Thursday, March 3, 2016

March-April 2016 Outlook March-April 2016 Outlook: March Madness
Thu, 03 Mar 2016 23:05 PM EST

Leonardo DiCaprio's now infamous run-in with a bear may have been a harbinger for the markets early this year. Just a couple of days into the New Year, it was apparent that global markets were going to test the resolve of central bank policy makers. Stocks and oil prices were mauled, currencies saw outsized daily movements, and bond yields experienced renewed downward pressure - all signaling discontent in the markets.

Looking back, the last two months of retrenchment were not entirely unexpected after the rough start seen in the opening days of 2016. As predicted, the markets didn't have much appetite for the Fed's tightening message, and expectations are growing that the Fed will take an even slower rate tightening path. The fourth quarter earnings season was subpar, as retailers continued to struggle against ecommerce at Christmas, a number of tech firms failed to justify their large multiples, and Apple appeared to turn the corner from a growth stock to a value stock. The US Presidential race has been pared down, with only three viable GOP candidates left, and a likely Clinton versus Trump general election moving toward a reality. Meanwhile, the PBoC refrained from any new big currency moves, as expected, and even pushed the value of the yuan up over most of February to discourage speculative trading.

For the time being, the optimism about the US recovery that led the Fed to raise rates in December has been dampened by a fresh round of global uncertainties ranging from persistent low inflation to an unprecedented political environment. These problems are being magnified as Europe and Asia are still struggling to right themselves.

The question for this spring is how bad the current economic environment will become. It may just be another short lived "tantrum" caused by the Fed starting a tightening cycle years before other central banks can follow suit. Or it could be the prelude to a recession, which is a growing minority opinion. In the worst case scenario, it could be a global deflationary wave eroding confidence in central banks set to trigger a fresh financial crisis at a time when central banks are low on ammunition.

Marching to a Different Drummer

Stubbornly low inflation remains at the heart of the current economic malaise. Central bankers in the US, Europe, and Japan would roll out the red carpet for any sign that consumer and industrial demand was starting to edge inflation up toward target levels. But inflation has so far defied numerous predictions that an upturn is just around the corner, leaving economists and central bankers to repeatedly push out their forecasts for rising prices.

While other factors are certainly at play, oil prices have been emblematic of the low inflation problem. Crude futures have surrendered all of their speculative froth, while the Fed has been describing the effects of low oil prices as "transitory" since December 2014. The two-year long collapse in energy prices has still not seeded any of the consumer spending that economists were counting on, and razor thin margins are pummeling the energy extraction industry, resulting in dramatic capex cuts and the loss of many high paying jobs.

Despite some high cost wells being shuttered, all indications are that crude still has lots of excess inventory to work off. Cushing crude stocks continue to hit fresh record highs almost every week and the big refinery turnaround season underway in the next two months will exacerbate the glut. In another anecdotal indication of oversupply, a recent report said that port of Rotterdam has 50 tankers awaiting unloading, the highest number since 2009 and double the normal amount. To top that off Middle Eastern oil supplies will expand as Iran ramps up its production as sanctions are lifted.

Russia and Saudi Arabia have raised hopes for an end to the misery in the oil market by striking a tentative deal to freeze output levels. Under the agreement brokered by Qatar and Venezuela, participants would freeze production at January levels. This would not eliminate the supply and demand imbalance any time soon, but could create the prospect for a more wide reaching production accord when participating nations meet to discuss the freeze sometime during March (the meeting date has not been specified yet).

Mounting global uncertainties are also contributing to the low inflation environment, as consumers fear overspending when they can't predict if the economic recovery will continue or if recession is around the corner. One inescapable source of uncertainty is the strange dynamic of the US Presidential race. A year of populist revolt has seen the rise of Donald Trump as the now likely GOP nominee and a strong challenge from Bernie Sanders against Hillary Clinton. The untimely death of Justice Scalia may become the deciding factor as President Obama's Supreme Court nomination in the next few weeks will draw out partisans on both sides (assuming Obama can find a sacrificial lamb willing to expose her life to the political circus with little chance of ever being rewarded with a confirmation hearing).

The other major ongoing political story is the UK referendum on remaining in the European Union, with a vote now scheduled for June. PM Cameron came back from Brussels with a reform deal to keep the UK in the union, but some high profile members of his own party, including a number of cabinet members and the flamboyant London mayor, have come out in support of a Brexit. The uncommitted vote is still large enough to swing the referendum in either direction, so Cameron will have to campaign hard, and the polling will be watched very closely between now and June.

The other prickly topic in Europe these days is the continuing flood of migrants fleeing the Syrian conflict. The EU and Turkey will hold a summit on March 7th to discuss the flow of refugees through Turkey and into Europe. There has already been a backlash in many EU states and the burden for Greece -- being on the front line of the migrant influx -- is causing complications in Athens' ongoing debt discussions with European creditors. The issue has even given some Euro-skeptics ammunition to suggest that the Schengen agreement, a cornerstone of the Union which allows unhindered travel between states, should be suspended.

PREDICTIONS: Crude prices have been behaving better in the last couple weeks, showing tentative signs of stabilization. Russia and Saudi Arabia have made a good show of their oil freeze accord, but it won't make much difference if the agreement doesn't bring in other large oil producers. So far, Iraq has expressed support for the idea but has not agreed to sign on to it, and Iran's oil minister declared the production freeze to be "a joke."

Saudi drew its line in the sand on production two years ago and it will take some time for shrinking capex budgets to trickle down into a tighter oil supply. The good news is that the gyrations in oil prices may be more about the oil market itself than about a prospective global downturn. Economists note that recessions tend to be proceeded by rising energy prices, not falling prices. They also still hold out the hope that consumers will start spending their energy savings more readily when some of the uncertainties that have led them to save the money start to dissipate.

For the markets, the ultimate question will be how far ahead we can anticipate the eventual rebound in oil prices. Some optimistic OPEC ministers are hoping for better prices in the second half of this year, but more conservative estimates see prices finding somewhat higher levels in 12 to 18 months. Oil market speculators could push up that timetable in anticipation a more balanced market, so late 2016 might indeed be a better time for oil prices and energy companies.

The major political campaigns of this spring will continue to create uncertainties for the voters and the markets. The Presidential race looks poised to enter the general election campaign with two highly flawed candidates, marked by some of the highest negative polling ratings in history. Dreams of a white knight at a contested Republican convention (Mitt Romney) or a miraculous third party entrant (Mike Bloomberg) could keep stirring the political pot for months to come. Meanwhile in the UK, an affirmative Brexit vote is still seen as the outlying case. However, if the polling should drift toward that result in the weeks ahead, it should be noted that an HSBC analyst has predicted that a Brexit would wipe 20% off the pound sterling.

Beware the Ides of March

A lot of central bank activity will converge around mid-March. For more than a month, the ECB has been teasing new measures at its March 10th meeting. The BOJ will hold its monthly conclave a few days later, and then on the 16th the Fed will take its turn in the spotlight.

The ECB has all but guaranteed more stimulus at its upcoming policy meeting. At the last meeting, President Draghi promised to fully review and "reconsider" policy in March alongside the release of updated economic projections. He said the council would weigh a full range of policy options and gave assurances that there are still many monetary policy tools at their disposal as well as the required "power, willingness and determination to act."

There must be some concern, however, that the ECB is no longer getting the bang for its buck (or rather, the 'effect for its euro'). The new measures announced just last December disappointed markets to some extent. Though the key rate was cut another 10 basis points to negative 0.30% and the scope of QE was expanded in both duration and composition, the monthly size of QE purchases was not increased. Reports at the time indicated that a northern European block objected to going further and indeed there were five dissenting votes on the council (led by the Bundesbank's Lautenschlaeger and Weidmann).

The German contingent has led the hawks throughout Europe's navigation of the financial crisis, but this time they may sit on their hands when Draghi calls for new stimulus because Germany's largest bank is at the center of the latest financial storm. Negative rates and a still slow loan environment have been especially tough on Deutsche Bank, which has prided itself on providing the entire menu of banking services, even at the expense of the bottom line. The ECB's Coeure recently indicated that the council is sensitive to the burden that negative rates are putting on European banks and hinted that the next stimulus package could include provisions to help banks deal with adverse consequences of prolonged negative rates. If true, that could convert prior dissenters into affirmative votes.

Even as the ECB has been telegraphing its next policy moves, Asian central banks have tried a different tactic. The BOJ shocked almost everyone with its decision to match Europe's negative rate posture. And in China, the PBoC continues to utilize the element of surprise in its efforts to thwart the speculators that the government vilifies.

With only a month gone by since its surprise rate move, the BOJ is not expected to do more than jawbone at its March meeting. The government, however, may be on the move again. Reports say that Prime Minister Abe's cabinet has begun to consider new emergency economic measures to provide additional support. This comes as corporate profits deteriorated last quarter, leaving many Japanese firms bracing for further weakness as a stronger yen has undermined the PM's growth initiatives.

China got a lot of the blame for the market retrenchment in the New Year on escalating fears that policy makers were losing control of the currency. The Chinese central bank has refrained from any more jarring currency moves like the sudden devaluation that caught markets off guard last summer, but further yuan weakness in early January raised some questions about whether monetary officials were still in control. The PBoC has since firmed up the yuan to thwart currency speculators, and to assuage concerns of foreign partners that China might export deflation to the world. Furthermore, at the G20 meeting of financial ministers that was just hosted by China, Beijing gave assurances that it would not initiate more sudden movements in its currency.

Over the first half of March, China's National People's Congress will hold its annual meeting to introduce major policy initiatives and set new targets for growth and inflation (announcements expected March 5). Going into the congress, reports say that the CPI target is likely to be maintained at 3% and the M2 money supply target could be raised one percentage point to 13%. The GDP target could step down another notch as PBoC officials are forecasting growth between 6.0-7.0% this year after 2015 came in just under the target of "around 7.0%." Additionally, the PBoC statistics department has called for the fiscal deficit to be increased by one percentage point more than previously planned to 4% of GDP. Presumably that would promote greater government spending on stimulative public works projects.

Back in the US, the Fed has to consider scaling back its plans for higher rates. At the March FOMC meeting, the policy statement probably will not change drastically after the economic outlook was downgraded earlier this year. In the January statement, the Fed said it now expects inflation to remain low in the near term and it deleted a reference to being "reasonably confident" about inflation being on track. Commentary about global concerns was also intensified, as the Fed struck language about the outlook for economic activity being balanced. Altogether these changes signaled the Fed would probably be on hold for a while.

In their individual speeches, Fed officials have tried to create the impression that they have an open mind about the March meeting, with many of them saying every meeting is still "live" for potential rate hikes. However, the Fed's data dependent stance won't leave much room for policy action in March, because the data has not been particularly good.

Though payrolls have been solid, a lot of the job creation has been in low paying entry level jobs. It's true that unemployment has edged below five percent, but the economy has been near full employment for the better part of a year, so the low jobless rate has lost some of its positive psychological impact. Wage inflation is still elusive, and that, coupled with continued weak industrial production data, should give the Fed enough cover to keep rates on hold in March.

The Fed's updated Summary of Economic Projections (SEP) will be the most closely scrutinized part of the FOMC release. In December, the SEP predicted a central forecast of four rate hikes in 2016, which would be a pace of every other meeting. Global economic conditions clearly no longer warrant such an aggressive tightening schedule, and the dot chart is expected to reflect this in March.

PREDICTIONS: The periodic application of fresh stimulus has kept markets in a risk on mode for most of the last several years, but there is growing evidence of diminishing returns. Markets retrenched throughout the first two months of the year despite the ECB's expansion of QE in December (and the promise of more in March) and the BOJ's surprise rate move. The experimental use of negative rates pioneered by the ECB, shows central banks can continue to innovate, though it has also created some misgivings.

The ECB President may hear fewer dissenting voices if he brings out the bazooka again, possibly completing the QE trifecta announced in December by increasing the pace of monthly bond purchases from the current €60B/month. For good measure, the ECB may also cut rates another 10 to 15 basis points into negative territory, as long as they find a way to shield commercial banks from the blow. After pledging new action for the last six weeks, anything less would surely disappoint markets.

For the time being, Japanese officials will probably choose rhetoric over additional action, taking time to assess if negative rates are having the desired effect. Yet, now that the BOJ has crossed the threshold to experiment with negative rates, it seems likely that further cuts will be forthcoming eventually. In the meantime, the government may provide a supplementary budget with targeted stimulus, or give more consideration to postponing the next phase of a planned consumption tax hike.

Growing pessimism about the prospects of the world's second largest economy demand that China keeps up its ad hoc stimulus initiatives. The People's Congress will set achievable targets as it continues to ease the economy into a consumer driven model. Further monetary easing is likely to be proposed and executed periodically to help cushion the pain of reform efforts.

In the US, the Fed can afford to be patient on any further tightening. Uncertainty abounds, and another rate hike at this fragile moment could tip things in the wrong direction. Also, other central banks are cutting rates, which is the equivalent of the Fed tightening - so, relatively speaking, the Fed can essentially tighten just by standing still.

Fed Funds Futures aren't fully pricing in the next Fed rate hike until early 2017, way out of line with the December dot charts that predicted FOUR more hikes this year. Clearly something has got to give and that will probably be the Fed forecast, which could be trimmed to three hikes or even two, but certainly won't give up on the notion that the tightening cycle should continue. In giving this ground Chair Yellen will reprise her warning that a slower start to the cycle is apt to lead to steeper hikes later on.


1: UK Manufacturing PMI; Euro Zone Unemployment; US ISM Manufacturing PMI; Super Tuesday Primaries & Caucuses in 12 states
2: UK Construction PMI; China Caixin Services PMI
3: US ISM Non-Manufacturing PMI; US Factory Orders
4: US Unemployment & Payrolls; US Trade Balance
5: China National People's Congress annual meeting

7: German Factory Orders; EU Summit on Refugees; Japan Final Q4 GDP; China Trade Balance (tentative)
9: UK Manufacturing Production; China CPI & PPI
10: ECB policy statement and press conference; US JOLTS Job Openings
11: US Preliminary University of Michigan Confidence
12: China Industrial Production

13: BOJ policy statement
15: US PPI; US Retail Sales
16: UK Claimant Count & Unemployment; US Housing Starts & Building Permits; US CPI; US Industrial Production; FOMC policy statement & press conference
17: Euro Zone Final CPI; BOE policy statement; BOJ Minutes
18: Philadelphia Fed Manufacturing

21: Various Euro Zone Flash Manufacturing readings; US Existing Home Sales
22: UK CPI & PPI; German ZEW Economic Sentiment
23: German Ifo Business Climate; US New Home Sales
24: UK Retail Sales; US Durable Goods Orders; Tokyo CPI
25: US Final Q4 GDP

28: US Personal Income & Spending; Japan Retail Sales & Household Spending
29: German Retail Sales; German Unemployment; US Conf Board Consumer Confidence
30: German CPI; US ADP Employment
31: UK Final Q4 GDP; Euro Zone Flash CPI; ECB Minutes; US Chicago PMI; Japan Tankan Manufacturing & Non-Manufacturing; China Manufacturing & Non-Manufacturing PMI; Caixin Manufacturing PMI

1: UK Manufacturing PMI; Euro Zone Unemployment; US Unemployment & Payrolls; US ISM Manufacturing PMI

4: UK Construction PMI; US Factory Orders
5: German Factory Orders; US Trade Balance; US ISM Non-Manufacturing PMI; China Caixin Services PMI
6: FOMC Minutes
7: US JOLTS Job Openings
8: UK Manufacturing Production

10: China CPI & PPI
12: UK CPI & PPI; China Trade Balance (tentative)
13: US PPI; US Retail Sales
14: Euro Zone Final CPI; BOE policy statement; US CPI; China Q1 GDP; China Industrial Production
15: US Industrial Production; US Prelim University of Michigan Consumer Sentiment

19: German ZEW Economic Sentiment; US Housing Starts & Building Permits
20: UK Claimant Count & Unemployment; US Existing Home Sales
21: Various Euro Zone Flash PMI readings; ECB policy statement & press conference; US Philadelphia Fed Manufacturing
22: German Ifo Business Climate

25: US Durable Goods Orders; US New Home Sales
26: US Conf Board Consumer Confidence; BOJ policy statement
27: UK Prelim Q1 GDP; FOMC policy statement; Japan Household Spending; Tokyo CPI; Japan Retail Sales
28: German CPI; US Advance Q1 GDP
29: BOJ Outlook Report; German Retail Sales; Euro Zone Flash CPI; Euro Zone Unemployment; US Personal Income & Spending; Chicago PMI
30: China Manufacturing & Non-Manufacturing PMIs