snow storms across the country kept shoppers out of stores, hampered outdoor businesses like homebuilding, and delayed deliveries heavy industrial equipment by truck and by rail. Economic data got a pass for the entire season, culminating in the advance Q1 GDP coming in at a piddling 0.1% growth rate, missing expectations by more than a percentage point. That big miss has been brushed aside based on optimism for the rest of the year, and it is true that the Q1 GDP figure may be bolstered when the second and third revisions, using more complete data, come out in late May and late June.

So far the April economic data has been good enough to keep alive the narrative that the winter paralysis has ended and better times are around the corner. The headline numbers from the April employment report were stellar, showing the best nonfarm payrolls gain in over two years (+288K), and unemployment dropping an astounding four-tenths of a percent to 6.3%, its lowest level since before the financial crisis. Those data justify the Fed maintaining course on its tapering plan, and shifting its policy back toward the more standard qualitative guidance, having withdrawn its 6.5% unemployment threshold just in time to avoid difficult questions about what jobless level would trigger a rate hike.

Hidden inside the headline unemployment data, like a Russian nesting doll, were some unsettling undercurrents. A closer look revealed much of the drop was caused by another decline in the labor force participation rate, slipping to its lowest level since 1978, when women were less likely to be part of the formal workforce (the male participation rate is at a record low for the modern era). The White House Council of Economic Advisors suggest the participation rate is subject to volatility and is also naturally weighed on by demographic trends, but some economist note that the unemployment rate would still be closer to 10% if the participation rate were more stable. Should the unemployment rate drop continue to be fueled by people leaving the workforce, it is sure to raise doubts about the quality of the US economic recovery.

China's slowing growth trajectory has been a fact of life for several years, but it could start grabbing headlines again if certain trends continue. The nation chalked up a 7.4% GDP growth rate in Q1 as employment and income growth held up well, but it was still a notable drop from the 7.7% rate achieved in the prior quarter and the slowest pace in year and a half. The cooling of the Chinese property market is contributing to this slower growth. New property construction had its worst Q1 since 2009, and the total value of properties sold slid year over year, confirming anecdotal reports of a real estate correction in some smaller cities.

China's atrocious March trade data is another worrisome sign. After blaming an unusual February trade deficit on the Lunar New Year holiday, Chinese officials had a harder time explaining away March exports down 6.6% and imports down 11.3% when a mid-single digit increase was expected for both. Some analyst believe the discrepancy is related to Chinese firms fudging invoices to exaggerate exports and bring capital into China to take advantage of the rising yuan early last year. The customs administration has since cracked down on fraudulent invoicing, creating a difficult comparison for Q1 trade data. However, a third straight month of poor trade readings on May 8th could set off alarm bells.

Chinese officials insist these transitory data do not merit a major policy response. Summarizing the official view, Premier Li Keqiang recently stated that China "will not adopt short-term and strong stimulus policies in response to temporary fluctuations in the economy," but instead "will focus more on healthy growth in the medium to long term and will make efforts to achieve sustainable and healthy development." More negative data could change the minds of economic planners in Beijing, however, and raise hopes for a 'mini-stimulus' package.

Central Planning

Better global growth may lead to a pick-up inflation, which is the desperate desire of central bankers in developed economies. With economies in recovery mode, the issue of low inflation has come to the forefront as a driver of central bank policy. Inflation is uncomfortably low for central bankers in Europe and the US, while Japan's entire economic reform program seeks to sling-shot the country out of a deflationary rut. So far stimulus policy has had limited success in getting inflation back toward target levels in these nations.

The ECB council continues to stick with its aggressive verbal intervention, pronouncing that it is unanimously committed to using its arsenal of unconventional and conventional policy instruments if needed to stave off the emergence of deflation, but it has yet to act. ECB President Draghi has stated that a worsening of medium-term inflation would be context for QE and lower long term rates could boost inflation, but in recent weeks improving European data has given the ECB reason to pause before plunging ahead with a QE program or negative rates. Euro Zone unemployment has finally started to edge lower, dipping to 11.8% in March, its lowest level in over a year, as even peripheral nations like Italy and Spain are seeing chronic high unemployment start to ease. European manufacturing readings have seen a better trend in recent months as well. Most importantly, ECB rhetoric that inflation expectations are stable and that deflation is not an imminent threat appears to be true. The highly anticipated April Euro Zone CPI estimate came in at 0.7% (with the core reading at 1.0%), arresting a downward trend that took the inflation reading to a four year low of 0.5% in the prior month.

In the US, the utility of QE has already come to an end and tapering is the order of the day. The FOMC's mid-June meeting is the next one that features a press conference, and by that time the tapering process will be more than half over, so it stands to reason that the Fed could use the meeting to assess the status of the QE wind down. After questionable communication caused the "taper tantrum" last June, Janet Yellen had her own bobble during her first press conference as Fed Chair when she ad-libbed that the "considerable period" between the end of QE and first rate hike is approximately six months. At the June meeting Yellen will likely refrain from repeating her six month remark and give some more attention to low inflation concerns to fend off any new policy dissents (note that the last dissent against the FOMC majority, from Kocherlakota in January, was on the grounds that the committee was not doing enough to push inflation expectations back toward the 2% target).

The issue of deflation is still most acute in Japan, which has been battling the problem for over a decade. Since the launch of Prime Minister Abe's eponymous economic plan a year ago, inflation has been trending higher as measured by the key Tokyo core CPI reading. Keeping that trend going is vital to the ongoing success of Abe's experiment.

Dollars and Kopecks

Volatility has dried up in foreign exchange as many of the reserve currency nations face similar problems of slow growth and uncomfortably low inflation. Something may get shaken loose in the currency markets as Japan maneuvers itself into phase two of the government's growth strategy in the months ahead.

After a slow start to 2014, Japan is trying to recapture some of the early momentum of Abenomics. Household spending surged in March ahead the April 1st consumption tax increase, but it is still too early to gauge the long term impact of the tax hike on Japanese consumers. Some major firms have responded to the government push for wage increases to help offset the tax increase, but the application has been inconsistent.

For its part, the government plans to forge ahead with the next step of its growth plan. Press reports indicate that Mr. Abe will announce new growth strategies in June. The centerpiece of the latest measures to help companies is said to be a cut in the corporate tax rate to 20% from the current 35% in FY 2015, supplemented by business tax breaks to promote things like angel investments in start-up companies. By some accounts the tax cut will be implemented gradually, similar to the two-stage consumption tax increase. An early indicator of the effects of all of these changes may be domestic auto sales: The last time Japan increased its consumption tax (from 3% up to 5% in April 1997) car sales in Japan dropped 15% and kept declining for 21 months in a row, but more favorable taxes and a weaker currency should help bolster results at Toyota, Honda, and Nissan.

The persistent strength of the euro has been troubling European officials for quite some time, hindering an already tepid economic recovery, and ECB chief Draghi has acknowledged that forex has become increasingly important for policy, though central bank refrains from setting a target rate. Now French President Hollande and his team have declared they will raise the issue of the strength in the euro after the new European Parliament is seated at the end of May. Mr. Hollande wants to put pressure on the ECB to shift its monetary policy toward weakening the currency, which may be the most politically expedient way to aid the French economy.

China has sent ripples through the FX market with the sudden reversal in its currency this year. After three and a half years of steady appreciation, the yuan has weakened over 3% against the greenback in the last three months. The move has been seen as an effort to flush out currency speculators that sought to take advantage of what had been a predictable and gradual appreciation of the currency, and perhaps a demonstration that the yuan can trade in two directions, a prerequisite for eventually attaining reserve currency status. The move has not gone unnoticed by global economic officials, and drew another rebuke from the US Treasury in its latest semi-annual currency report, which said that the yuan did not appreciate as much as it should have in 2013, that it remains significantly undervalued, and that China needs to be more transparent about its FX market interventions to increase credibility. If the Chinese currency does not level off and resume appreciating again soon, it may reanimate talk of a "currency war" as well as feed fears that Beijing is intervening to mask some deeper economic issues.

Back in the USSR

Russian President Putin's apparent desire to relive the glory days of the Soviet era has led to 2014's first new crisis. The potential for a real shooting war in Ukraine is dominating the geopolitical landscape, particularly since national politics have calmed in Europe and the US.

The biggest political flashpoint in Western Europe, namely Italy, appears to have steadied under the ambitious new Prime Minister Renzi. On the broader European canvas, elections to the European Parliament will be held in all member states of the European Union in late May. The political implications are limited, though some polling has indicated that anti-EU populists and nationalist from the left and right could potentially double the number of seats they hold in the body to over 20%, which could put a drag on the dream of "more Europe." Meanwhile, US partisans will not resume throwing Molotov cocktails at each other until this summer when the November mid-term elections are coming into view and Republicans eye retaking control of the Senate. At least until then, there are no political bombshells expected in the West.

A five week long general election is being held in India through May 12 and could draw some interest from market participants, particularly if the National Democratic Alliance (NDA) pulls out a victory. The NDA's candidate for Prime Minister is Narendra Modi, who has branded himself as a pro-growth economic reformer, could excite some renewed interest in India as an investment opportunity on speculation that he can unlock more of the great potential of country's workforce. The Indian vote may also be a harbinger for October elections in another BRIC country, Brazil, where a centrist reformer has the opportunity to unseat the left-leaning President, Dilma Rousseff.

Of course, the biggest political event of the weeks ahead is the scheduled election in Ukraine. The May 25th vote will be a watershed moment for the country, giving political legitimacy to a new leader after the ouster of Putin crony Viktor Yanukovych. The apparent frontrunner is billionaire Pyotr Poroshenko, who made his fortune in the confectionary business. It is unclear yet if the moderate candy oligarch will be palatable to Mr. Putin who, since annexing Crimea, has been leaning hard on Kiev, branding the unelected interim leadership as a rogue regime. If not, Putin may see the rapidly approaching election as a deadline for a decision to invade eastern Ukraine. Once the vote has been held, Russia's protests against an illegitimate government in Kiev will hold even less water. The substantial Russian military presence on the border is already influencing the election: candidates are barely campaigning, Poroshenko's main challenger Yulia Tymoshenko declared her Fatherland party would become a national "resistance force" to battle Russian aggression, and the interim government has announced it will reinstitute military conscription (which was suspended just last year in favor of an all-volunteer force).

Russian Roulette

It's hard not to see the next few months through the prism of the Ukraine conflict; the country's own national anthem, which loosely translates to "Ukraine is Not Dead Yet", certainly applies to the current crisis. If Mr. Putin chooses to escalate the situation by launching a full scale military incursion it will roil markets in the short term until a new equilibrium is reached in the geopolitical situation, as we saw after Crimea was reabsorbed by Russia. It will also trigger harsh new sanctions that will take a hammer and a sickle to the Russia economy, but will also have negative implications for Russia's big trading partners like Germany and could crimp the nascent global recovery. As the world await s Putin's next move, headline risk could lead the stock market heed the old adage "sell in May and go away", or things could remain range-bound, stuck between optimism for the future and short term uncertainties.

A Russian offensive could also send commodities soaring in the near term - gold would surge on concerns a confrontation with NATO may be next, and energy futures would rise on speculation that Russia could hold Europe hostage by cutting off pipeline flows (though remember that those pipelines remained open throughout the Cold War era). Safe haven flows would also further compress treasury yields.

If Putin backs off, markets could return to more risk-on behavior, faced with more mundane concerns. These include looking for confirmation that a weak Q1 was truly due to seasonal factors, and whether the monetary oligarchs at central banks can get the right mix of policy to promote steady growth and healthy inflation without generating undue market distortions. Anyone in their right mind would certainly rather grapple with the CPI than the CCCP.

CALENDAR (based on Eastern Time Zone)

1 (Thrs): UK Manufacturing PMI; US ISM Manufacturing PMI; Japan Household Spending
2: US Payrolls and Unemployment Rate

4 (Sun): China HSBC Manufacturing PMI
5: US ISM Non-manufacturing PMI
6: US Trade Balance
7: German Factory Orders
8: BOE policy decision; ECB policy decision; China CPI; China Trade Balance
9: German Trade Balance; China New Loans

13: China Industrial Production; German ZEW Economic Sentiment; US Retail Sales
14: UK Unemployment Rate; BOE Inflation Report; US PPI; Japan Prelim Q1 GDP
15: Euro Zone Prelim Q1 GDP; Euro Zone CPI; US CPI; Philly Fed Manufacturing; NAHB Housing Market Index
16: US Housing Starts and Building Permits; Prelim University of Michigan Confidence

19: Japan Trade Balance
20: UK CPI; BOJ Policy Statement
21: BOE Minutes; UK Retail Sales; FOMC Minutes; China HSBC Flash Manufacturing PMI
22: Euro Zone Prelim Manufacturing PMI; UK Q1 GDP (second reading); US Existing Home Sales; US Prelim Manufacturing PMI
23: German Ifo Business Climate; US New Home Sales
22-25: European Parliamentary Elections

25 (Sun): Ukraine extraordinary elections; BOJ Minutes
27: US Durable Goods Orders; US Consumer Confidence; Japan Retail Sales; Tokyo CPI
28: German Unemployment
29: US Prelim Q1 GDP (second reading); US Pending Home Sales
30: German Retail Sales; Chicago PMI
31 (Sat): China Manufacturing PMI

TBA: June G7 leaders meeting in Brussels (replaced the G8 that had been set for Sochi, Russia)
1 (Sun): China HSBC Final Manufacturing PMI
2: UK Manufacturing PMI; US ISM Manufacturing PMI
3: Euro Zone Flash CPI Estimate; Euro Zone Unemployment rate; US Factory Orders
4: US ISM Non-manufacturing PMI
5: Euro Zone Retail Sales; BOE Policy Decision; ECB Policy Decision
6: German Trade Balance; German Industrial Production; US Payrolls and Unemployment Rate;
7 (Sat): China CPI and PPI

8 (Sun): China Trade Balance; China Industrial Production
9: Japan Final Q1 GDP
10: China New Loans
11: UK Unemployment Rate
12: Euro Zone Industrial Production; US Retail Sales; BOJ Policy Statement; World Cup play begins
13: US PPI; Prelim University of Michigan Consumer Sentiment

16: Euro Zone CPI; US Industrial Production; US NAHB Housing Market Index
17: German Zew Economic Sentiment; US CPI; US Housing Starts and Building Permits; G7 Meetings (17-18th); BOJ Minutes
18: FOMC Policy Statement and Press Conference; Japan Trade Balance
19: Philly Fed Manufacturing Index

23: US Existing Home Sales; China HSBC Flash Manufacturing PMI
24: German Ifo Business Climate; Euro Zone Flash Manufacturing PMI; US Consumer Confidence; US New Home Sales; US Flash Manufacturing PMI
25: US Durable Goods Orders; US Final Q1 GDP (third reading)
26: UK Final Q1 GDP; Japan Retail Sales; Tokyo CPI

30: Euro Zone CPI Flash Estimate; Chicago PMI; US Pending Home Sales; China Manufacturing PMI; China HSBC Manufacturing PMI
1: Euro Zone Unemployment; US ISM Manufacturing PMI
2: US Factory Orders
3: ECB Policy Decision; US Payrolls and Unemployment Rate; US Trade Balance
4: German Factory Orders