Wednesday, September 3, 2014

September-October 2014 Outlook: Going to Extremes  Going to Extremes

The headlines this summer - Russian weapons and troops magnifying the bloodshed in Ukraine, Hamas rocket attacks inviting a terrible reprisal from Israel, ISIS militants ravaging Iraq, a new civil war brewing in Libya, and the worst ever outbreak of Ebola in Africa - have done surprising little damage to market confidence and the expectation that the economic recovery will continue. The S&P500 notched a record high above 2,000, bond yields haven't budged off their recent lows, and commodities have showed almost no reaction to these geopolitical flare ups.

The next two months may see more obstacles placed on the wall of worry, but it's hard to say if events will send the markets in a new direction. After years of providing copious accommodation, global central banks are about to move in opposite directions, with some looking to add even more stimulus while others start to withdraw extraordinary accommodation. This divergence could be a trigger for a global retrenchment, especially when the markets decide it's time to start anticipating Fed tightening next year. Corporate events too can play a role, as firms need to confirm continued momentum in the economy when they report Q3 results in October. And of course the wrong geopolitical headline could turn market sentiment on a dime, particularly if the Ukraine crisis escalates to the point where Russia and NATO might butt heads. There is a low probability of an outcome that extreme, but at some point markets will find a trigger for shifting into a new phase, either reversing on the weight of too much negative sentiment or undergoing a revival of animal spirits that accelerates the recovery.

The Corporate Pendulum Swings

As traders return from summer vacation, key corporate news may shape the markets. In addition to earnings season in October, two highly anticipated corporate events in September may mark the decline of one tech giant and the ascendancy of another. The first is Apple's likely entry into the mobile payments space and the wearable device market on September 9th. Wearables would be the first new category Apple has entered that goes beyond the roadmap laid out by Steve Jobs and the scope of its success could set a tone for the stock of the world's largest company. If Apple's wrist computer, featuring notifications and NFC technology, becomes another device that people "didn't know they needed" it would create a new consumer category, but if it ends up as just a niche product it could reignite the talk that Apple has lost its visionary edge.

Just days after the Apple event, Alibaba will launch its massive US IPO on the NYSE. China's dominant e-commerce company has its tendrils in every corner of online selling and boasts extremely high margins that put US counterparts eBay and Amazon to shame. With China rapidly moving to overtaking the US as the world's largest economy, the Alibaba IPO in New York may come to symbolize the ascendency of emerging markets to an equal footing with developed economies. Alibaba is at the vanguard of a flood of IPOs expected in weeks ahead, which could weigh on broader markets as traders rotate out of other positions to invest in the new issues.

Politics In Extremis

Of the many bloody conflicts of 2014, the Ukraine crisis has exerted the most influence over the markets. More tough talk about expanding the sanctions regime against Russia will be heard at the NATO summit in Wales in the first week of September. President Obama will be in attendance and will visit Estonia during the trip to reinforce the US commitment to the mutual defense organization and especially the Baltic states if Moscow turns its attention to them. President Putin's response to more NATO rhetoric is difficult to predict, but he appears intent on continuing the Ukraine conflict and may gain more leverage as winter approaches and Western Europe seeks to keep Russian gas flowing uninterrupted.

For his part, President Obama has the look of someone who is worn out by the succession of geopolitical crises he has faced, not to mention the obstructionist policies of his adversaries at home. This weariness may have contributed to his recent gaff about having "no strategy yet" for dealing with ISIS in Syria, a poor choice of words that Republicans will undoubtedly capitalize on as the election season heats up. By late October it may be clear whether the GOP will gain enough seats to take control of the Senate, which could bring the acrimony between the White House and Congress to a whole new level.

The biggest European ally of the US may get a taste of its own standoffishness about tighter bonds with its neighbors on September 18th, when Scotland holds its referendum on the question of independence from the United Kingdom. If a simple majority of the votes cast are in favor of independence, then Scotland would break from the UK after a process of negotiations with the government in London. The 'yes' vote has consistently polled below 50%, though there is always a chance that a late surge of Scottish nationalism will tip the vote in favor of independence. In that event, the UK economy and markets could be subject to significant gyrations as politicians decided how to handle the tricky issues of separation ranging from EU membership to currency to pensions.

Brazil goes to the polls for a general election on October 5th, though the next president will likely not be determined until the run-off three weeks later. The incumbent, Dilma Rousseff, has seen her popularity sag along with the economy, also hurt by fallout from the national soccer team's failure to win the World Cup after the country went to great expense to host the event. The anti-Rousseff vote seems to be growing, with her challenger from the other major leftist party, Marina Silva, pulling ahead in polls. Market watchers would prefer a win by the right-leaning PSDB candidate, Aecio Neves, but he is now polling in third place, and PSDB members are indicating they would throw their support behind Silva in a run-off election against Rousseff.

Dove and Dover

The economic recovery of the last five years has been built, with varying degrees of success, on a cushion of central bank largess. Despite all the stimulus that has already been put in place more may be on the way in Europe and Asia, even as the Fed and Bank of England are starting to draw up plans for an exit strategy from accommodation.

The ECB appears to be moving ever closer to launching its own form of quantitative to boost credit availability and avert a Japan-style deflation spiral. Increasingly it is a question not of if but when, as ECB chief Draghi recently noted the bank has made significant progress in laying the technical groundwork for an ABS purchase program. Mr. Draghi has never been one to rush into a new program, however, and it seems he would prefer to wait to see the impact of the targeted LTRO program and have the bank asset quality review (AQR) squared away before tackling QE. That would mean further action would come only after October.

Since announcing new TLTROs in June, the ECB has been jawboning the market, which has worked to some extent on the back of US Fed providing so much liquidity. But with the Fed ending its QE program in October and starting to consider normalization of policy, it may force the ECB to move up its timetable for action on its own asset purchase program. Many ECB watchers may now be disappointed if the central bank does not announce more policy action at the September 4th policy meeting.

Draghi may feel enough pressure from declining confidence data and monthly CPI readings creeping ever closer to zero to take a half measure at the September meeting. This could involve another small 10 basis point cut in the deposit rate (to negative 0.20%) or the launch of the ABS buying program, rather than outright purchases of government bonds. The ECB may have continued reservations about a full QE program because legal considerations raised by the German Constitutional Court could limit the ability of a European QE program to "shock and awe" markets the way the Fed did. Draghi may split the difference by outlining a QE program in September and making it operational later this year.

After the Fed's QE program is completely tapered out, the next question will be when rates will start to rise from near zero. In her inaugural FOMC press conference, Fed Chair Yellen ad-libbed that the first rate hike may come about six months after QE ends. She has since withdrawn that gaff and hammered home the point that rate moves will be tied to data, not the calendar. With employment data showing steady improvement and inflation still below target, market expectations of a mid-2015 rate lift off appear to be reasonable. In the months ahead, the Chair will likely focus on the themes of data-dependence and rates staying below historical norms for longer than in the past.

The Bank of England is even further along the path toward policy normalization than the US, as UK economic indicators are solid and the real estate market remains hot. Two members of the Monetary Policy Committee voted for a rate hike at the August meeting, the first such dissent since 2011, though rates are not expected to move just yet. Wage growth remains subpar, inflation has been coming in weaker than expected, and growth has cooled off a bit, leaving the BOE some room to wait before tightening, especially with the Scottish referendum hovering in the background.

More accommodation could be in the offing in Asia. A surprise slowdown in China manufacturing data in the first half of August has prompted fresh speculation about additional policy stimulus from Beijing. August manufacturing PMIs showed slippage, taking them dangerously close to contraction. In the wake of this data, the Chinese Ministry of Industry and Information Technology warned that the economy is faced with strong downward pressure, leading to some predictions that Beijing will have to do more than the sporadic 'mini-stimulus' packages it has provided this year. A Barclay's analyst suggested that this PMI slump could result in as many as two interest rate cuts by the PBoC before the end of 2014. That would be the first easing since mid-2012, the last time the central bank used rate policy to address a perceived slowdown in rate of economic growth.

Japan may also need a new round of stimulus after a run of tepid economic data in the wake of a controversial sales tax increase. Top government economic advisors have said that if Q3 GDP data (due out early November) come in weaker than expected it would warrant a delay in the second stage of the tax increase that is slated to take effect next spring. Reports also indicate that the government wants to set aside one trillion yen in funds from the 2015 budget to build a stimulus fund to support small business, presumably to help soften any further blow to the economy if PM Abe decides to proceed with a second consumption tax increase. As the momentum of the world's third largest economy wanes, expectations have grown that the Bank of Japan could cut its growth forecast for the fourth time this year at its October policy setting meeting, which could poise the BOJ for more loosening of monetary policy.

The Outer Limits

Markets have seen some new extremes in recent months, and there is a sense that eventually something has got to give. The S&P500 and DJIA have visited new all-time highs, and most analysts believe the indices are not over-extended yet. Meanwhile treasury yields remain very low, not yet anticipating Fed tightening, while European government bonds are largely at record lows ahead of the ECB taking out the bazooka again.

In the currency market, the greenback which rallied against the yen last year, has recently reversed its weakness against the euro as well, coming off of three-year lows. Some bold analysts are now forecasting that Draghi fulfilling his pledge to do "whatever it takes" to save the common currency will, within a few years, take the dollar/euro to parity, a condition not seen since 2002, the year euro notes and coins first went into circulation.

September is historically the worst month for stocks, though out of the last ten a majority of Septembers have shown solid performance. October is hung with the moniker of the month of crashes, but in recent years the "October surprise"-type events have developed early in the year (e.g. Fukushima, Arab Spring, Ukraine crisis). That does not rule out a 'black swan' this autumn, or a cluster of market events coalescing into a sentiment changing moment.

The obvious jarring events to watch for are Russia declaring an open war in Ukraine or a major terrorist attack (brought into focus by Britain raising its terror alert level in late August). The fallout from stronger sanctions against Russia could hurt Europe enough to push it back into a mild recession (already seen in Italy). At the opposite extreme, peace could suddenly break out in Ukraine, lifting the weight of the Russian menace off of the market outlook.

Markets reaching new extremes could also tip sentiment. Stocks may soon stretch multiples too far if Q3 results disappoint. Meanwhile, continued dollar strengthening could exert more downward pressure on oil prices, which would in turn put pressure on the energy sector, creating another drag on the broader equity market.

US treasury yields are eventually expected to rise in anticipation of the Fed starting the long process of normalization, but many questions arise from this notion: will the bond vigilantes emerge from hibernation and force the Fed to act faster? How will higher UST yields influence other markets, particularly European bonds that are in many cases at historic lows, with the peculiar condition of EU peripheral debt often yielding less than USTs?

In the meantime, markets may keep pushing out to new extremes. Historically, markets typically don't start pulling back until a few months ahead of rate tightening, so the risk-on environment may have another six months or more to run before reaching that catalytic moment.

CALENDAR (based on Eastern Time Zone)

1: Various EU Manufacturing PMI readings
2: UK Construction PMI; US ISM Manufacturing PMI; China Non-Manufacturing PMI
3: UK Services PMI; EU Retail Sales; US Factory Orders; BOJ Policy Statement
4: BOE Policy Statement; ECB Policy Statement; US Trade Balance; US ISM Non-Manufacturing PMI; NATO Summit in Wales (Sept 4-5)
5: US Payrolls and Unemployment

7: Japan Final Q2 GDP
8: China Trade Balance; German Trade Balance; BOJ Minutes
9: UK Manufacturing Production
10: China CPI and PPI
12: EU Industrial Production; US Retail Sales; Preliminary UofM Consumer Confidence
13: China Industrial Production

15: US Industrial Production
16: UK CPI; German ZEW Economic Sentiment; US PPI
17: BOE Minutes; UK Unemployment; US CPI; FOMC Policy Statement and Press Conference
18: UK Scottish Independence Vote; UK Retail Sales; US Housing Starts and Building Permits; Philly Fed Index; Japan Trade Balance

22: US Existing Home Sales
24: US New Home Sales; China HSBC Flash Manufacturing PMI
25: Various EU Flash Manufacturing and Services PMI readings; German Ifo Business Climate; US Durable Goods Orders
26: US Final Q2 GDP

29: US Pending Home Sales; Japan Tokyo CPI; Japan Retail Sales; Japan Industrial Production
30: German Retail Sales; UK Final Q2 GDP; EU Flash CPI Estimate; EU Unemployment; US Consumer Confidence; China Manufacturing PMI

1 (Wed): Various EU Manufacturing PMI readings; US ISM Manufacturing PMI
2: UK Construction PMI; ECB Policy Statement; China Non-Manufacturing PMI
3: UK Services PMI ; EU Retail Sales; US Payrolls and Unemployment; US Trade Balance; US ISM Non-Manufacturing PMI

5: Brazil general elections
6: German Factory Order
8: China Trade Balance (tentative); FOMC Minutes; BOJ Policy Statement (tentative)
9: German Trade Balance; UK Trade Balance; BOE Policy Statement; BOJ Minutes
10: UK Manufacturing Production

13: UK Unemployment
14: UK CPI; German ZEW Economic Sentiment; China CPI and PPI
15: US Retail Sales; US PPI
16: EU Final CPI; Philly Fed Index
17: US Housing Starts and Building Permits; ECB Bank Stress Test Results (tentative)

20: UK Retail Sales; Japan Trade Balance; China Q3 GDP; China Industrial Production
21: US Existing Home Sales
22: BOE Minutes; UK Prelim Q3 GDP; US CPI; China HSBC Flash Manufacturing
23: Various EU Flash Manufacturing and Services PMI readings
24: US New Home Sales

26: Brazil Presidential run-off election
27: German Ifo Business Climate; US Pending Home Sales; Japan Retail Sales
28: US Durable Goods Orders; US Consumer Confidence; Japan Tokyo CPI
29: German CPI; FOMC Policy Statement (final taper)
30: German Retail Sales; US Advance Q3 GDP
31: EU Flash CPI Estimate; EU Unemployment; China Manufacturing PMI