Wednesday, July 2, 2014

July-August 2014 Outlook: All in One Rhythm  July-August 2014 Outlook: All in One Rhythm

With headline fatigue setting in over the Ukraine crisis, and the mounting Iraqi upheaval stirring concerns about an all-out sectarian war in the Middle East, the world is seeking a temporary diversion from the World Cup. The quadrennial event provides an apt metaphor for the next few months in the markets - many countries have high hopes for a strong showing, things may get a bit contentious as national interests collide, and there will be a few upsets, but in the end we can only watch and wait for the scores to come in. To coopt the 2014 World Cup slogan, economic leaders seem to be "all in one rhythm", pausing for more data before making their next moves. Let's get to the matchups.

US vs Expectations

The initial three months of 2014 were decidedly disappointing for the US economy, as the final tally on Q1 GDP came in at -2.9%, even worse than expected, due to horrendous winter weather. Markets largely ignored those temporary factors as did the Fed, which has continued to steadily taper its QE program on the expectation and recent materialization of better jobs and growth data.

After the decidedly slow start to the year, monthly non-farm payrolls in the first five months are now averaging over 200 thousand new jobs, enough to keep unemployment on a downward trajectory. The next reading comes on July 3, an unusual Thursday release of the jobs data because of the Independence Day holiday. Forecasts are for another payroll report in line with the average, though more breakout numbers like the nearly 300 thousand jobs gained in April are not out of the question and could help ease the Fed transition into its next policy phase.

Chair Yellen and other senior Fed officials have already begun to lay the groundwork for next year when they are likely to move rates away from near-zero. To get people accustomed to the idea, Yellen has started the discussion of future rate hikes, though stressing that rate policy will be entirely data dependent. At her last press conference she also brushed off some recent higher CPI data as "noise", insisting that inflation is developing within Fed expectations. This seems to indicate the Chair is pleased with market reckoning of the first rate hike coming around mid-2015, but this outlook could be toppled by more hot inflation data (due out toward the middle of each month).

With stronger inflation in view, Fed hawks are positing the scenario that the recovery will kick into high gear and unemployment will fall to normal levels sooner rather than later. Philadelphia Fed chief Plosser recently expressed discomfort with rates still near zero while inflation is rebounding toward the 2% target. The more moderate St. Louis Fed President Bullard has worried out loud that the Fed may get behind the curve if joblessness falls faster than expected, and set his personal forecast for the first rate hike in early 2015 (though still data dependent). Meanwhile the Richmond Fed's Lacker has proposed the Fed should starting trimming back reinvestment of balance sheet holdings before looking at raising rates, so discussion of that may come into vogue as the policy agenda for normalization gels. Representing the dovish team, San Francisco Fed President Williams has suggested that the most recent data is consistent with the first rate hike coming in the latter half of next year.

On the US policy scoreboard, so far it is QE 3, and fiscal policy nil. The grand fiscal bargain that was often speculated about in the last few years now seems impossible. Congress and the Administration are so at odds that the President has resorted to small scale policy tweaks through executive orders on things like the minimum wage for federal contractors and immigration policy. The unprecedented primary loss of House Republican majority leader Cantor to a poorly funded Tea Party newcomer who ran to Cantor's right portends more intense gridlock in Congress. Another two dozen state primaries will be conducted over the next two months, and if the GOP fringe experiences a resurgence headed into the November mid-term elections, Tea Party purists in the next Congress may choose to ignore the political lessons of 2013 government shutdown.

Europe vs Deflation

As in the US, the next two months are expected to be a wait and see period for Europe. The biggest monetary policy move of recent months was the ECB's new package of negative rates and targeted LTROs to spur economic growth and more lending. The IMF and other observers applauded the move but immediately urged the ECB to follow up with a full on quantitative easing scheme. The ECB has acknowledged that is an option in its playbook, but central bank President Draghi has made it clear that he wants to wait some time to gauge the impact of the just launched program before unloading another monetary volley.

There is much to consider. Though central bank officials insist there is almost no chance of deflation taking hold in the euro zone, the latest monthly CPI estimate matched a 4-year low of 0.5%, and in some peripheral countries it's even lower. If the next few inflation readings drift downward from this already very low level, the ECB may be forced into more action, with some reports saying it could start by cutting the key deposit rate another 15 basis points to -0.25% to give banks even more incentive to lend.

Ultimately, if circumstances don't press them into action, reports say ECB officials would prefer to take six to nine months to judge whether the new package is creating the desired behavior. The ECB took its time considering negative rates, given that charging banks to sit on money could have unintended consequences, and now that its committed to the policy, it will need time to see if banks are following the play as it was drawn up. There is some concern that bankers may undermine the new measures because they are reluctant to boost lending in the next few as their balance sheets are under the heavy scrutiny of the asset quality review (AQR).

Central bank watchers have praised Draghi for his proactive style, but only time will tell if this latest in a series of bold policy strikes will win him the central bank equivalent of the Golden Boot or turn out to be an 'own goal' rife with unintended consequences. Draghi's skills as a leader will be put to the test again if conditions warrant a full quantitative easing program, as it will be very challenging to get his whole team to reach agreement on the details of a QE program that would work convincingly across a diverse and still economically fragmented monetary zone.

In the UK, monetary policy also remains data dependent, but the BOE could soon find itself breaking away from its peers to become the first major western central bank to start raising rates. A year long run of strong growth data has brought UK manufacturing readings to 16-month highs and the construction PMI to 14 straight months of expansion. The BOE has thus far ignored calls to use tighter monetary policy to cool of the nation's booming housing market, instead in June opting to use other measures to curb the real estate market.

In an annual economic address in mid-June, BOE Governor Carney warned that UK rates could rise sooner than some investors expect. Current expectations are for the rate to come off the 320-year low of 0.5% during the first quarter of 2015. Other MPC members have also said data could drive an earlier start to the tightening campaign, perhaps before the end of this year.

China vs Corruption

China is also in a relatively quiet period, managing to stick to its growth target without having to resort to any significant new stimulus programs. Targeted mini-stimulus measures orchestrated by policymakers have started to gain some traction, helping restore manufacturing PMI readings to their best level in six months. The central bank remains insistent that this targeted stimulus aimed at reviving credit for smaller enterprises and the rural economy is not a sign of any change in its "prudent" monetary policy stance.

Instead, the biggest policy shift out of Beijing this year may be its unprecedented effort to weed out poor management and corruption, which have become a perverted institution much liking flopping in football. To combat this entrenched bad behavior the government is implementing a number of new policies. This year China has allowed a handful of financial and property development firms to default, a first for the country that historically swept failed firms under the rug with bailouts that made investors whole but also less prudent about finding good investments. In May regulators also asked that commercial banks perform stress tests as part of a larger effort to control worsening bad loan ratios amid a weakening investment environment. Officials have also shown a willingness to make some foreign firms squirm by launching investigations into bribery allegations at their Chinese units.

To show just how serious it is about anti-corruption efforts, the Communist Party is handing out red cards to bad actors within its own ranks. State media has reported that a number of high level officials have been expelled from the party on charges of taking bribes, including Li Dongsheng, former vice minister of public security, Jiang Jiemin, former head of the state asset regulator, and Wang Yongchun, former deputy head of China National Petroleum Company. Also ousted on allegations of graft was General Xu Caihou, the former vice chairman of the Central Military Commission, who now holds the dubious distinction of being the most senior former Politburo member to be formally expelled from the Communist Party.

The crackdown on corruption and faulty business practices is not without costs. For example, the Chinese property sector is showing more signs of slowing in the face of the new policy landscape. Real estate data will be closely watched after May housing numbers showed prices falling in fully half of the survey cities, with the average price down overall for the first time in two years. The cleanup effort has also extended to blowing the whistle on shaky business loans backed by questionable commodity collateral. The unwinding of these financing deals is thought to have contributed to a spike in the gold and silver prices in late June, and more pressure from the Beijing government could subject the metals market to further turmoil. Further exacerbating the situation are the findings of the National Audit Office, which admitted that spot checks at 25 precious metals trading firms in China uncovered $15B in loans backed by falsified gold trades, which may only be the tip of the iceberg. If the anti-corruption campaign continues full tilt it could be a near-term drag on the Chinese economy as participants adjust to the new way of doing business. In the longer run, though real reforms could bolster the economy and attract new waves of foreign investment.

Japan vs Stagnation

In neighboring Japan, Prime Minister Abe is on the offensive, trying to develop an attack that can break away from decades of stagnation and entrenched deflation. So far the Abenomics experiment has shown promise. For the last two months CPI readings show inflation has risen at its fastest annual rate in decades. This buys more time for the government to watch how the economy reacts to the sales tax increase imposed in April (which did contribute to the higher May CPI reading). In late June, Mr. Abe also formally unveiled his "3rd arrow", announcing plans to cut the corporate tax rate from current 35% or more to below 30% over the next few years, enact pension fund management reforms to broaden their investment portfolios, and revise the tax system with the intention of increasing the number of women in a dwindling workforce stricken by an aging population.

Market participants aren't convinced yet. The Nikkei took a rocket ride during the honeymoon phase of Abenomics last year, but the index has been range bound in 2014, and the Yen has leveled off at a little bit above 100 to the dollar. Traders will be watching the CPI and retail sales data for Japan that come out together late each month and rooting for a passable preliminary Q2 GDP number on August 11, after a better than expected growth reading in Q1. For its part, the Bank of Japan has stated that the impact of the sales tax hike has been within expectations and it has maintained its formal economic assessment for eleven straight meetings.

The Middle East vs Itself

The biggest current threat to the status quo of the markets may be the risk of a spike in energy prices, driven by the Middle East's proclivity for implosion. A month ago the concern was that Russia could cut off Europe from its natural gas supply over sanctions imposed after the annexation of Crimea. Now as the Ukraine crisis appears to be steering toward a resolution, Iraq has taken its place as the focal point for geopolitical concern. The fighting in Iraq, the world's second largest oil producer, threatens to play havoc with the energy markets if the ISIS insurgents capture or disrupt key oil production facilities. After declaring a swath of central Iraq a new caliphate, the Sunni militants aim appears to be spreading their sectarian conflict across international borders. A full scale civil war in Iraq like the one that has ravaged Syria could send oil prices up $20/barrel or more, slamming the brakes on the global economic recovery just as it has the makings of becoming self-sustaining. The inept and unpopular President of Iraq, Maliki, has pledged he will strive to create a more inclusive government as the new Parliament starts July 1, but it is still as yet unclear if any government under Mr. Maliki will be effective in restoring order.

Complicating matters, Mr. Maliki has been accepting military assistance from the Shia governments of Iran and Syria in the battle against ISIS. Not only does this make the option of military aid less palatable for the US, it could also throw a monkey wrench in the Iran nuclear talks which are at a delicate stage with just weeks to go before July 20, the agreed upon deadline for a deal. On top of that, new hostilities between Hamas and Israel could further inflame the region.

The Knockout Round

We have now reached halftime for 2014, which may be indicative of a lull in the action. Central bankers are assessing what their game plans have achieved in the first half of the year while politicians are preparing for their extensive summer breaks.

The scorecard at the halfway point of the year shows the broad US stock market dribbling to record highs, having posted its sixth straight quarter of gains, shaking off the chilling effects of a nasty winter and geopolitical risks abroad. Equity markets are entering the July earnings season with relatively low expectations after an anemic Q1, generating chances for some upside surprises if the private sector really has turned the corner. Working against it may be the new issues - the IPO market remains hot and crowded, and will culminate with the initial offering of Chinese e-commerce giant Alibaba, likely to come in August. The biggest IPO of the year on top of dozens of smaller names going public may temporarily flood the market with too much supply and cause another downdraft in momentum stocks like the one seen earlier this year, as traders take profits and try to get fresh legs from the new issues.

The continued compression in the bond market indicates that doubt remain about the quality of a global recovery being fueled by massive central bank stimulus. With the Fed and BOE starting to ponder exit strategies including when to raise rates, we could also see another bout of the "good news is bad news" mentality in markets as they start to rationalize future rate hikes.

Just as in football, a winning strategy in policy-making can take a long time to develop and may only pay off after a lot of near misses. Economic officials across the globe are now tentatively searching for an opening for their next policy strike: The ECB is waiting to see how its latest stimulus plays out, the Fed and BOE are watching data before deciding on rate policy changes next year, Japan is still assessing the impact of its first tax increase, and China is holding off on bigger stimulus plans as it focuses on purging corruption. Though some readings in the months ahead may jostle central bankers, they seem to have the best control of the monetary policy ball since the kickoff of the financial crisis, so if improving data trends continue they may find a path toward normalization, achieving their ultimate GOOOOOOOOAAAL!

CALENDAR (based on Eastern Time Zone)
1 (Tues): Euro Zone Unemployment; US ISM Manufacturing
2: UK Construction PMI; China Non-manufacturing PMI
3: Various European Services PMI readings; ECB policy decision and press conference; US Payrolls and Unemployment; US Trade Balance; US ISM Non-Manufacturing
4: German Factory Orders; 4th of July holiday, US markets closed

7: China CPI and PPI
8: China Trade Balance; China Industrial Production; Various European trade balance data
9: FOMC Minutes; BOJ policy decision
10: BOE policy decision
11: Preliminary U of M Consumer Sentiment

14: Euro Zone Industrial Production
15: UK CPI; German ZEW Sentiment; US Advance Retail Sales
16: UK Unemployment; US PPI; US Industrial Production
17: US Housing Starts and Building Permits; Philly Fed Index

22: US Existing Home Sales; US CPI
23: China HSBC Flash Manufacturing PMI
24: Various European PMI readings; US New Home Sales
25: German Ifo Business Sentiment; UK Q2 GDP; US Durable Goods Orders

28: US Pending Home Sales; Tokyo CPI; Japan Retail Sales; Japan
29: US Consumer Confidence
30: US Q2 Advance GDP; FOMC policy decision
31: Euro Zone Unemployment; Euro Zone Flash CPI; China Manufacturing PMI
1: US Payrolls and Unemployment
4: UK Construction PMI
5: Various European Services PMI readings; US ISM Non-Manufacturing

6: German Factory Orders; US Trade Balance; BOJ policy decision
7: BOE policy decision; ECB policy decision and press conference; China CPI and PPI
8: China Trade Balance; China Industrial Production; Various European trade balance data

11: Japan preliminary Q2 GDP
12: German ZEW Sentiment;
13: UK Unemployment; BOE Inflation Report; US Advance Retail Sales
14: EU preliminary Q2 GDP; EU CPI
15: US PPI; US Industrial Production; Preliminary U of M Consumer Sentiment

19: UK CPI; US Housing Starts and Building Permits; US CPI
20: FOMC minutes
21: US Existing Home Sales; Philly Fed Index

24 (Sun): China HSBC Flash Manufacturing PMI
25: Various European PMI readings; German Ifo Business Sentiment; US New Home Sales; Jackson Hole Symposium starts
26: US Durable Goods Orders; US Consumer Confidence
27: Tokyo CPI; Japan Retail Sales
28: US Q2 Prelim GDP (2nd reading); US Pending Home Sales
29: UK Q2 GDP (2nd reading); Euro Zone Unemployment; Euro Zone Flash CPI

31: China Manufacturing PMI
1: Various European Manufacturing PMIs; US ISM Manufacturing
2: UK Construction PMI; China Non-manufacturing PMI
3: US ISM Non-manufacturing PMI
4: BOE policy decision; ECB policy decision and press conference; US Trade Balance; BOJ Minutes
5: US Payrolls and Unemployment