Monday, November 2, 2015

November-December 2015 Outlook: Trick or Treat November-December 2015 Outlook: Trick or Treat
Mon, 02 Nov 2015 13:29 PM EST

The last couple of months have been a wild ride for the markets. A summertime scare triggered by the Chinese stock market meltdown sent global equity markets into corrections of 10% or more but they have since erased most of those losses. 10-year treasuries have started to percolate above a 2.00% yield as the Fed creeps closer to a rate hike. The dollar index has zigzagged several times in recent months but is now trying to push higher, though not to the extent of the much-touted prospect of euro parity. Energy prices have resumed a downward trajectory, keeping pressure on weak inflation readings.

Reviewing the last couple of months, like a kid going through the spoils after a long night of trick-or-treating, our baseline expectations were well satisfied with a few surprises tossed in the bag. As expected, worries about Chinese stock market gyrations subsided, though commodity-driven emerging markets are still hurting from China's shift toward a slower growth domestic consumption economy. That has contributed to the weak commodity environment persisting, as predicted, keeping inflation pinned at low levels in the advanced economies and driving the ECB toward more intervention. Some of the political landmines of the last few months were diffused, most surprisingly the debt ceiling debate in Washington (a two year deal that shows Congress is perhaps ready to stop toilet-papering its own House and get down to a serious legislative agenda). Others could still blow up: Brazil's President is still under the cloud of a potential impeachment, and Spanish elections in December could create ripples for Europe.

For the next couple of months markets will be more focused on central bank activity than ever. Expectations are that the ECB will reach back into its goody bag to dole out additional stimulus. China's PBoC and the Bank of Japan may also be handing out more treats. By contrast, the Fed is contemplating withdrawing some accommodation, and many market watchers may feel it's a dirty trick if Fed doesn't raise rates in December. All of these decisions will be tied to data on growth and especially inflation. Central bankers continue to insist that low inflation is linked to transitory factors, but there is a growing sense they may be whistling past the graveyard and feeling more nervous about the issue underneath their masks of cool assuredness.

Rate Liftoff Haunts Markets

After what many Fed members described as a "close call" to keep rates on hold in September, they stood pat in October but withdrew stated concerns about global economic developments restraining growth. The October statement also specifically referenced the next meeting in December as a moment for the Fed to make a choice about rate policy. Though the Fed is always data dependent, this shift in the latest statement, along with recent comments from Chair Yellen and other key committee members that they still forecast a rate hike this year, give a strong indication that the cycle could begin at the December 16 meeting. This view is also supported by the minutes of the September Discount Rate meeting which showed that for the first time a majority of the Fed regional bank boards urged an increase in the discount rate (8 of 12 sought an increase, up from 5 at the prior meeting).

The decision to lean more hawkish at the October meeting but not to pull the trigger on rates gave Yellen's team another six weeks of data to observe before they render their final decision of the year. Among that data are two more non-farm payrolls reports (November 6 and December 4). The Chairwoman will have a good sense of this fresh jobs data by the time she testifies before Congress on December 3, so she may use that platform to present a firmer opinion about the timing of rate liftoff.

Should the Fed take the plunge in December, Yellen will make every effort to put a positive spin on the decision. It will be touted as a show of confidence in the strength of the economic recovery, and be seen as a positive development for savers and for banks that have suffered under the low interest regime. The Fed will also stress that the new neutral rate is much lower than it has been historically and that this tightening cycle will be shallower than in the past and will not be "mechanical" (i.e. not one hike per meeting).

Even senior IMF officials, who have been urging the Fed to postpone liftoff to 2016, recently admitted that a rate hike would not be "cataclysmic." In addition, a Fed decision to move forward could make the path easier for the Bank of England follow suit early next year. For the last several months Governor Carney has stated that the decision to raise interest rates will come into sharper focus around the end of this year. That makes it reasonable to assume that the December 10 BOE meeting could lay out a clearer timeframe for rate liftoff in the UK.

PREDICTIONS: As has often been the case in the post-financial crisis era, the Fed is again facing a communication problem. It would not be a shock if the FOMC decides to raise rates at the December meeting, but it might still be considered a "surprise," given that fed fund futures are still forecasting a less than 50% chance of a hike at that meeting.

On the other hand, if the committee decides to hold off yet again, it could further erode confidence in Fed's forecasting abilities, since they have been indicating for most of 2015 that rate liftoff would occur in the second half of the year. A no-go in December would also fuel theories that the Fed suspects that 'something wicked this way comes.'

Unless another black cat crosses the Fed's path, the likely outcome appears to be a December liftoff. After a brief interlude of spotlighting foreign developments, the Fed can focus back on domestic data to come to its decision. A mixed bag of Q3 earnings reports from multinationals will be weighed on by continued weakness at the energy majors, but should not be bad enough to deter Fed action. A rate hike decision could be supported by two more solid jobs reports and early Q4 GDP indicators that show better growth than Q3's tepid result. The data should make this decision clearer by early December, and when it sinks in the markets may be hit with another "freak out" moment. That panic attack should be brief, however, on the realization that a second rate hike is not imminent (Janet Yellen is not going to peel off a mask to reveal Paul Volcker underneath).

ECB Handing Out More Candy

In the eventuality of a Fed rate hike (perhaps followed closely by a BOE move), other central banks could ease the blow by increasing their accommodation. Central bankers have already injected over $8 trillion into the global economy since the start of the financial crisis, but even more may be on the way.

Even though the ECB's massive is quantitative easing program is less than halfway completed, President Draghi appears to be drawing up plans to offer up more treats for the markets. In his latest press conference Draghi announced that the "degree of monetary policy accommodation will need to re-examined" in December, when new economic projections will be available. He said that while the domestic recovery is showing resilience, external demand from emerging markets is weakening, creating downside risks to inflation and economic growth exacerbated by continued weak commodity prices.

Draghi further extended his dovish commentary by revealing that additional rate cuts are one of the options available, a shift from prior rhetoric that had declared rates are at their lower bound. He made it clear that the choice of instrument has not yet been made from a whole menu of options, but that for the first time a lower deposit rate was among the choices.

The ECB's decision to do more will be complicated by the Fed's path toward withdrawing accommodation. Nearly simultaneous moves in opposite direction are bound to put some stresses on global markets, especially currencies. More talk of the euro-dollar parity is certain to arise in the weeks ahead. Furthermore, any action by the ECB could force the hand of other closely linked central banks, like the Swiss National Bank, which had to abandon its currency peg in January because of forex pressures created by ECB programs.

PREDICTIONS: The ECB has given every indication that more accommodation is on the way. It could come in the form of negative rates, an affirmative extension of the QE program, or some new innovation in monetary policy.

For central bankers, negative rates are still largely experimental, though a few smaller economies have already implemented them during this economic cycle. But at this point, negative rates for an economy the size of the Euro Zone probably has too much of a mad scientist feel to it to throw that switch, not to mention that it would further compress already pan-caked fixed income rates in Europe.

The safest route for Draghi's team would be to expand the QE program, a move that many analysts have been expecting for months, rather than throwing together a witch's brew of new policy measures. If the ECB's choice is to modify the QE program, expectations are that it will be a timeline expansion past the current presumed end date of September 2016, rather than any increase in size of the 60 billion euro per month in bond purchases, which could create an uncomfortable scarcity in certain bond categories. The mere discussion of other options like a negative deposit rate can be held up as evidence that the ECB is serious and prepared to do more in 2016 if deflation starts to take hold.

Treats from the Orient

Like many other central banks in developed economies, the Bank of Japan has struggled to gain traction toward a 2% inflation target despite three years of its own version of QE. Similar to its peers the BOJ has blamed much of the difficultly in achieving the inflation target on transitory weakness in commodity prices. That slow progress has prompted many analysts to call for the BOJ to further boost its 80 trillion yen per year expansion in the monetary base (after its last expansion in October 2014).

Apparently the economic data ahead of the October meeting was good enough that BOJ opted against this move. Instead the central bank pushed back the goal for reaching its inflation target to the second half of next year from the first half.

Still, with the ECB and PBoC moving toward adding stimulus, the BOJ may not be far behind. That decision will lie with the incoming data. Japanese consumer prices excluding fresh food fell 0.1% in both August and September, dipping below zero for the first time since early 2013 (though ex-food & energy readings have been substantially higher). More numbers like this could mean the witching hour is approaching for Japan and could certainly justify new action by the BOJ.

China's central bank has bumped up its stimulus several times this year. Its latest move was to cut key rates just ahead of the Communist Party plenum, a gather of top party officials to craft a new long-term policy agenda.

The plenum set a target of "medium-high" economic growth over the next five years, while a senior PBoC official declared that 6-7% growth remains achievable over that timeframe, though they would not "defend that target to the death." The plenum seemed to put more emphasis on social issues, such as easing the nation's one child policy and beefing up spending on poverty, education, environmental and healthcare programs.

China could get an external boost from an upcoming IMF decision on expanding its currency basket (November 4). All indications are that the IMF is ready to declare that the Chinese currency has matured enough to be added to its Special Drawing Rights after being denied inclusion during the last SDR review five years ago. Reports say the IMF has been sending Beijing encouraging signals about the decision, and even China's surprise currency devaluation in August, which dealt a brief shock to global markets, was praised by the IMF as a positive move toward normalizing the yuan.

Inclusion in the SDR would be a point of prestige, essentially recognizing the yuan as an international reserve currency. It would acknowledge China as meeting two key criteria: the nation's importance to global trade and the currency being "freely usable." China obviously meets the first test, but there may be some reservations about the second given the country's extensive capital controls. The IMF has said, however, that "freely usable" does not necessitate the currency being "fully convertible." By that standard the growing use of the yuan in bank reserves and international transactions should be enough to meet muster.

PREDICTIONS: If the BOJ joins in the new stimulus pageant, a likely scenario would be ramping up purchases of government bonds and other assets to 100 trillion yen a year from the current 80 trillion. Governor Kuroda said earlier this year that "many options" are available for more monetary policy action, so he could put forth a more creative option as well. In any case, more stimulus will translate into a weaker yen after it has been pinned close to 120 to the dollar for the last two months.

In China, the lack of more specific growth targets out of the Plenum seems to indicate that Beijing is willing to sacrifice some growth in favor of its continued reform agenda, which may benefit the country in the long run but could spook economists in the short term. However, despite some discomfort in the Chinese stock market, the consumer market remains fairly healthy. A hard landing for China remains a possibility, but seems a low probability at this point. Policy-makers in Beijing appear content with incremental and targeted stimulus efforts. One future example of this could be to follow through on promised assistance for the reeling Macau casino business.

An endorsement from IMF this month could result in the yuan being included in the SDR as soon as next year. This stamp of approval should lead to even wider use of the yuan for transactions and as a reserve currency and will encourage Beijing to continue on its reform path.

Inflated Ghost Stories

Normal healthy inflation has been absent in developed economies for so long it almost feels like it exists only as a fantastical ghost story told by central bankers. But since returning to inflation targets is at the heart of most central bank policies these days, it's a tale worth listening to.

By most accounts, the bogeyman in the story is the plunge in energy prices. Cheaper oil over the last year has failed to engender the pickup in economic activity that many economists had predicted, and it has laid waste to inflation forecasts across the globe.

Since Saudi Arabia threw off the mantle of swing-producer in favor of maintaining its market share, US oil firms have scrambled to shutter unprofitable wells. After a year of this, US production is at a 12 month low, but the remaining oil rigs are extremely productive and efficient. A couple of brief WTI rallies have been attributed to the ever shrinking North American rig count, but oil prices have not been able to make a sustained move out of the mid-$40's range.

The semi-annual OPEC ministers summit (December 4) would be an opportunity for oil producers to address the oversupply in the market, but it does not appear that Saudi Arabia and its Gulf allies want to take action at this time. The Saudis have shot down the idea of a meeting with non-OPEC producers ahead of the December gathering, indicating they are not ready to relent in putting market share over market price.

Other factors could exert additional forces on the oil market soon. Western sanctions against Iran could be lifted as early as next spring, which will soon flood the market with up to a million barrels per day of additional oil, presuming the Iranians don't violate any provisions of the nuclear accord. The growing US military presence in Syria also poses a risk of an unfortunate incident with Iranian or Russian military forces backing the Assad regime.

A bill to end a 40-year old ban on crude oil exports from the US, enacted during the Arab oil embargo, is moving through Congress. If the export ban is reversed it would force some rapid recalculations in the energy markets and likely narrow the spread between WTI and Brent crude prices. President Obama has issued a veto threat for a version of the bill that has already passed in the House, but the issue could be used a bargaining chip for the White House to get more clean energy funding.

PREDICTION: Oil prices will not be resurgent any time soon: supply remains elevated, storage facilities are awash in excess, and demand is only growing slowly. Producers may have to wait another year before global imbalances resolve themselves, hopefully on the back of a stronger economy.

In the meantime, market watchers may get tired of central bankers calling the phenomenon "transitory." Persistent low inflation will force at least some central banks to hand out more goodies to the market.


1: China Caixin Manufacturing & Services PMI; Turkey Parliamentary Elections
2: UK Manufacturing PMI, US ISM Manufacturing PMI
3: US Factor Orders
4: US Trade Balance; US ISM Non-manufacturing PMI; IMF SDR review; BOJ Minutes
5: German Factory Orders; BOE policy statement & inflation report
6: US Payrolls & Unemployment

9: China CPI & PPI
10: China Trade Balance (tentative)
11: China Industrial Production; UK Claimant Count & Unemployment
12: US JOLTS Job Openings
13: Euro Zone Flash Q3 GDP; US Advance Retail Sales; US PPI; US Preliminary University of Michigan Confidence

15: Japan Preliminary Q3 GDP
16: Euro Zone Final CPI
17: UK CPI & PPI; German Zew Economic Sentiment; US CPI; US Industrial Production
18: US Housing Starts & Building Permits; FOMC Minutes; BOJ Policy Statement (tentative)
19: ECB Minutes; US Philadelphia Fed Business Outlook
20: Euro Zone Flash Manufacturing PMI

23: US Existing Home Sales
24: German Ifo Business Climate; US Advance Q3 GDP; US Consumer Confidence; BOJ Minutes
25: US Durable Goods Orders; US Personal Income & Spending; US New Home Sales; Japan Retail Sales
26: German Preliminary CPI; Tokyo CPI
27: UK Q3 GDP second estimate

30: Chicago PMI; China Manufacturing & Non-manufacturing PMIs; China Caixin Manufacturing PMI
1: UK Manufacturing PMI; Euro Zone Unemployment; US ISM Manufacturing PMI
2: Euro Zone Flash CPI estimate
3: ECB Policy Statement and Press Conference; US ISM Non-manufacturing PMI; US Factory Orders; Fed Chair Yellen's Congressional testimony
4: German Factory Orders; US Payrolls & Unemployment; OPEC ordinary meeting

7: Japan Final Q3 GDP
8: China Trade Balance (tentative); UK Manufacturing Production; US JOLTS Job Openings; China CPI & PPI
10: BOE Policy Statement
11: China Industrial Production; US Advance Retail Sales; Preliminary University of Michigan Consumer Sentiment

15: German Zew Economic Sentiment; US CPI
16: UK Claimant Count & Unemployment; US Housing Starts & Building Permits; US Industrial Production; FOMC policy statement & press conf
17: German Ifo Business Climate; US Advance Retail Sales; Philadelphia Fed Manufacturing Index
18: BOJ policy statement (tentative)

20: Spain national election
22: Euro Zone Flash PMI; US Final Q3 GDP; US Existing Home Sales
23: UK Q3 Final GDP; US Durable Good Orders; US Personal Income & Spending; US New Home Sales; BOJ Minutes
24: Tokyo CPI
25: Christmas Day

29: US Consumer Confidence; Japan Retail Sales
30: Chicago PMI
31: ECB Minutes; China Manufacturing PMI