Thursday, May 5, 2016

May-June 2016 Market Outlook: The Dismal Science May-June 2016 Outlook: The Dismal Science
Thu, 05 May 2016 7:20 AM EST

Early 2016 has been characterized by recognizable patterns but erratic results. There have been some bizarre gyrations with seemingly incongruous movements across the varied financial markets. This period has been a strong reminder that the art of economic forecasting is easy until the predictions are tested - anyone can make economic predictions, but most of them don't come true.

The markets have been full of contradictions lately. Through much of April, global government bond yields moved higher, a pattern that usually indicates rising expectations of growth and inflation, yet the data remains subdued. The US economy is in better shape relative to the global economy, but the dollar has been weakening, even as the Fed has contemplates further divergence from the global easing regime. Stocks continue to trend higher despite S&P500 corporate earnings sagging for three straight quarters, and yet gold, the ultimate risk hedge, has broken out to new multi-year highs.

As for our last round of predictions, they were a little more hit than miss. As anticipated, energy prices have managed to stabilize, even in the face of Saudi Arabia's last minute veto of the oil production freeze. Better crude prices have in turn eased concerns that the oil patch might implode in a whirlpool of debt defaults. On the political front, Donald Trump and Hillary Clinton took longer than expected to close out the competition. Meanwhile in the UK, polling on the Brexit vote has remained surprisingly tight despite the Prime Minister throwing his weight behind the effort to stay in the European Union. As expected the European Central Bank boosted QE and cut rates again in March, while the Bank of Japan stuck to verbal intervention in April. The Fed stayed predictably patient and cut back its forecast for 2016 rate hikes to something that more closely represent market expectations, citing risks in the global economy.

This jumble of circumstances is a set up for more volatility in months ahead. Though major averages haven't fallen in May since 2012, the "sell in May and go away" mentality may have set in a little early as stocks have sold off in the wake of the Bank of Japan's inaction and another quarter of mediocre corporate profits. The preliminary readings on Q1 GDP for many regions showed poor growth, which could trigger some retrenchment in Q2 until the data proves a better trend. Market jitters may spark another quick contraction in stocks like those seen in January and last August, and risk hedges like gold could keep plowing higher. The political battles expected this summer will add to the risk of fresh volatility.

The Invisible Hand

The politics of the post-crisis era have been shaped by the vox populi as many voters have grown wary of the institutions that contributed to the crisis. Populist movements of many stripes have popped up almost everywhere in the West, sometimes with disastrous consequences in places like Greece, but also recasting old political machines like the two-party system in the US.

As the Presidential election unfolds, frustration with Washington has led to Donald Trump leading the GOP race and to the surprising longevity of Bernie Sanders' campaign. But now the nomination races are all but over. Trump and Clinton are poised to win their party nominations, barring an 'October surprise' (an unlikely event such as a legal escalation of Clinton's classified e-mail scandal crippling her candidacy). The final primaries are on June 7, and by then Trump and Clinton should be the clear winners and will already be ramping up the mud-slinging ahead of the party conventions in late July.

Elsewhere in the Americas, the political crisis in Brazil could deepen this month as the Senate is expected to vote on or around May 11 on whether or not to convene an impeachment trial for President Rousseff. If the Senate agrees to proceed with the impeachment case that was proposed by the lower house, Vice President Temer would become acting President for up to 180 days as the trial is litigated. For her part Rousseff continues to try and win back her erstwhile populist supporters by decrying the impeachment proceedings as a "coup." Reports say she has also floated the idea of moving the next election forward to early October (currently scheduled for 2018), perhaps hoping to ride a post-Olympic euphoria to a new electoral mandate.

In the coming weeks Greece and Spain could return as flashpoints in Europe. Spanish legislators were unable to form a new government over the last month, largely because the upstart left-wing Podemos party refused to support PM Rajoy's centrist party or the opposition Socialist party. Another general election is now tentatively scheduled for June 26, though the polls show the parties tracking at about the same levels of support as in the last vote, which could lead to more months of uncertain government in Spain. Meanwhile, the latest round of Greek talks is making slow progress toward an agreement for additional bailout requirements. Negotiations have been far less acerbic that in the past, but Greece is still capable of authoring a sudden drama.

Perhaps the most riveting political event of the next two months will be the June 23 referendum on the UK's membership in the European Union. After gaining certain special concessions from the EU, Prime Minister Cameron has campaigned against the so called 'Brexit', but he has pledged to abide by the people's decision.

An exit from the European Union would have serious consequences, involving two years of untangling the current political relationship, followed by renegotiation of all existing trade deals with the continent. An affirmative vote for splitting with the EU would also wreak havoc with the currency market - some analysts foresee a 20% drop in the pound sterling. Furthermore, it would set the unsettling example of a G7 nation abandoning a larger political structure, a bad precedent for the euro zone. The UK could also be bitten by its own example of political self-interest as Scotland would surely revive its own separatist movement. On top of that, a vote for a Brexit could also bring an abrupt end to PM Cameron's political career.

For months the polls have shown a close race between the voters who want to stay in the EU and the euro-skeptics. The economic difficulties on the continent and the surge of Syrian refugees spilling into Europe have scored points for Britons who want more self-determination. A year ago a Brexit was seen as a low probability outcome, but as the polls have stayed close the risk has become real. One sign of this: The cost of purchasing protection against a plunge in the value of the pound post-referendum has reached levels higher than during the 2008 financial crisis.

Shifting to the Middle East, the politics of the region as always revolve around oil, which has become central to the global inflation issue. Low energy prices continue to weigh on the prospects of healthier inflation levels, constraining central bankers' policy efforts.

The OPEC cartel is effectively broken, as was clearly demonstrated by the abortive attempt to agree on an oil production level freeze in Doha last month. After voicing support for the freeze plan, Saudi Arabia scotched the deal at the last minute, citing the lack of participation by hated rival Iran.

Since the deal blew up many OPEC nations have been boosting oil output, most notably Iran as it strives to get back to pre-sanction levels. Libya could also soon restore its full quota of high quality oil, as the country's eastern and western governments have agreed upon a tentative Government of National Accord. If the major players in the country can overcome their factionalism and quell an ISIS uprising, it could foster some long absent stability and allow for oil production and exports to ramp up. The head of the national oil company aspires to see production -- which has languished around 400K bpd for years -- double in a matter of weeks after a unity government is formed.

PREDICTIONS: Fortunately for oil producers, the lead up to the Doha meeting was enough to breathe some life back into the energy market and WTI prices have held in the $40's even after the freeze plan melted. Advocates for the plan still hold out hope that the June 2 OPEC meeting, which will invite non-OPEC producers to attend, could be a platform to agree on an oil freeze. That would certainly give the energy market a lift, benefiting producers and heartening economist looking for better inflation. However, the same political animosities that scuttled the Doha deal abide, so the "freeze" will most likely remain just a talking point. That could contribute to a retracement in oil prices this summer. Another concern on that front is the belief among some energy analysts that China has used this period of low commodity prices to top up their reserves, which may mean exports to the Far East could slow in the months ahead - bad news for the fledgling oil recovery.

Hillary and The Donald are about to face off, as somehow the market forces of the political campaign have delivered the two candidates with the highest negative ratings in history. As the election draws nearer, the financial markets may begin to fret over both of the extremely flawed nominees: Trump for his poor temperament and dubious policy ideas, and Clinton for her legacy of scandal and air of being a 20th century, dynastic candidate.

The Brexit polls have been in a relative dead heat for months with the 'stay' and 'leave' camps each getting numbers in the low 40%'s. If this persists, the vote will likely break toward continued EU membership, as late undecided voters tend to go with the certainty of the status quo.

There's No Such Thing as a Free Lunch

All of the monetary policy fuel expended in the last eight years helped to avert a new Great Depression and restored tepid growth, but there has been a cost beyond the billions central bankers have printed. Central bank decisions have come in for increasing criticism as policies have become more expansive.

A case in point is the slow burning conflict between the ECB and conservative critics in Germany which may come to a head in early May as the German Constitutional Court issues a fresh decision on the limits of ECB powers. The central bank's Outright Monetary Transactions (OMT) program is at the center of the case. Though in a preliminary judgment in 2014 the German court found legal problems with OMT, it asked the European Court of Justice (ECJ), for guidance. The international body ruled that OMT was compatible with EU law and that it fell within the ECB's mandate of maintaining price stability, leaving the German court to mull the question again this spring. The constitutional court is expected to render its decision in the next few weeks.

OMT was announced at the height of Europe's financial crisis, meant as a last resort with the power to aim unlimited bond purchases at a country that would agree to a strict reform program under a bailout package. It is separate from the ECB's quantitative easing program, and it has never actually been implemented by the central bank, but when OMT was announced as part of a stabilization package in 2012 it helped to calm markets that were spooked by the euro zone sovereign debt crisis. A big part of Draghi's now famous pledge to "do whatever it takes" to preserve the euro zone was represented by the OMT. If the German high court decides that OMT cannot be countenanced under the nation's constitution it could put a chilling effect on the ECB's accommodation efforts and raise doubts about the central bank's ability to stave off any future financial crisis.

As the court prepares its decision, a number of German officials have expressed concerns about ECB policy extending too far. ECB president Draghi responded to this talk at his April press conference saying that some "polite and lively" debate may be welcome, but criticism of a certain type could endanger ECB independence. Furthermore, he warned that questioning the credibility of the central bank could delay results of policy transmission and thus create the need for even more action, prolonging the very policies that critics have questioned. He also defended negative rates, saying that the euro zone's experience with them has been broadly positive thus far, with no pass through of negative rates to depositors, and noting that other central banks are using the same tools.

Negative interest rate policy (NIRP) is undoubted the biggest development in central bank policy in the last year. The ECB, BOJ and a number of smaller central banks have begun experimenting with negative rates. The ECB has indicated that its current -0.40% rate on excess reserves is about as low as it wants to go, though it won't rule anything out. And in light of the ECB rate, the BOJ has said that in theory it could drop its key rate to as low as -0.50% from the current -0.10%.

Policy makers have expressed optimism about the early results of negative rates but banks in Europe and Japan have been on the losing end of the policy. Press reports suggested that the ECB and BOJ might tack on ancillary measures to alleviate stresses on banks, including one report that said the BOJ was considering lending to banks at negative rates. But no bank boons materialized at their respective policy announcements, probably on concerns it would create the perception of subsidizing banks and engaging in beggar-thy-neighbor devaluation.

The BOJ surprised markets when it took no new action in April. There was much speculation that the BOJ would move rates even further into negative territory, but no rate cut was forthcoming and Governor Kuroda explicitly stated that they did not discuss negative interest rate loans for banks. Instead the committee pushed back its calendar target for achieving its 2% inflation goal by up to 18 months, moving the target to "within FY17/18" from the previous timeframe of the first half of FY17. That longer time horizon implies stimulus measures will be in place for longer, and will give the central bank more time for fine-tuning its accommodation programs.

The BOJ may have been inhibited by the impending G7 leaders' summit on May 26-27, which Japan is hosting. Japan has already faced some scrutiny over the effects of its policies on the foreign exchange market and it may have been uncomfortable about the prospect of explaining even more aggressive negative rate policy action to G7 peers that are also struggling to right their own economies. Ahead of the summit, Prime Minister Abe proclaimed he will propose a G7 version his 'three arrows' program, Japan's three pronged strategy of monetary easing, robust fiscal policy, and growth initiatives to spur private investment.

The BOJ's inaction in April was amplified by the Fed policy statement just hours earlier in which it remained non-committal about tightening rates at the key June FOMC meeting. The Fed delivered a fairly neutral statement, removing concerns about immediate downside risks from the global economy, but also dropping a reference to inflation "picking up."

Fed officials continue to say that the June meeting is "live" for a possible rate hike decision, though they acknowledge there isn't much growth data to scrutinize between now than then. The Fed and the markets appear to have chalked up the weakness in Q1 to seasonal factors, but they are still awaiting evidence of the expected pick up in Q2.

Measures of inflation are still uninspiring despite energy prices edging higher, and now there may be questions about the most consistent part of the US recovery, namely the jobs market. The April ADP employment reading showed the worst monthly job growth in three years. If that is echoed by the official Non-farm Payrolls report (May 6 and then June 3), the Fed may have to roll back its 'dot' forecast again in June.

PREDICTIONS: After the soft patch in Q1, it may be some time before the Fed feels sufficiently confident that growth has rebounded enough to raise rates. The Fed may also be deterred by the uncertainty over the too-close-to-call Brexit vote, which comes just a week after the June FOMC meeting. Many economists don't see a rate hike happening until Q3 and Fed Funds futures are not fully pricing in a move until December.

But the Fed could confound those expectations if better data shows itself in May. The tone of many FOMC moderates has started to lean hawkish this year, and Kansas City Fed chief Ester George has established a beachhead for the hawks with her dissent at the last two meetings. The weakness in Q1 has become a familiar pattern in the last several years, so it may be more easily dismissed if the typical rebound develops early in Q2. Better data would support a rate move and the Fed may feel pressure to move sooner rather than later because of the longstanding tradition of avoiding monetary policy changes too close to the Presidential election in November.

Ultimately, each successive FOMC meeting will be a closer and closer call, but the central bank will probably err on the side of caution. That might translate into additional hawkish rhetoric in the next six weeks, but leaving rates on hold in June with a firmer promise of the next hike coming soon.

In Europe, central bankers trumpet that they are always prepared to do more at an instant, but it seems the ECB is content to let its latest QE boost and rate cut work through the economy this summer. Indeed, recent press reports say that the ECB has no desire to make any new moves before its September meeting. The German contingent that led the dissent against the March stimulus package will continue to debate the extent of monetary policy, but Draghi remains in firm control of the council.

The discord between Germany and the ECB may resolve with the German Constitutional Court ruling. The most likely outcome seems to be that the German tribunal will defer to the European high court again, with assurances that an OMT program would only occur with extremely stringent requirements imposed on the member state being rescued. Even if the decision is tinged with political implications, the German court will probably, if reluctantly, endorse the ECB's ultimate backstop, with the hopes it never gets utilized.

Though Draghi has stated his pleasure with the early results of negative interest rate policy, the full economic effects of NIRP are not yet known. Some market luminaries such as Blackrock CEO Larry Fink suspect that NIRP could unintentionally dampen consumer spending and undermine the economic growth they are supposed to encourage. And the unexpected decision by the BOJ to refrain from taking rates deeper into negative territory might be a sign that at least one central bank is sensing unwelcome side effects.

For its part, Japan has gotten into an uncomfortable spot with its currency again. The failure to go further at the April BOJ meeting sent the USD/JPY to its lowest level in 18 months, with a 5% move alone in the two days after the decision. Monetary and fiscal authorities have been trying to jawbone the yen without much success, so if the central bank is getting cold feet about deeper negative rates, it may be up to the government to do more. That might include the long awaited decision on delaying the next sales tax increase, or it could lend more urgency to PM Abe's 'three arrows' presentation to the G7.

The greatest fear for Japanese officials is a scenario in which they undertake more policy action but see no constructive move in the yen, as occurred after the last round of accommodation. If new policy fails for a second time to weaken the yen, Japanese officials may appear impotent, which could set off a chain reaction that brings the USD/JPY to 100 or even lower. However, the consensus view is still that some better Q2 data will emerge in the US which should help the dollar firm up and limit further stress on the yen.

2: UK Manufacturing PMI; China Caixin Manufacturing PMI
3: UK Construction PMI; Indiana Primary
4: UK Services PMI; US ISM Non-Manufacturing PMI; US Factory Orders; China Caixin Services PMI
6: US Payrolls & Unemployment

8: BOJ Minutes; China Trade Balance (tentative)
9: German Factory Orders; China CPI & PPI
11: UK Manufacturing Production; Japan Current Account; Brazil Senate vote on whether to proceed with Rousseff impeachment trial
12: BOE policy decision; US JOLTS Job Openings
13: Euro Zone Preliminary Q1 GDP (second estimate); US Retail Sales; US PPI; US Preliminary University of Michigan Consumer Sentiment
14: China Industrial Production

17: UK CPI; US Housing Starts & Building Permits; US Industrial Production & Capacity Utilization; Japan Preliminary Q1 GDP (first reading)
18: UK Claimant Count & Unemployment; Euro Zone Final CPI; FOMC Minutes
19: UK Retail Sales; ECB Minutes; US Philadelphia Fed Manufacturing
20: US Existing Home Sales

23: Euro Zone Flash Manufacturing & Services PMIs
24: German ZEW Economic Sentiment; US Durable Goods Orders; US New Home Sales
25: German Ifo Business Climate
26: UK Q1 GDP second estimate; Japan Tokyo CPI; G7 Leaders Summit in Japan (May 26-27)
27: US Preliminary Q1 GDP (second estimate)

29: Japan Retail Sales
30: Japan Household Spending; US MEMORIAL DAY
31: German Retail Sales; Euro Zone Flash CPI; US Personal Income & Spending; US Core PCE; US Chicago PMI; US Consumer Confidence; China Manufacturing & Non-manufacturing PMIs; China Caixin Manufacturing PMI

1: UK Manufacturing PMI; US ISM Manufacturing PMI
2: OPEC semi-annual meeting; German Unemployment Change; UK Construction PMI; ECB Policy Decision & Press Conference; China Caixin Services PMI
3: UK Services PMI; US Payrolls & Unemployment; US Trade Balance; US ISM Non-Manufacturing PMI; US Factory Orders

6: German Factory Orders; Euro Zone Corporate Sector Purchase Program (CSPP) begins
7: Final US Primaries including California; Japan Current Account; Japan Final Q1 GDP
8: UK Manufacturing Production; China CPI & PPI; China Trade Balance (tentative)
9: US JOLTS Job Openings

12: China Industrial Production
14: UK CPI; US Retail Sales; BOJ Policy Statement (tentative)
15: UK Claimant Count & Unemployment; US PPI; US Industrial Production; FOMC Policy Statement & Press Conference
16: UK Retail Sales; Euro Zone Final CPI; BOE Policy Decision; US CPI; US Philadelphia Fed Manufacturing
17: US Housing Starts & Building Permits; US Preliminary University of Michigan Consumer Sentiment

20: BOJ Minutes
21: Euro Zone Flash Manufacturing & Services PMIs; German ZEW Sentiment
22: US Existing Home Sales
23: US Durable Goods Orders; US New Home Sales; UK Referendum on EU Membership (Brexit vote)
24: German Ifo Business Climate

26: Spain general election
28: US Final Q1 GDP; US Consumer Confidence; Japan Retail Sales
29: BOE Financial Stability Report; US Core PCE; US Personal Income & Spending
30: German Retail Sales; Euro Zone Flash CPI; ECB Minutes; US Chicago PMI; Japan Household Spending; ; Japan Tokyo CPI; Japan Tankan Manufacturing & Non-Manufacturing; China Manufacturing & Non-Manufacturing PMIs; Caixan Manufacturing PMI