Wednesday, January 6, 2016

January-February 2016 Outlook: A Long Time Ago, in a Financial Crisis Far, Far Away January-February 2016 Outlook: A Long Time Ago, in a Financial Crisis Far, Far Away
Wed, 06 Jan 2016 22:46 PM EST

It feels as if the 2008 financial crisis was a long time ago, and indeed it has now been the better part of a decade since the bottom fell out. More than seven years of CENTRAL BANK largesse has helped restore the global economy to modest growth but it continues to suffer from problems with low inflation.

The "dark side" of the economy still holds sway as evidenced by how 2015 went out with a whimper. The S&P500 dropped about 0.9% to snap a three year winning streak, and the Dow turned in its first losing year since 2008. Oil was pummeled for the second straight year, yet cheap energy prices have still shown little sign of trickling down into more consumer spending. Global terrorism has the world on edge as the depravity in Syria has inspired ruthless attacks far from the front lines in the Middle East.

The theme of global monetary policy divergence that has been theorized about for the last year finally materialized in December. The Federal Reserve followed through on rate liftoff last month, yet many questions remain about whether this divergence from global policy easing was prompted by a stronger economy or by the Fed backing itself into a corner with its rhetoric. Markets took the news of higher US rates even better than expected, with only a mild and brief bout of indigestion as the punch bowl was partially drained. Almost simultaneously, that bowl was replenished by other central banks. The ECB followed the script by expanding its QE program, though some market participants were disappointed that it grew only in breadth and timeframe, but not in the size of monthly purchases. To a lesser extent, the central banks of Japan and China also contributed new stimulus measures. And, as expected, oil prices continued to slide to multi-year lows as Saudi Arabia did not blink at the semi-annual OPEC meeting.

A period of market retrenchment is almost inevitable as the policies of central banks diverge - it's only a matter of when and how extreme the reaction is. The scope of the market rebalance could be determined in the next few months as forecasters refine their predictions for the shape of the Fed tightening cycle. To a large extent, Fed policy will be the force driving the global economy, as most market and policy movements will play off of how far the Fed pulls away from the global easing regime. The policy divergence will put new stresses on the global economy that will be observed in equities, fixed income, energy, and foreign exchange markets and in how other central banks rejigger their own policy strategies.

The Fed Awakens

After some months of hemming and hawing, the Fed went ahead with rate liftoff last month. By early December, the jobs numbers had solidified expectations that the Fed would make its first move toward normalization at its last meeting of the year. The decision was unanimously supported by FOMC voters, suggesting the doves and the hawks were able to reach a collegial consensus, though there may have been some added pressure to move since failing to do so risked the central bank's credibility after members had all but promised the first move would occur in 2015.

The new slate of FOMC voting members for 2016 has a decidedly more hawkish leaning, appropriate for a year in which rates are expected to rise. Cleveland's Loretta Mester (hawk), St. Louis' James Bullard (hawk), Kansas City's Ester George (hawk), and Boston's Eric Rosengren (moderate) will replace a more dovish group of Fed Presidents from last year. This new roster is not likely to shy away from rate hikes if conditions merit. If a dissenter does emerge, it might be either a hawkish George or dovish Rosengren. Back in 2013, the last time they were voting members, George dissented against prolonging the QE3 program on concerns it could spark inflation, while Rosengren later registered his opposition to the initial tapering of that program.

So the big question now is "when will they raise rates again?" Early indications from the Jedi Masters at the Fed have been that rates will rise slowly and will find a lower peak rate than in past tightening cycles. The first and most consistent guidance from Fed Chair Yellen has been that rate hikes will not be "mechanical." This means that rates moves will depend on the incoming data, and won't step higher at each successive meeting. Fed speakers have also used "gradual" to describe the expected rate path. One Fed president (Lockhart) has elaborated that gradual suggests a hike at every other meeting. These code words combined with the FOMC 'dot chart' have set the initial expectation that rates will be increased four times in 2016, to bring the key rate above 1.25% by the end of the year.

Since the Fed wants to be transparent as possible, the committee may deem it logical to provide a signal for the next raise one meeting in advance. Thus, an otherwise uneventful January meeting could still hold some intrigue should the Fed add language that sets up the sequel to rate liftoff in March.

PREDICTIONS: With the first move out of the way, the Fed must face the challenge of managing future rate expectations in a context of a global economic malaise that is forcing other central banks to add even more stimulus. If the Fed keeps pulling rates farther off of the zero bound while other central bank policy regimes are sinking below zero, the policy divergence could begin to have unintended consequences and create a backlash in markets.

The second rate hike now becomes all important to the policy schematic, and its timing will be hotly debated. So far it's penciled in for March, but it could be knocked off track by a number of potential events including a stock market swoon or negative developments in the global markets (which blocked Fed liftoff in September).

The key question for the Fed is whether members need to see continued improvement toward its dual mandate (jobs & inflation) before approving a second rate hike, or if they are prepared to keep raising rates until bad data stops them. Some forces believe the Fed will not be able to muster more than a couple of rate hikes this year, and the markets may actively try to test the Fed's resolve with stock market correction.

Though rate liftoff in December was framed as a vote of confidence in the economy, mixed data in recent weeks suggest that the US is hardly a bastion of strength even compared to the anemic global economy. Many forecasters expect US Q4 GDP will be subpar and even the Atlanta Fed has cut its GDPnow tracking estimate to as low as 0.7%. Lingering concerns about low inflation and the strong dollar could also leave the Fed extremely cautious. The uncertain start for markets in the New Year seems like a strong reminder that even the best laid plans often go awry, foreshadowing some difficulties ahead that could delay more Fed rate action until the spring.

"It's a Trap!"

So what might disrupt the Fed's plan of attack? A broad variety of developments could put new stresses on the economy and markets, raising questions about the viability of monetary policy divergence. These could range from a simple stock market correction as Q4 earnings reports come in, to falling energy prices sparking a high yield crisis.

It's almost universally agreed that global easing has inflated equities, so the Fed taking its foot off the gas could hamper stocks. Former Dallas Fed President recently asserted that the Fed deliberately front-loaded an enormous equity rally over six years and that he would not be surprised if the market goes through a period of digestion now as stimulus is lifted, and could see a 10-20% correction.

That prediction could be tested as some potentially unsettling corporate earnings reports start to roll in during mid-January (Alcoa unofficially kicks off earnings season on January 11). The warm weather in December wreaked havoc on many retailers who couldn't sell off large inventories of winter clothing during the holiday sales season.

There could also be trouble in store for Apple. 2016 is now expected to be the first year ever in which iPhone sales will shrink as the company's suppliers are tamping down iPhone production due to high existing inventories of the 6S handsets. If leading consumer brands like Apple can't get traction in the quarter, it does not bode well for other firms that are reliant on outsized holiday retail sales.

Fed tightening cycles generally lead to a pullback in equity indices, though the good news for bulls is that it's sometimes a year or two into the cycle before stocks peak. The fact that rates are coming off of historic lows and that their upward trajectory will be shallow should also ease the blow. And at least one sector - the big commercial banks - should start to see better returns as rates rise after years of making their organizations leaner.

The energy sector was the biggest drag on stocks last year and conditions could get worse for these companies in early 2016. Smaller energy services firms without the resources of an ExxonMobil have been struggling to right-size their businesses and their dividends to cope with the downturn in oil prices. Oversupply issues could continue to plague the oil market for a long time to come, so crude prices could go lower still. Demand for energy has risen, too, but not enough to overcome the crude glut, and there are now even some concerns that storage at the Cushing crossroads could eventually fill to capacity (Cushing storage is at record highs near 64 million barrels, edging closer to its 71 million barrel capacity).

The geopolitics of the Middle East always bear close attention, and more so than ever as relations between Saudi Arabia and Iran have reached an all-time low in recent days. In response to the Saudis execution of a popular Shiite cleric on terrorism charges, the Iranian government allowed protestors to ransack the Saudi embassy in Tehran. The Saudis, who are already embroiled in proxy wars with Iran in Syria and Yemen, then decided to cut off all commercial and diplomatic relations. A direct confrontation between the two is highly unlikely, but the heightened tensions could lead oil speculators to push Brent crude a bit higher. On the other hand, this latest clash might steel Saudi's resolve to continue oil production at full tilt to hurt Iran just as it works to bring more supply back to market as nuclear sanctions are lifted.

The collapse of oil prices has also bedeviled the junk bond market. Many smaller oil firms issued significant amounts of high yield debt to fund their growing operations during the shale oil boom, but the reversal in energy prices has raised concerns about default on those debts. As oil prices stretched to multi-year lows in December, the high yield market was hit by news that Third Avenue Management, a large mutual fund specializing in high-yield bonds, was liquidating the fund and had blocked investors from withdrawing money as it wound down. Jitters over Third Avenue lasted only a couple of sessions but some powerful voices in the markets such as Carl Icahn suggested it was another sign that a long-prophesied high yield debt meltdown could be underway. For the high yield market, each step higher in Fed rates could become the straw that breaks the camel's back as yield-starved investors who packed into junk bonds start seeing better and safer opportunities in more conventional instruments.

PREDICTIONS: The crucial Q4 earnings season will tell the true tale of how the holidays played out for retailers and other seasonally impacted businesses. So far, lower gasoline prices have not translated into any noticeable rise in economic activity, but perhaps the November-December shopping period got a small boost.

The Fed has made it clear that it worries about stock market performance, and the market may decide to test the central bank's resolve early this year. The old saying "as January goes so goes the market" holds true about 70% of the time, so a poor performance in the next few weeks could bode poorly for the year.

Stock prices remain intertwined with the energy market, and no relief is in sight on the supply side. Iran and Saudi have had a long rocky relationship as the centers of their rival branches of Islam, but they don't appear to be ready to spill blood over oil. When Iran turns the spigots back on it may be forced to ramp up oil exports only gradually to avoid further price erosion.

May the Forex Be With You

It was China that got 2016 off to a rocky start. New stock market circuit breakers were tested on the very first trading day of the New Year as Shanghai and Shenzhen equity indices tumbled 7%.

The first economic data point of the year was another disappointing industrial reading: the December Caixin PMI Manufacturing number missed estimates and registered its tenth straight month of contraction. On top of that, forex watchers noted with concern that the PBoC fixed the yuan to its weakest level in five years.

Since the PBoC shocked the FX market with a sudden 4% devaluation last summer, it has steadily weakened the currency fixing. In the New Year this has begun to shake confidence in the Chinese economy. The concern is that the PBoC may overuse the currency as a tool for stimulating its weakened economy. If China allows its currency to depreciate further it could make large amounts of dollar denominated debt held by state owned companies harder to repay.

Some of the early equity weakness may also be linked to a ban on large shareholders selling stakes in Chinese firms that regulators put in place to reinforce the stock market last July. That six month ban on insider sales will soon expire (January 8th) and some traders may be front running expectations that large shareholders will be eager to sell.

It's not a pretty picture in Europe either, where the ECB was forced to supplement its stimulus program last month, magnifying the policy divergence with the tightening Fed. The ECB cut its deposit rate another ten basis points into negative territory, to -0.30% and expanded its QE program. The bond buying program was extended by six months to March 2017 and expanded to including regional government bonds, widening the variety of assets that can be bought. Markets were apparently disappointed that the ECB failed to boost the monthly purchase size of €60 billion, but ECB President Draghi defended the measures taken as "adequate." In addition, he explained they would also commence reinvesting principal as bonds mature, a move that would add €680 billion in liquidity to the system by 2019.

Despite assurances from Draghi that more monetary stimulus is possible, there is some speculation that the ECB council is near its limit. A recent poll conducted by the Financial Times found that many experts don't believe the ECB has the wherewithal to increase the asset purchase program again. The December decision to extend the QE program drew five dissenters, including representatives from Germany, Netherlands, Estonia, and Latvia. The minutes of the December meeting to be released on January 14th will amplify that this growing rebel faction is unhappy with the snowballing amount of accommodation. This could relegate further jawboning by Draghi to the status of an ineffectual Jedi mind trick.

Some smaller central banks are having difficulties coping with the stresses created by grand schemes of the major central banks. For example, Sweden's Riksbank threw down the gauntlet at an emergency meeting on January 4th. The Riksbank said that the Krona's appreciation is a threat to its efforts to return inflation to its 2% target. To that end, Swedish officials said they stand ready to intervene in the FX market without notice, and could take other measures including extending QE or making indirect loans to companies if needed.

Monetary policy regimes at many other foreign central banks required some quick adjustments after the Fed rate liftoff. Almost immediately, several Latin American central banks that are closely aligned to Fed policy, like Mexico's, raised rates to discourage depreciation of their local currencies. They may be compelled to mirror additional Fed moves.

PREDICTIONS: After smart money predictions of EUR/USD parity in 2015 were dashed, forecasts are more varied in the New Year. Some banks including Citigroup expect four Fed rate hikes to create enough policy divergence to foster euro parity by the end of this year. Other analysts are less optimistic about the US outlook and think some of the dollar strength is speculative froth. They see the ECB growing less tolerant of additional easing, and predict fewer rate hikes from a cautious Fed, which could actually lead to a modest strengthening of the euro.

The dollar index rose more than 9% during 2015 on the run up to rate liftoff, so some of the strength is already baked in, but higher US yields will act as a magnet for funds from abroad and that should result in sustained strength for the greenback. So as the Fed continues to raise rates it's likely to further strengthen the dollar against major currency pairs.

Despite the Treasury's oft repeated mantra that a strong dollar is in the interest of the US, in some cases it isn't. If the dollar gets even stronger there could be an outcry from large US firms, given that a large chunk of their earnings comes from exports and currency headwinds are already hurting business.

A stronger dollar could also have negative spillover effects in emerging markets, where corporate debt has increasingly been dollar-denominated. As that debt becomes more expensive in local currencies, it could ratchet up financial stresses. Meanwhile, the PBoC will likely content itself with slowly dropping the value of the yuan, since another large, sudden devaluation could create a panic.

Pol Wars

As the rhetoric heats up on the Presidential campaign trail, cooler heads have prevailed in Washington. Congress and the White House signed off on a two year budget and debt limit increase that gives the government authority to borrow freely through March 2017. This averts the threat of a government shutdown during the Presidential campaign, and may allow the Congress to work quietly on smaller issues during Obama's lame duck year.

The campaign for the White House will soon kick into hyper-drive now that the voting is about to begin. A year of wild stump speeches and unruly debates will culminate in actual voting starting on February 1st at the Iowa Caucus.

On the Democratic side Bernie Sanders has energized many liberals and he may pull off a victory in New Hampshire, but his rebel campaign is unlikely to overthrow the Hillary Clinton juggernaut. Meanwhile, there is a great disturbance in the Republican side of the field. Donald Trump, who has led in most GOP polls almost since he launched his bid in June, has confounded pundits who keep predicting his campaign will blow up more spectacularly than the Death Star. But despite some controversial statements and the disdain of the party establishment, Trump still has a full head of steam going into the Primaries. Thus, he will get a chance to prove whether or not his base of disillusioned Republicans will actually pull the lever for his name.

Trump fended off an autumn surge in the polls by Ben Carson, who seems to have all but vanished from the race, but now a new challenger is rising in the form of Ted Cruz. With the backing of evangelicals Cruz could win the Iowa Caucus and gain some momentum headed into the next primary states (New Hampshire Feb 9th, followed by South Carolina and Nevada a couple weeks later, and then Super Tuesday on March 1st). It is hard to believe that a political "padawan" like Trump could lead the GOP race from wire to wire, and if The Donald's fan boys don't get out to the polls then Cruz might assume the mantle of the "outsider" candidate.

It's well known that Mr. Cruz thrives on thumbing his nose at the establishment wing of the party (making him the most despised figure within a legislative body since Jar Jar Binks). Many political observers are betting that Cruz and the radical Republicans will ultimately face off with Marco Rubio who is leading the pack of more traditional candidates that are palatable to the establishment wing.

In Europe, the inconclusive election in Spain has yet to produce a new government. With opposition parties apparently unwilling to form a coalition, it appears that Madrid is on its way to establishing a minority government later this month. Portugal's presidential election on January 24th is expected to have a more certain result. The center right Social Democratic Party is expected to hold on to power as President Silva steps down.

PREDICTIONS: By the end of March, the US Presidential field should be weeded out considerably. The congested GOP side might even be ready to ordain Trump, Cruz, or Rubio as their champion (or less likely, Chris Christie or Jeb Bush could make a late surge). But it might not go smoothly. The Republican Party was embarrassed last year when a report emerged that they were considering the possibility of a brokered convention if no single candidate could grab a majority of delegates.

If the Republican Party can't coalesce around a credible candidate in the next few months, it could damage the chances of the eventual nominee in the general election. Four more years of a Democratic President dueling with a Republican Congress promises another long stretch of brutal gridlock in Washington.

Border security has become a prominent issue in the face of global terrorism that touched Paris and California late last year. The unfortunate occurrence of any further terrorist incidents could weaken the incumbent party as scared voters could flock to a candidate that promises to make them safer from the phantom menace, helping Republicans in the US and nationalist parties in Europe.


4: German Prelim CPI; UK Manufacturing PMI; US ISM Manufacturing PMI; China Caixin Manufacturing PMI; Puerto Rico $1B debt payments due
5: Euro Zone Flash CPI Estimate
6: UK Services PMI; US ISM Non-Manufacturing PMI; US ADP Employment; US Trade Balance; US Factory Orders; FOMC Minutes; China Caixin Services PMI
7: German Factory Orders; Euro Zone Unemployment
8: US Payrolls & Unemployment; China CPI & PPI

11: US JOLTS Job Openings; Alcoa earnings report (unofficial start of earnings season)
12: UK Manufacturing Production; China Trade Balance
14: ECB Minutes; BOE policy decision
15: US Retail Sales; US PPI; US Industrial Production; Prelim University of Michigan Consumer Sentiment

18: US Markets Closed for Martin Luther King Day
19: UK CPI; German ZEW Economic Sentiment; China Q4 GDP; China Industrial Production
20: UK Claimant Count & Unemployment; US Housing Starts & Building Permits; US CPI
21: Various EU Flash Services & Manufacturing PMIs; Euro Zone Final CPI; ECB Policy Decision & Press Conference; US Philly Fed Manufacturing
22: UK Retail Sales; US Existing Home Sales

24: Portugal presidential election (second round Feb 14th if needed)
25: German Ifo Business Climate
26: US Consumer Confidence
27: US New Home Sales; FOMC Policy Decision (no press conf)
28: German Prelim CPI; UK Prelim Q4 GDP; US Durable Goods Orders
29: Euro Zone Flash CPI Estimate; US Advance Q4 GDP; Chicago PMI

31: China Manufacturing & Non-Manufacturing PMIs

1: UK Manufacturing PMI; US ISM Manufacturing PMI; US Personal Spending; Iowa Caucus; China Caixin Manufacturing PMI
2: Euro Zone Unemployment
3: UK Services PMI; US ADP Employment; US ISM Non-Manufacturing PMI; China Caixin Services PMI
4: BOE Policy Decision & Inflation Report; US Factory Orders
5: German Factory Orders; US Payrolls & Unemployment; US Trade Balance

7: China Trade Balance
9: US JOLTS Job Openings; China CPI & PPI; New Hampshire Primary
10: UK Manufacturing Production
12: Euro Zone Flash Q4 GDP; US Retail Sales; Prelim University of Michigan Consumer Sentiment

16: UK CPI; German ZEW Economic Sentiment
17: UK Claimant Count & Unemployment; US Housing Starts & Building Permits; US PPI; US Industrial Production; FOMC Minutes
18: ECB Minutes; US Philly Fed Manufacturing
19: UK Retail Sales; US CPI
20: Nevada Dem Caucus; South Carolina GOP Primary

22: Various EU Flash Services & Manufacturing PMIs;
23: German Ifo Business Climate; UK Inflation Report hearings; US Consumer Confidence; US Existing Home Sales; Nevada GOP Caucus
24: US New Home Sales; Q4 Mortgage Delinquencies
25: UK Q4 GDP Second Estimate; Euro Zone Final CPI; US Durable Goods
26: German Prelim CPI; US Prelim Q4 GDP (second estimate); US Personal Spending
27: South Carolina Dem Primary

29: Euro Zone CPI Flash Estimate; Chicago PMI; China Manufacturing & Non-Manufacturing PMIs
1: UK Manufacturing PMI; Euro Zone Unemployment; US ISM Manufacturing; China Caixin Manufacturing; Super Tuesday Primaries & Caucuses in 12 states (AL, AK, AR, CO, GA, MA, MN, OK, TN, TX, VT, VA)
2: US ADP Employment Change
3: US ISM Non-manufacturing PMI; US Factory Orders; China Caixin Services PMI
4: US Payrolls & Unemployment; US Trade Balance