Monday, January 9, 2017

January-February 2017 Market Outlook: Winter is Coming January-February 2017 Outlook: Winter is Coming
Mon, 09 Jan 2017 20:35 PM EST

The poll-defying outcome of the US election has sent ripples across the markets for the last two months. Since November 8, the dollar index is up over five percent and bond yields have spiked, as investors sold assets to buy dollar-denominated ones, betting the new US government will enact measures that boost economic growth and inflation. This shift wiped out well over $1 trillion of value in the global bond markets, even as stock indices soared to new record highs.

In the same timeframe the other late-2016 surprise - OPEC actually agreeing to a produce cut scheme - has firmed up energy prices. That along with some long overdue signs of wage growth has given some central banks the cover they need to begin contemplating pausing or even reversing their expansive monetary stimulus programs.

For various reasons, the stock market has had three bad Januarys in a row, and January 2017 may fall prey to the same pattern. The market euphoria over a Republican sweep that helped lift the DJIA to nearly 20,000 by year end was in part due to investors waiting to sell their winners until 2017 when the presumption is that capital gains will be lower under the new Administration. That could translate into delayed portfolio rebalancing in early January, and that selling may be exacerbated by traders starting to consider potential policy missteps by the Trump Administration which don't appear to have been factored in over two months since the election. At the first sign that the Republican love fest in Washington has soured investors may turn tail and run.

Out in the Cold (War)

The reflation rally may have more legs, but it will have to climb a steeper wall of worry. Aside from potential blunders by the rookie President, a new American leader is often tested by foreign powers early in his first term. Given Trump's campaign rhetoric questioning ties with old allies including the financing structures for NATO, the early antagonist may be Russia. Early in the New Year, President Putin may want test whether his deferential treatment of Trump has bought him any latitude in exerting Russian power in Syria, the Ukraine or even the Baltic states.

North Korea is another likely trouble spot. In recent weeks, South Korean officials have indicated that they expect a new provocation from the North, possibly in the form of a new nuclear weapons test (which would be the North's 6th such test). The North itself has proclaimed that it could also test launch an ICBM at "any time." Whether its North Korea, Iran, China, or Russia that prods Trump, it may reveal how he will behave as Commander-in-Chief - either following the established doctrine of proportional response or simply going with the gut instincts that seem to dominate his decision making process.

Inauguration Day is January 20, bringing with it the first US government controlled by a single party since President Obama's first two years in office. Republicans appear to be energized by their proposed agenda and may have learned a few things from the mistakes that bogged down the Democrats in the early Obama years. But it remains to be seen if the GOP can execute its big ideas, including the repeal of Obamacare, deregulation, and major tax reform. All of these ideas appeal to the party base, but executing the legislation well will be difficult in the sausage factory that is Washington DC, and Republicans leaders may have to woo Democratic votes to navigate around Senate filibuster rules.

There is already talk that it will take years of complex negotiating to replace Obamacare, so the repeal vote that Republicans plan in the early days of the new Congress will only be symbolic. Meanwhile the public will continue to get accustomed to the benefits received under the ACA and may get upset with changes in a future Republican healthcare plan. The same may be true of tax reform and deregulation efforts - the policy wonks in Washington will hail their own efforts but the ordinary citizen might not understand the intricacies of legal changes until they see some effect on their own pocketbooks years later (or until the first scandal breaks in a 'deregulated' industry).

Any goodwill toward the Republican agenda may come down to President Trump communicating the benefits of the changes he wants. During the campaign his simplistic messaging was good enough to get voters to sweep him into office as a 'change' candidate, but when he assumes the office, the American public may demand more details about Trump's plans than just a handful of adjectives about being "great" or "the best." Trump's first full press conference since the election will be held on Jan 11 and could be an indication of whether Washington has started to moderate the President-elect or if he will continue to shoot from the hip.

In the global picture, Mr. Trump's nationalist bent, and apparent belief that geopolitics is no different from business deal making, may leave a vacuum that rival powers seek to fill. Notably, Chinese Premier Li will headline the World Economic Forum in Davos later this month. Li's appearance is symbolic of China's efforts to gain more influence in the West, while consolidating its influence in East Asian after the death of the Trans-Pacific Partnership trade deal.

The Winter of Our Discount Rate

With political change afoot and with some governments finally looking at providing new fiscal measures to help their economies, many central banks are contemplating pulling back some monetary stimulus. That trend is being led by the Fed, which raised rates for the second time in December and promises to start normalizing rates in earnest this year, forecasting rates will go up another 75 basis points in the next twelve months.

The Fed may be in a wait and see mode during the early part of 2017, watching for the new Republican controlled government to follow through on promises of an assertive fiscal policy. As it stands, a lack of 'shovel ready' projects and clashes with fiscal conservatives may ultimately whittle down Trump's infrastructure spending plans.

If, however, substantive fiscal policy does materialize, the Fed may seize the opportunity to begin normalizing monetary policy. The latest Summary of Economic Projections from the Fed's December meeting predicted three rate hikes in 2017, but the Fed may surprise markets with an even more aggressive tightening schedule if the economy continues to gain its footing and has the added stimulus of an infrastructure investment plan and tax reform out of Washington.

Much of the Fed board now sees the US at essentially full employment (though some still see a bit of slack) and their attention is shifting toward the inflation mandate. Wages rebounded strongly in the December jobs data. Should that continue in early 2017 it could mean wage inflation is finally taking hold, perhaps due in part to many US states taking it upon themselves to bump up the minimum wage. And if OPEC can keep a floor under oil prices that could remove another nettlesome drag on prices that has weighed down inflation forecasts for the last two years.

Ironically the Fed could begin tightening more eagerly even as the voting memberships rotates out 2016's three dissenting hawks in favor of a decidedly more dovish group of Fed presidents. The FOMC will still be under the guidance of Chair Yellen until early 2018, but President Trump will get his chance to influence the seven-member board which still has two vacancies. Even as he has criticized Fed policy, Trump has declared himself to be a "low rate" guy, so its not yet clear what type of Fed governors he will nominate.

The rise in interest rates since the election is likely adding to the debate at the Fed. The doves may worry that the interest rate spike could raise borrowing costs and become a drag on economic activity. The hawks will counter that the increase in yields was a natural shift in the economic outlook in light of the election outcome, which could put the Fed at risk of falling behind the curve.

Despite all the anticipation of a tighten cycle after the December move, the Fed is not likely to take any new action at its February 1 policy meeting. At most the February statement will lay the groundwork for a possible hike in March, the next meeting with a scheduled press conference.

Winter Forexland

The ECB and BOE are also showing signs that stimulus efforts may be exhausted. The BOE surprised the markets in November by moving into a neutral stance (from easing), but given the overall trend of post-Brexit UK data beating expectations, the BOE is expected to hold policy steady in early 2017. Many analysts now believe that Governor Carney's next move could be a rate hike down the road as UK inflation edges its way back towards target.

Meanwhile, the ECB decided in December to prolong QE, but at a reduced pace. President Draghi said the committee had discussed continuing at the €80 billion pace for six more months but ultimately decided to cut it to €60 billion. He said there was "very broad consensus" on the decision, indicating that the doves made some concessions to German-led faction that sees a need to start ratcheting down monetary stimulus. Draghi however refused to call this action 'tapering' (suggesting that bond purchases could easily be restored to €80 billion) and said there was no discussion of taking QE to zero. In a nod to doves, he also implied that the accommodative policy framework could continue past 2019, as he noted the 1.7% CPI forecast for 2019 is "not really close" to the 2% inflation target.

In contrast to their western counterparts, officials at the Bank of Japan are still adamantly pushing stimulus. The post-US election shift in the bond market weakened the yen and pushed the yield on 10-year Japanese government bonds above zero for the first time in a couple months. That runs counter to the goals of the BOJ, which under 'Abenomics' has strove to end over a decade of debilitating deflation by buying JGBs to keep bond yields down.

Four years into the program, the BOJ has had little success at kindling inflation, despite boosting the annual QE program to ¥80 trillion and cutting the key rate to -0.1%. BOJ governor Kuroda has blamed low oil prices and weak emerging markets, perhaps ignoring Japan's burgeoning demographic issues. His critics have formulated the uphill battle this way: "Kuroda can print money, but not people." After some speculation that the BOJ might reverse course on its aggressive easing strategy, Kuroda boldly promised in a speech last fall that he would keep the 10-year JGB yield at near zero until inflation surpasses the 2% target rate. "It is often argued that there is a limit to monetary easing but I do not share such a view," he declared. As rising Fed rates shift global conditions, Kuroda's promise will become harder to achieve, but for now it appears he is unwavering.

One central bank that may be open to additional easing is the PBoC. Though the Chinese central bank's official monetary policy stance remains at "prudent", the China Banking Regulatory Commission (CBRC) recently proposed that the Reserve Ratio Requirement (RRR) for commercial banks be cut at an "appropriate time." The last RRR cut came in October 2015, so a new cut might be timed to help boost liquidity ahead of the Spring festival Golden Week holiday that begins on Jan 29. As ever it remains difficult to tell if officials would actually implement a fresh rate cut or if this CBRC rhetoric is another ploy by the Chinese government to keep the investor class off balance as it battles capital flight.

For the time being there is not much standing in the way of the strong dollar trend, which is reflective of US monetary policy getting out of the trenches before other central banks, thanks to the relative strength of the American economy. The dollar has pushed the euro to a 14-year low below 1.04 as robust US economic data have outstripped any signs of recovery in the Euro Zone. A more concrete demonstration that corporate tax reform will become a reality in the Congress could extend the reign of King Dollar in early 2017. Many currency analysts are now eyeing EUR/USD parity, which was last tested in December 2002.

The pound sterling may also weaken further against the greenback as the starting gun for the Brexit process is set to be fired in March. After the Brexit vote squashed GBP/USD to a 30-year low, the pound is wending its way toward the 1.1950 low it hit during a still unexplained 'flash crash' in early October (still a long way from the all-time GBP/USD of 1.05 set in February 1985 at the height of the Reagan/Volcker era).

Indeed the movement in the forex market since the election has raised alarm bells at the IMF, whose chief economist Obstfeld is concerned about it sparking a crisis in emerging markets, which have much of their debt priced in dollars. Weaker domestic currencies could make those debts harder to pay. Already we have seen Mexico central bank raise rates by a surprise 50 basis points in December and then openly intervene in FX markets trying to defend the peso (without much success, as the peso swoons after each Trump tweet on a business moving from Mexico to the US).

Oil Freeze

The prospects for less easy central bank policy may depend on energy prices finally rebounding, meaning monetary officials are to some extent counting on OPEC's production scheme to pan out. OPEC confounded many predictions when it actually pulled together a deal to cut oil production by 1.2 million bpd within the cartel. The promised output cuts went into effect on the first of the year and many non-OPEC producers have agreed to follow suit with over half a million more bpd in cuts, led by Russia ramping down its production over several months. Anticipation of the initial six month agreement has already boosted oil prices back into the mid-$50's range, and if producers follow through, crude could push toward $60/barrel.

The problem is, as former Saudi Oil Minister Al-Naimi said candidly right after the deal was struck, "we tend to cheat." Historically, OPEC members have exceeded production quotas on a routine basis, and if that occurs this time it could undermine the hard-won agreement. To limit cheating, the signatories of the production deal have agreed to establish a monitoring council that will meet regularly starting in mid-January.

The fact that the Saudi's agreed to shoulder about half of the OPEC production cuts while allowing their biggest political rival, Iran, to slightly increase output seems to indicate that the Kingdom is serious about the agreement. That combined with the establishment of the monitoring committee should keep the production deal on track for its initial six month trial period. Oil analysts are generally expecting to see 75% compliance, which should be enough to prevent crude prices from suffering another collapse. If the accord is successful OPEC could extend the agreement another six months through year end. The upshot is that the declarations of the monitoring committee will be followed closely and if it uncovers unacceptable amounts of cheating, it could scuttle the chances for the output cuts to continue past mid-year.


2: New Year's Day (observed US, UK); Euro Zone Manufacturing PMI; Japan Manufacturing PMI
3: Euro Zone Unemployment; UK Manufacturing & Construction PMIs; US ISM Manufacturing PMI
4: UK Services PMI; Euro Zone Flash CPI Estimate; US ISM Non-Manufacturing PMI; FOMC Dec Minutes
5: ECB Dec Minutes
6: German Factory Orders; German Retail Sales; US Payrolls & Unemployment; US Factory Orders

8: China CPI & PPI
10: US JOLTS Job Openings
11: UK Manufacturing Production
12: US Import Prices; China Trade Balance (tentative)
13: BOE Credit Conditions Survey; US Retail Sales; US PPI; US Prelim UofM Consumer Sentiment

16: China Q4 GDP; China Industrial Production; MLK Jr. Day Holiday (US)
17: UK CPI & PPI; German ZEW Economic Sentiment; US Empire Manufacturing; Davos conference (4 days)
18: UK Unemployment & Claimant Count; US CPI; US Industrial Production & Capacity
19: ECB Policy Decision and Press Conference; US Housing Starts & Building Permits; US Philly Fed Manufacturing Index
20: UK Retail Sales; US Presidential Inauguration

23: Euro Zone Manufacturing & Services PMIs
24: US Existing Home Sales; Italian constitutional court ruling on election law
26: UK Prelim Q4 GDP; US New Home Sales; Tokyo Core CPI
27: US Advance Q4 GDP; US Durable Goods Orders

29: China Spring Festival Golden Week holiday (through Feb 2)
30: US Personal Income & Spending; BOJ Policy Statement
31: German Retail Sales; German Unemployment; Euro Zone Flash CPI; Euro Zone Flash GDP; US Chicago PMI; US Consumer Confidence; China Manufacturing & Non-Manufacturing PMIs
1: UK Manufacturing PMI; US ISM Manufacturing PMI; FOMC Policy Statement (no press conf)
2: UK Construction PMI; BOE Policy Decision; BOE Inflation Report; US Non-farm Productivity
3: UK Services PMI; US Payrolls & Unemployment

6: German Factory Orders
7: US Trade Balance; US JOLTS Jobs Openings; China Trade Balance
8: China CPI & PPI
10: UK Manufacturing Production; US Prelim UofM Consumer Sentiment; US Mortgage Delinquency Report (tentative)

12: Japan Preliminary Q4 GDP
14: German Preliminary Q4 GDP; UK CPI & PPI; Euro Zone Q4 Flash GDP; German ZEW Economic Sentiment; US PPI
15: UK Unemployment & Claimant Count; US CPI; US Retail Sales; US Empire Manufacturing Index; US Industrial Production & Capacity Utilization
16: ECB Jan Minutes; US Housing Starts & Building Permits; US Philly Fed Manufacturing
17: UK Retail Sales

20: President's Day Holiday (US)
21: UK Inflation Report Hearings
22: Euro Zone Flash Manufacturing & Services PMIs; Euro Zone Fina CPI; US Existing Home Sales; FOMC Jan Minutes
23: UK Q4 GDP (second estimate); US Housing Starts
24: US New Home Sales

27: US Durable Goods
28: Euro Zone Flash CPI Estimate; US Prelim Q4 GDP (second estimate); US Consumer Confidence; China Manufacturing & Non-manufacturing PMIs
1: UK Manufacturing PMI; US Personal Income & Spending; US ISM Manufacturing PMI
2: UK Construction PMI; Tokyo Core CPI
3: UK Services PMI; US ISM Non-Manufacturing PMI