Tuesday, July 5, 2016

July-August 2016 Outlook: Summer Break

TradeTheNews.com July-August 2016 Outlook: Summer Break
Tue, 05 Jul 2016 18:17 PM EST

A traditionally quiet summer for the markets was about to begin. Then Britain surprised the world with its decision to leave the EU, turning the summer doldrums into a summer break.

Before the fateful vote, our forecasts were lining up nicely: the Fed held off on a rate hike one more time; the ECB remained in wait-and-see mode and the German Constitutional Court affirmed its OMT powers; the Japanese PM delayed a sales tax increase; and crude had eased off of recent highs. Then the Brexit vote came in, shocking most financial experts and even Britains vaunted bookies. The high-quality bond trade got even more crowded and gold hit a 15-month high as the sterling got pounded down by a double digit percentage overnight. Stocks tumbled for two days and European banks were especially hard hit on concerns about interest rates remaining near zero for even longer and about the chilling of financial relations between the UK and the continent.

In the aftermath of the Brexit vote, the trajectory of everything in the financial world has been altered. The Fed, once poised to raise rates imminently, is now likely to sit on its hands for the rest of the year. European and Asian economies struggling to regain momentum may have to resort to even bigger and more exotic stimulus schemes. And the UK has the greatest uncertainty ahead as it reshapes its position in the European political and economic structure.

Bon Voyage Britain

What did Britons get for their Brexit vote? An economic slowdown, a weaker currency, and some multinational businesses threatening to pull out. The UK, which had been on a good path toward recovery, could now quite possibly suffer a recession and a severe case of Bremorse.

The BOE is already giving serious consideration as to how it can ease the blow. A few days after the referendum, BOE Governor Carney laid out a measured reaction. He said that the central bank will give an assessment of options at its upcoming July 14 meeting, with the intention to take action at the following meeting (on August 4). Carney signaled that a rate cut is likely this summer, which would take the key rate below 0.50%, where it has sat for the last seven years. The post-Brexit stimulus package may also involve boosting the BOEs Asset Purchase Target from the current £375B. In his speech, Carney attempted to look at the bright side, saying the UKs highly flexible economy can handle change and will adjust: The question is not whether the U.K. will adjust, but how quickly and how well." He also warned that the monetary policy could not carry the entire burden of easing the adjustment, urging political leaders toward forceful policy actions.

Unfortunately the government will be in limbo for the next two months as the ruling party decides on a new leader. Prime Minister Cameron will step down after a large majority of Conservative Party voters flouted his advice to vote Remain. Tory MPs are now mulling over five candidates, and will whittle them down to two before a wider party vote selects the new PM.

In a surprising turn, Brexit poster-boy Boris Johnson was outmaneuvered by an ambitious ally and is already out of the race for PM. The man who turned the tables on Johnson, Michael Gove, is now the leading candidate from the euro-skeptic wing of the party. In early polling, Gove is trailing Home Secretary Teresa May who was a lukewarm supporter of Remain during the referendum.

There was some early speculation that, if selected, May might look for a backdoor to reverse the Brexit vote, but as she formally announced her candidacy, she made it clear that she would abide by the peoples mandate. Meanwhile, Gove is making the case that the next PM should be from the winning side of the referendum. The eventual winner will be announced on September 9, but both May and Gove have said they would not trigger Article 50, the event that starts a two year clock on leaving the EU, until next year at the earliest.

The rest of Europe is already growing impatient with the secession process Britains ship of state is waving goodbye but its still tied up at the dock. Though top European leaders have discouraged taking retribution against the UK for leaving, much of the continent is seething over the troubling fallout from the Brexit vote. How the UK handles its invocation of Article 50 will greatly influence the tone of treaty re-negotiations with its former EU partners. If the new PM in London pushes for preconditions before starting the clock, the political tensions and uncertainties created by the Brexit could be extended by several additional months.

EU leaders worry that prolonged uncertainty about the Brexit process could poison the economy. International trade could slow and business planning could be chilled. It could also bolster populist movements ahead of general elections in France and Germany next year in which voters may express similar frustration with the current political path in Europe. Euro-skeptics playing a longer game are looking ahead to 2019 when, Mario Draghis term as ECB president ends. The thinking is that Germany will almost certainly get the nod for the Presidency after the Bundesbank candidate opted out in 2011, leading to Italys Draghi taking the post. A German at the helm of the ECB will be less prone to central bank largesse.

Eventually the Brexit could spell the end of the United Kingdom itself. Scotland has made noises about reviving its own referendum for independence so that it can rejoin the EU. In their own bid to regain European status, Northern Ireland politicians are openly discussing the reunification of Ireland. Such moves would certainly diminish the UKs economic clout and may make it harder to get good terms in renegotiated trade agreements.

As the BOE goes to battle stations, other central banks may bide their time for now. Markets have been volatile since the Brexit vote, but they have remained orderly, with no real signs of panic. If conditions stay relatively calm, global central bankers may breathe a sigh of relief.

Initial surveys of economists show most believe the ECB won't cut its already negative deposit rate any further over the coming months. President Draghis team is still crunching the numbers on impacts of new stimulus added earlier this year, and wont overreact to the unknown extent of the Brexit fallout. If markets do take a turn for the worse, the ECB could muster another token 10 basis point cut to bring its deposit rate down to -0.50 percent.

The BOJ appears patient as well, even in the face of the Brexit strengthening the yen back toward uncomfortable levels. Many currency analysts see a USD/JPY level of 100 as an obvious point for the central bank to try and hold the line with interventions. But the BOJ is still assessing the effects of the negative interest rate policy (NIRP) it instituted in February and has stuck with verbal interventions. Before the Brexit turmoil a key economic advisor to PM Abe said that Japan would have to intervene in FX market if yen strengthened to 90-95 area even if the US objected, so that level may be the actual line in the sand.

NIRP has had a modest stimulative effect, but its skeptics are legion. The unprecedented combination of negative interest rates at the BOJ, ECB and other central banks, fear of Brexit, and deep uncertainty about Fed rate hikes have fostered an extraordinary low yield environment. The Japanese 10-year benchmark yield has slid to -0.25% and the German 10-year bund has now joined the sub-zero club. With the Brexit adding to the compression, yields have fallen so far that approximately $11.7 trillion of government debt worldwide is now trading with negative yields. Thats up more than 15% from a month ago when Bill Gross declared that the huge pile of negative-yielding sovereign debt a "supernova that will explode one day."

Most banks have suffered silently after the Brexit blew away any sign of higher interest rates over the horizon, but some are starting to show signs of disgust with NIRP. In a clear demonstration of its frustration with negative rates, the Bank of Tokyo-Mitsubishi UFJ announced it might stop acting as a primary dealer of Japanese government bonds. In the same vein, Germanys Commerzbank is said to have considered pulling its cash from the ECB and physically storing it in vaults. These warnings should cause the ECB and BOJ to think twice before submerging rates further.

PREDICTIONS: The BOE is poised for a rate cut in August, but its unclear if Governor Carney is prepared to delve into negative rates. If the economic assessment in July finds the adverse scenario isnt materializing, then a more modest 25-50 basis point cut may serve for the time being. That may be followed up in the autumn with a quantitative easing package on the order of £75B or more.

In the short-term, Europe and the rest of the global economy will have to deal with waiting for Britain to choose its leader, and for that leader to decide when the Brexit will actually begin. This waiting game opens the door for more nervous volatility in markets for the next two months.

Markets should not count on splashy new stimulus plans in the near term. Central bankers are still assessing the results of NIRP, and there is little room left to cut rates.

The reaction in the markets will ultimately depend on how much separation anxiety develops in the wake of the Brexit. The precedent set by the UK referendum could inspire other EU countries to reconsider issues of sovereignty, and if that movement snowballs it might eventually threaten to unravel the EU or EMU.

The Boys (and Girls) of Summer

Across the pond, the surge of populism that ushered in the affirmative Brexit vote is a ray of hope for the Donald Trump campaign. Trump has had a series of stumbles lately, and is trailing Clinton in the national polls and in money-raising headed into the party conventions in July. The Republican National Convention will be held July 1821, followed by the Democrats convention a week later, giving both candidates a chance to reset the tone of their campaigns.

While there are similarities between the Brexit vote and the Trump campaign, its not clear if that will be enough to propel Trump to a Brexit-like upset. Much like the Leave voters, many Trump supporters are focused on issues of immigration and globalization, and demographically they tend to be older and white. But the Presidential election also involves a choice of leadership style, and polls show the majority of Americans have a poor view of Trumps temperament and competence. Another hurdle for the GOP nominee is that the US electorate is about 30% non-white, about twice the percentage of the UK minority population. The identity politics built in to the prospect of electing the nations first female President is yet one more notch in Mrs. Clintons favor.

Janet Yellen, perhaps the second most prominent female official in the US, has many challenges ahead. In June, she gave the impression that although interest rates stayed on hold, there were still probably a couple of hikes coming soon. In the aftermath of the Brexit, the Fed will have to reassess. The market has already voted, pushing the Fed Funds futures forecast for the next rate hike out into early 2017.

Recent Fed commentary has been mostly non-committal. Fed Vice Chair Fischer forecast very little impact on US trade from the UK referendum, but noted that predicting the full impact of Brexit is difficult because it will unwind over a long period of time. That means the Fed will probably be waiting at least until Britain actually invokes Article 50 no sooner than September before it even begins considerations on the next rate move.

The Fed will also have new data to look at over the next few months. Economic growth and consumer confidence data have been solid. Employment figures have been mostly good too, though the unexpectedly sharp drop in the May payrolls report was a concern. If the payrolls continue to peter out over the next two months, it could further dampen the outlook for Fed policy normalization. However, other labor indicators do remain strong, including the sub-five percent unemployment and recent record levels in the JOLTS Job Openings, a favorite indicator of Chair Yellen.

Corporate earnings will also begin rolling in over the next two months. Second quarter earnings are expected to be solid but guidance may be clouded by ripples from the Brexit, including recent big shifts in the currency market.

PREDICTIONS: Eight days of wall-to-wall coverage of the party conventions will make it impossible to avoid thinking about the outcome in November. The mud-slinging generated by Trump, Clinton, and their supporting super PACs will keep both candidates favorable ratings low, giving them both a shot at victory.

As the conventions get underway in late July the race will draw more attention that it has so far, which could stir some market jitters, especially from forecasters who believe Trumps proclamations on trade could be a disaster for the economy. Clinton remains the likely winner in November, which could hold negative implications for certain businesses. She already made a dent in the pharmaceutical sector earlier this year as she pressed hard on the issue of excessive price hikes by drug makers. Weakness in the stock market usually undermines the incumbent party, something Clinton will have to be aware of as she squeezes her Wall Street donors for funds.

Electioneering aside, the US markets will soon switch their focus to the Q2 earnings season starting in mid-July. Even if the Brexit turmoil fully subsides by then, US corporate earnings reports could be challenged as the second half outlook will be weighed upon by renewed dollar strength that resulted from sterling losing its shine.

The Fed is on hold indefinitely, and what was once expected to be a close call at the July 27 FOMC meeting is now a definite no. Meanwhile the minutes of the last monetary policy meeting, to be released on July 6, might suddenly sound quite hawkish after the Brexit surprise. Global central bankers gathering at the Jackson Hole symposium in late August may use it as a moment to provide a reassessment of global monetary policy in the post-Brexit world.

As a side note, the Rio Olympic Games (August 5-21) may prove a distraction for already light markets during the peak vacation period. However, the triumphs of human athletic achievement could be marred if it turns out Brazils troubled government falls down in its hosting duties. The Zika virus could also get renewed attention, possibly stoking pandemic fears, though not on the scale of the 2014 Ebola scare.

Happy Summer!


4: UK Construction PMI; China Caixin Services PMI; US 4th of July holiday
5: UK Services PMI; BOE Financial Stability Report; US Factory Orders
6: German Factory Orders, US Trade Balance; US ISM Non-Manufacturing Index; FOMC minutes
7: UK Manufacturing Production; Japan Current Account
8: UK Goods Trade Balance; US Payrolls & Unemployment
9: China CPI & PPI

12: UK Inflation Report Hearings; US JOLTS Job Openings; China Trade Balance (tentative)
13: BOE Credit Conditions
14: BOE Policy Decision; US PPI; China Q2 GDP; China Industrial Production
15: Euro Zone Final CPI; US CPI; US Retail Sales; US Industrial Production; Prelim University of Michigan Sentiment

1821: Republican National Convention

19: UK CPI; German ZEW Sentiment; US Housing Starts & Building Permits
20: UK Claimant Count & Unemployment
21: Various Euro Zone Flash Manufacturing & Services PMIs; ECB Policy Statement & Press Conf; US Philly Fed Manufacturing Index; US Existing Home Sales

25: German Ifo Business Climate
26: US Durable Goods Orders; US Consumer Confidence; US New Home Sales
27: UK Prelim Q2 GDP; FOMC Policy Statement; Japan Retail Sales; BOJ Policy Statement (tentative)
28: German CPI; German Unemployment; Japan Household Spending; Tokyo CPI
29: BOJ Outlook Report; German Retail Sales; Euro Zone Flash CPI estimate; Euro Zone prelim Q2 GDP; US Advance Q2 GDP; Chicago PMI
31: China Manufacturing & Non-manufacturing PMIs; China Caixin Manufacturing PMI


1: UK Manufacturing PMI; US ISM Manufacturing PMI
2: UK Construction PMI; US Core PCE Price Index; US Personal Spending; China Caixin Services PMI
3: UK Services PMI; US ISM Non-Manufacturing PMI
4: BOE Inflation Report; BOE Policy Statement & Press Conf; US Factory Orders
5: US Payrolls & Unemployment; US Trade Balance
5-21: Rio Olympics

7: Japan Current Account; China Trade Balance (tentative)
8: China CPI & PPI
9: UK Manufacturing Production; UK Goods Trade Balance
11: China Industrial Production
12: Euro Zone Flash Q2 GDP; US Retail Sales; US PPI; US JOLTS Job Openings; US Prelim University of Michigan Sentiment

14: Japan Prelim Q2 GDP
16: UK CPI & PPI; German ZEW Sentiment; US Housing Starts & Building Permits; US CPI; US Industrial Production
17: UK Claimant Count & Unemployment; FOMC Minutes
18: UK Retail Sales; ECB Minutes; US Philly Fed Manufacturing Index

22: Various Euro Zone Flash Manufacturing & Services PMIs
23: US Durable Goods Orders; US New Home Sales
24: US Existing Home Sales
25: German Ifo Business Climate; Japan Household Spending; Tokyo CPI; Jackson Hole Symposium begins (tentative)
2528: Democratic National Convention
26: UK Q2 GDP Second Estimate; US Prelim Q2 GDP (second estimate)

28: Japan Retail Sales
29: US Core PCE Price Index; US Personal Spending
30: US Consumer Confidence
31: Euro Zone Flash CPI Estimate; Chicago PMI; China Manufacturing & Non-manufacturing PMIs; China Caixin Manufacturing PMI

1: UK Manufacturing PMI; US ISM Manufacturing PMI
2: UK Construction PMI; US Payrolls & Unemployment; US Trade Balance; US Factory Orders

9: UK Conservative Party selects new PM