Monday, May 4, 2015

May-June Market 2015 Outlook May-June 2015 Outlook: Win, Place, or Show

Many of our predictions from March came through as reliably as the Kentucky Derby favorite American Pharoah. As predicted, more central banks joined in on the rate cutting frenzy -- most notably the Bank of Korea executed a surprise 25 basis point rate cut in March, taking its key rate to a record low 1.75%. China's central bank offered up a cut in the reserve requirement ratio, and now there is even talk of Beijing style QE being considered.

The strong dollar had the expected effect on Q1 corporate results: many firms in Europe benefitted from currency tailwinds, while US firms that missed consensus numbers invariably complained about FX headwinds and large multinationals like IBM, P&G, and J&J each took more than a $1 billion revenue haircut in Q1. Energy companies made rapid cutbacks in capital expenditure forecasts and reduced their workforces in the face of lower energy prices. As expected, in April the US rig count reached a 50% drop from its peak level in just six months, and that has helped stabilize oil prices, though the extent of the energy rebound has been somewhat surprising. The sudden collapse in oil last year has continued to weigh on global inflation readings, while the expected economic benefits of cheaper energy have not yet passed through as of the lackluster first quarter.

Looking out to the next two months a variety of issues could come to the forefront, but only a handful could win, place, or show when it comes to their impact. The favorite topic of the handicappers is the timing of Fed rate liftoff and whether markets are psychologically ready to handle the move. Conversely, other central banks are whipping up more stimulus, and the latest conjecture is about China going all in. In Europe, the leading topics are whether Greece will be disqualified from the euro zone, and a contentious UK election at a time when that nation is questioning its role in the EU. Lastly, the Iran nuclear talks are headed into their final lap, with a binary outcome for energy markets and Middle East stability.

And They're Off!

Market participants have become obsessed with Fed monetary policy as it is about to diverge from the global norm of ever easier policy. While policy in Asia and Europe has just recently turned to additional extraordinary accommodation, the US central bank continues to signal that it will be tightening in the not too distant future. The question has become exactly when rate lift off will occur, but the Fed has not been obliging about an answer.

The Fed dropped its "patient" language at the March FOMC meeting and its final calendar reference to forward guidance in its April statement. At the same time it downgraded commentary on the current economic environment in both statements, though this was largely attributed to "transitory" factors. In their interstitial speeches both hawks and doves at the Fed seem to largely agree that the seasonal Q1 slowdown will pass and the data that policy is directed by will turn up again soon.

Economic reports in early May could start the countdown to race time. To confirm the transitory nature of the Q1 numbers, the nonfarm payrolls data on May 8 will need to show a strong rebound from the 14-month low registered in the March payrolls, which came in at only half the expected number. Upward revisions in the March figure could also be constructive. Most forecasters are also looking for another one-tenth drop in the unemployment rate to 5.4%, and even some Fed doves are forecasting the jobless rate will drop below 5% before the end of the year.

If the data don't support a rate hike in mid-June, Chair Yellen will explain why in great detail at her press conference. At that time we will also get a look at the Fed's updated economic forecasts and dot chart. If data stays tepid this spring, then the dot chart could show more Fed members defecting to a 2016 rate lift off scenario (as of the March rate path forecast, only two members want to hold off until next year).

The last two FOMC policy statements have also given a nod to the stronger dollar by noting weaker US exports. Though the standard central bank position is that foreign exchange rates do not determine monetary policy, it is clear that the level of the dollar will have a role to play in near term policy considerations. In the last year as the Europe and Japan have expanded their extraordinary stimulus programs, the greenback has appreciated by double digit percentages against the euro and yen, though it has reversed slightly in the last month on technical factors and some sluggish US data. If Q2 economic data in the US rebounds smartly (as the Fed seems to be expecting), and the pace of recovery in Japan and Europe stays glacial, then the dollar could be reinvigorated and see a new push toward parity with the euro and breaking out above 122 against the yen. Such moves would undoubted set off warning bells at central banks worried about the divergence in global monetary policies setting off an uncontrollable slide in some currencies.

PREDICTIONS: The Fed is on the verge of leaving the pack behind as it plots its course for rate lift off. Fed Fund futures put the odds of a June rate liftoff as very low, while the heaviest bets are on September for the first rate move. With the Fed now fully data dependent, however, if the economic readings don't cooperate, rate lift off could be pushed back even further. The wise men of the market don't really care what month the rate liftoff comes - data gurus have noted that in the year after a tightening cycle begins, on average shares rise in mid-single digits.

China: Another Late QE Entrant?

Within the last month, the PBoC became the latest bank to pile on new stimulus, cutting its reserve requirement ratio (RRR) by one percent. The cut signals some concern about the trajectory of the economy even after the official target GDP level was reduced earlier this year. After the cut, a senior PBoC official noted that the RRR is still relatively high and has room to go lower.

For the Chinese stock market, the timing of the new stimulus is interesting, coming at a time when the Shanghai composite is at a 7-year high. As part of an evenhanded approach toward keeping growth on track but avoiding bubbles, Chinese authorities have recently issued some common sense measures to temper stocks. These include a tougher stance on margin trading and measures to make it easier to short stocks which could help scrape off any froth.

The latest financial press reports say that the PBoC is mulling its own brand of QE asset purchase program that would let commercial banks swap local-government bonds they hold for loans from the central bank to help stave off a potential credit crunch. Beijing has already been trying to rein in the local government debt market by implementing more controls, without too much success. This latest effort, should it materialize, would seek to deflate ballooning debts at various levels of local government.

PREDICTIONS: China's leadership is nothing if not deliberate. If they are considering a QE program, which remains to be verified, it will likely take some time before it is fully formulated, so we are not likely to see anything on this front in the next two months. Officials will want to gauge how the most recent RRR cut is playing out in the economy, and they could use more concrete hints of QE to jawbone the markets.

Greece's Last Furlong

The government of Greek Prime Minister Tsipras is playing a dangerous game of brinkmanship. Greece keeps making hopeful noises that a deal with creditors is just around the bend, but in reality it seems as though talks will continue to drag on through May and perhaps into June. In the opening week of May, Athens will submit yet another list of potential reforms to its European partners, after the last several submissions were rejected for lack of detail and conviction. If the Greek scratch sheet is disappointing again, some press reports suggest that the nation's creditors could draft an ultimatum that sets June 30 as a final deadline for Greece.

The next hurdle for Greece is coming up fast: it has a €1.4 billion bill redemption coming due on May 8, and another €1.4 billion on May 15. Athens was able to make a large payment to creditors in April, but its reserves are dwindling, and in the absence of a new agreement with European partners, the government may soon have to decide between paying its debts and paying bureaucrats' salaries. Neither option is attractive: either technically default on debt (though ratings agencies seem willing to withhold the "default" appellation for a little while), or pay creditors and rile up the public by issuing IOUs to government employees.

There have been a few hopeful signs lately. For instance, the PM's move to swap out the sometime abrasive finance minister Varofakis with the deputy foreign minister, a staid economist, as the head of his bailout negotiating team, indicates that Tsipras may be ready to deal in realistic terms. Also an overture by Tsipras toward Russian President Putin only resulted in promises of joint energy projects but nothing to satisfy short term funding needs.

Speaking of Russia, its adventure in Ukraine continues to be a concern for the rest of Europe. Reports say that the Russians have been moving troops back toward the border in the biggest build up since its "military exercises" in the region last October. If the Minsk accord unravels and Russia commits more resources to destabilizing Ukraine, Europe has promised more sanctions, even though the existing sanctions regime against Moscow has resulted in significant trade losses for Western Europe, particularly Germany.

A setback in Greece or Ukraine could be enough of a short term shock to knock a slowly improving European economy off track. The euro zone has just moved out of a temporary bout of deflation in April, reporting the first no-negative CPI estimate in six months. Other recent data showed euro area lending rising for the 1st time in almost 3 years, showing QE may be having the desired impact on the credit market.

PREDICTIONS: The odds of a Grexit still seem small, if only for the concerns about such an outcome challenging the idea of the euro being irreversible. Tsipras has tried to leverage this fear to his advantage, but he has gained few concessions and appears to be slowly coming to the realization that a Grexit would be much worse for Greece than for Europe.

Run for the Roses

It's no War of the Roses, but the struggle for power UK elections this month could come down to a photo finish. The presumed favorite, the incumbent Conservative PM David Cameron, has not been able to pull away from the sometimes awkward Labour leader Ed Miliband, despite the ruling party being able to point to a demonstrable economic recovery underwayuntil recently.

After posting a better than expected 3% GDP growth in Q4, the UK preliminary Q1 reading of 2.4% was the slowest in two years and missed estimates by two-tenths of a percent. If that slower growth data persists in the second and final readings of Q1 GDP (due on the last trading days of May and June, respectively), it could put the brakes on any chance of the Bank of England following on the heels of Fed rate lift off this year. As it stands, only a small minority of the monetary policy committee sees a window for a BOE rate hike this year, but a strong upward revision in the Q1 data might help them make that case. Leading survey data has shown signs of accelerating manufacturing and service sector activity that could translate into upward revisions of GDP and a pick-up in inflation expectations, which would likely lead to a rise in the pound sterling.

Headed into the May 7 general elections, Labour and the Conservatives have been swapping the lead in daily polls, with each garnering numbers in the low 30's. For the markets, a Labour Party win would inevitably create more uncertainty than a status quo victory by the incumbent, and would be particular hard on the utility industry, which has become a lightning rod for complaints about the rising cost of living in the UK. Milibrand has pledged to cap utility prices and otherwise roll back energy market liberalization if elected.

Things could get complicated if neither of the two leading parties pulls away, because of a shortage of willing coalition partners. The Liberal Democrats are expected to lose seats in the parliament and may not be willing to return as the uneasy junior coalition partner of the current Conservative government. Meanwhile the Scottish National Party -- forecast to surpass the LDs and take the third largest number of seats in the House of Commons - could theoretically create a majority in the event of a Labour Party victory, but Scottish members of the Labour party would balk at the idea. Ultimately there may be a hung Parliament with a minority government, which could lead to a new election being called within the year.

PREDICTIONS: The UK election is coming down to the wire and seems likely to end a hung Parliament, but once the race is run, electioneering hype should die down for a while, and the focus of the markets will shift to BOE monetary policy.

Iran Dropping Out of the (Arms) Race?

Over the next two months senior diplomats hope to reach a conclusive agreement on monitoring Iran's nuclear program. The new deadline for a final deal is the end of June, though its unclear if the major powers will let that date slide again after the initial framework agreement took a few extra days beyond the March deadline to reach. If Tehran is truly serious about giving up its nuclear weapons ambitions and agrees to a transparent monitoring regime, Iranian oil could begin flowing at greater volumes into the global market. Industry experts say the process of ramping up Iranian oil deliveries could take over a year, however, so beyond the psychological impact, traders and other producers will have time to react to Iranian oil returning to an already saturated market. The EIA suggests Iran holds over 30 million barrels in storage and could increase crude production by at least 700 thousand bpd by the end of 2016.

A lot of things could still go wrong. Iran could refuse the terms of a final deal, or try to play for more time when the major powers' patience appears to have run out. The recent incident of Iranian patrol boats waylaying a cargo ship in the Strait of Hormuz reinforced the notion that an unplanned confrontation could unravel months of diplomacy. After the incident, the US navy said it would escort all US- and UK-flagged vessels through the Strait, a reasonable precaution but also creating a potential for friction with Iranian patrol boats, not to mention the Iranian naval forces hovering around Yemen where Tehran's proxy war with Saudi Arabia continues.

Tension between Saudi and Iran may be on display at the 167th ordinary OPEC meeting on June 5. The new Saudi king has stuck to his predecessor's policy of dropping the mantle of 'swing producer' for the global market. So far, he and his Gulf allies appear to be correct in their assertions that the market will correct itself as higher cost producers take unprofitable rigs offline. With WTI and Brent crude both more than 20% off of March lows and the Baker Hughes US rig count more than 50% off of its cycle high, that rig count will likely stabilize soon as shale producers conclude the culling of their least profitable wells.

PREDICTIONS: All year long, White House has been putting the odds of a successful negotiation with Iran at below 50/50, but sanctions have hurt Iran's economy enough that it appears to be ready to make a deal. Tehran is known for its gamesmanship and even if the nuclear accord gets done, it seems clear the issue will not go away for good especially with the Israeli government unconvinced.