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September-October 2017 Outlook: Hurricane Watch
Thu, 14 Sep 2017 14:42 PM EST
The 2017 Atlantic Hurricane Season has already been one of the most active and
destructive in years, and the rare occurrence of three simultaneous hurricanes
seems an apt metaphor for the geopolitical, monetary, and fiscal storm fronts
churning around the fringes of the global economy. Like their real world
counterparts, these metaphoric storms could make landfall with serious
consequences to the economy, but they are inherently unpredictable and could
also blow harmlessly out to sea or in some cases even provide a healthy
tailwind.
As global economies are starting to reach a stage of sustainable economic
recovery, geopolitical disturbances have flared up, most notably the tempest
brewing over North Korea. Amid these tensions and a sudden flurry of natural
disasters striking North America, central bankers are putting their fingers in
the wind, left to guess whether they can continue to remove accommodation or if
they need to take a pause. Meanwhile, fiscal authorities remain bogged down in
political disputes, most visibly over tax and spending policies in the US and
in the Brexit negotiations between the UK and EU.
Inherit the Wind
In the final accounting, hurricanes Harvey and Irma will have dealt tens of
billions of dollars in damage to homes and businesses, and have already caused
significant disruption to the regional economy. Some economists have estimated
that by itself Harvey will hit Q3 GDP by about three-tenths of a percentage
point. Irma may double that temporary economic dampener. The silver lining, if
any, is that the GDP hit is expected to be more of a deferral as the rebuilding
effort on the Gulf coast should provide a small boost to Q1 GDP next year.
The storms that have battered Texas and Florida are overshadowing the usual hot
air swirling out of Washington, D.C. For the time being, the focus is on relief
efforts across the south, which has quieted party politics in Washington, and
provided President Trump an opportunity to show leadership in a non-partisan
moment when the country is drawn together to address on the aftermath of the
hurricanes.
In the eyes of some of his fellow Republicans, Trump may have carried this
spirit too far when he snubbed his own party’s advice and embraced a Democratic
proposal for a three month extension of the debt ceiling and government funding
as part of a package to provide disaster relief. It’s not clear if this
rapprochement with the Democrats is signaling a new governing style from Trump,
but it could theoretically allow him to reposition himself as a neutral arbiter
of ideas in a still dysfunctional Washington. After months of the President
goading his own party to action with little success, Republicans can no longer
assume that Trump will stick to their talking points on the legislative agenda.
Yet it’s also unlikely that the President will stay on friendly terms with
Democrats for long, given his bluster and mercurial loyalties.
In any event, the three month deal gave the minority party some leverage
heading into legislative negotiations this fall. With the GOP off balance,
Democrats could find themselves with more influence in the tax reform debate.
Democrats might get on board with tax simplification, but there are strong
interest groups standing guard over various deductions, so it may be a tough battle
to strip down itemization even if the Republican plan includes a doubling of
the standard deduction, as reported. Since the debt ceiling deal, Speaker Paul
Ryan has conceded that a 22.5% tax rate for corporations is a “realistic” goal
(as opposed to the Freedom Caucus proposal of taking the corporate rates from
35% down to 16%, and the President’s opening bid of 15%). Ryan asserts that
Congress has made good progress on fleshing out the thumbnail proposal the
White House produced earlier this year, and that their plan will be unveiled in
late September with the hope of passing legislation before year end. The stock
market continues to anticipate that some major reform legislation will get
through Congress this year, and equities could resume their surge higher if
such a bill passes, especially if it is the much-sought tax reform package.
On another front, the Trump Administration is hoping to fulfill its promises on
revitalizing trade. Commerce Secretary Ross has set the goal of renegotiating
NAFTA by year end, and there have been a few meetings already with high level
Mexican and Canadian delegations. Mexican finance minister Meade recently
proclaimed that the trade talks are progressing as expected, and Canadian PM
Trudeau has said he wants to use this opportunity to make progress on labor and
climate issues. It should become clear in the next couple of months if the
three-party talks are indeed making any headway. If not, expect President Trump
to renew threats of withdrawing from NAFTA altogether, which could exert fresh
headwinds on North American currency pairs.
Across the Atlantic, an even more complex and contentious negotiation is under
a dark cloud. The Brexit clock is ticking: under the Article 50 provision of
the EU charter, there are now less than 20 months to sort out the UK’s divorce
from the European Union. To date, negotiators have had three rounds of talks
but have not made any tangible progress. Following the third round in late
August, the EU’s chief negotiator Barnier stated that they had not made enough
progress on the early issues including the Irish border to move on to free
trade discussions in October.
In an effort to maintain pressure on EU negotiators, UK Prime Minister May has
kept up the public refrain that no Brexit deal is better than a bad deal. The
next round of talks has reportedly been pushed back a week to accommodate a
speech that PM May is planning to make on the issue on September 22 from
Florence. The PM’s office has been vague about the details of the address, and
is calling it an “update” on the Brexit negotiations that will “underline the
government’s wish for a deep and special partnership with the European Union
once the UK leaves the EU.” This could be the most important moment of May’s
tenure as her words will act as a barometer for the negotiations. The speech
will be closely watched for any sign of softening in Britain’s stance.
For their part, EU negotiators have taken a tough line, chiding their UK
counterparts for producing incomplete position papers and threatening to delay
the next stage of scheduled talks by two months to December. That decision will
likely come at the conclusion of the fourth round of preliminary talks in late
September, and such a delay would be a blow to the UK and its hopes of disentangling
itself from the EU within the prescribed two year window. If a more
constructive tone is not established in the next few months it could reignite
speculation about a ‘Hard Brexit’ scenario, which could roil markets,
especially in the UK.
So far the UK has been spared the gale force economic headwinds that were
predicted before the Brexit vote, but as talks have begun in earnest the
economic realities of leaving the EU bloc may take hold. The UK reported
final Q1 GDP growth of only 0.2% q/q, the slowest rate in a year, and the
preliminary Q2 reading was only slightly better. The direst predictions for a
nearly 10% drop in GDP through 2030 may not come to pass, but uncertainty could
grow as the process drags on and cause UK consumers to moderate their spending
in the months ahead.
Elsewhere in Europe, German national elections will be held on September 24,
selecting the members of the Bundestag, Germany’s federal parliament.
Chancellor Merkel appears to be on track to win reelection, as her center-right
CDU party is consistently leading the Social Democrats (SPD) by double digits
in the polls. The same polling suggests that Germans are content with their
current government, a grand coalition of the CDU and SPD, which may lead to
another term under that structure. The CDU could also seek a renewed alliance
with the conservative Free Democratic Party (FDP), which acted as its junior
coalition partner during Merkel’s 2009-2013 term. Barring another polling snafu
(a la Brexit), Merkel’s fourth term as Chancellor appears to be secure, which
should be a calming influence at the center of Europe after the wave of
surprising voting outcomes last year.
Winds of War
More stability in Europe will be welcome given that security situation in Asia
is deteriorating. North Korea’s repeated missile and bomb tests have put the
Hermit Kingdom at the center of the geopolitical stage, and Pyongyang’s
aggressive posture has even unnerved its traditional state ally in Beijing. It
is notable that China has declined to veto recent UN Security Council sanctions
against North Korea, though it remains to be seen if China will choose to
enforce sanctions that could cripple the North’s economy.
President Trump has taken a tough rhetorical stance with North Korea, culminating
in his unscripted “fire and fury” threat, which was subsequently supported by
Defense Secretary Mattis in other very direct language. North Korea’s state
press has responded with more frequent declarations about annihilating the US.
So far, the markets have not concluded that a shooting war is imminent, but
that could change at any time with the Trump administration apparently resolved
that the status quo on the Korean peninsula is no longer tolerable.
The Trump administration has also had its sights set on Iran. The President has
made it clear he thinks the nuclear agreement with Iran (JCPOA) was a “bad
deal”, and has directed his cabinet to look for evidence it can use to revoke
the accord. Congress requires the administration certify Iran’s compliance
every 90 days, and the Trump White House has given that certification twice so
far. During the July review, however, Secretary of State Tillerson said that
his department will “evaluate whether suspension of sanctions related to Iran
pursuant to the JCPOA is vital to the national security interests of the United
States."
There is some speculation that the State Department may be prepared to declare
a finding of non-compliance at the next review in mid-October. That would put
the US at odds with the UN’s nuclear watchdog (the International Atomic Energy
or IAEA) which is in charge of verifying that Iran is meeting its obligations
to pursue only peaceful applications of nuclear energy. That may leave the
White House on thin ice, likely having to assert that Iran is violating the
‘spirit’ of the accord with its ballistic missile tests and continued support
of terrorist organizations, though those bad behaviors are not specifically
barred by the agreement.
A confrontation with Iran could set off speculative activity in the energy
market. Heightened tensions in the Persian Gulf could send oil prices higher
even as the Gulf of Mexico’s refinery row is still recovering from Hurricane
Harvey.
For the first time since Katrina devastated New Orleans in 2005, a hurricane
has caused significant damage to the Gulf Coast and disrupted its key energy
assets. Hurricane Harvey parked itself over Houston for half a week, causing
serious property damage with record flooding. The Houston petro-chemical
complex got through the storm with minimal damage, but about 15% of the
nation’s refinery capacity has been taken off line, and it appears that it will
take several weeks to normalize operations.
For the last two months, WTI crude prices have remained in a fairly tight range
in the high $40’s. Crude prices have stabilized as OPEC and its non-cartel
partners have maintained strong compliance with their production cutting deal,
and as the rise in the US shale oil rig count has finally leveled off. The
production accord was already extended by nine months to March of 2018, and now
major producers are said to be pushing for another extension of at least three
more months. That would provide more time for oil market imbalances to subside.
Recently, OPEC Secretary General Barkindo noted progress on this front,
observing that OECD commercial oil stocks stood at 195M bbl above the 5-year
average in July, down from 340M bbl above average in January. Barkindo also
forecast that higher oil demand in the second half of the year will contribute
to additional declines in oil stocks.
Shelter from the Storm
As geopolitical forces swirl and fiscal policy reform moves at a glacial pace,
global central banks are still providing significant shelter from the storm. A
sea change is underway, however, as the Fed will soon announce a balance sheet
reduction plan while the ECB has begun considerations on how to end its
long-standing QE program.
Of the major central banks, the Fed has made the most progress toward
normalizing policy after a decade of extreme accommodation, but the devastation
caused by Harvey and Irma may be enough to give the Fed pause in considering
its third rate hike this year. Prior to the storms materializing, the central
bank appeared to be firmly on track to raise rates one last time in December,
following an expected announcement about balance sheet reduction at the
September 20 FOMC meeting. At this point, not even the category 5 winds of Irma
could blow the balance sheet announcement off course, but if the storm damage meets
some of the worst case estimates, the Fed may err on the side of caution and
hold off on another rate hike.
The policy statement has made it clear that pace of tightening will be
“gradual,” and Fed members have observed that the current neutral rate is much
lower than historical levels, with some officials reckoning it to be well below
3.00%. In addition, inflation remains stubbornly low despite continued strong
jobs growth. Fed members have no good explanation for the absence of any real
signs of inflation pressure (notwithstanding the new $1,000 iPhone X), and
merely describe the low unemployment, low inflation environment as “puzzling.”
Given these points, the central bank will not rush to tighten rates through the
last months of the Yellen era, unless incoming inflation data starts to blow
the doors off of expectations.
Earlier this year, the Fed proved it can change expectations quickly and
effectively if needs be. In the course of one week, Fed speakers unleashed a
barrage of hawkish language that shifted fed funds futures from seeing little
chance of a March rate move to a near certain expectation of a hike, all
without creating a ripple in the markets. That experience should give the Fed
confidence that the markets will pay heed if the Fed ramps up the dovish
rhetoric after assessing hurricane damage or responding to geopolitical
uncertainties.
The question of who will lead the Fed through this critical period becomes more
momentous as more of the current board steps aside. The early resignation of
Fed Vice Chair Fischer has opened up yet another seat on the Board of
Governors, giving President Trump an unprecedented opportunity to put his stamp
on the central bank. So far, however, the Trump has not made filling the Fed
vacancies a priority, with only one nominee put forward so far (Randal Quarles
who is set to get Senate approval this month). The latest reports say that
White House staffers are vetting Fed governor candidates that include bankers
and economists, but that President Trump is not deeply involved in the process.
Even with several board seats remaining open, most of the speculation has been
around who the next Fed Chair will be. The leading candidate had been economic
advisor Gary Cohn, but he is now on the outs after he publically criticized the
President’s statements on Charlottesville. The former Goldman COO Cohn is a
Wall Street darling and is seen as a stabilizing force in the White House
economic policy, and for the time being he is said to be focused on putting
together a viable tax reform plan. Reports say that at least a half-dozen
candidates are being considered for the Fed Chair post.
The historic precedent of new Presidents reappointing Fed Chairs regardless of
party for the sake of continuity does not seem to suit Trump’s style, but there
has been some speculation about an outlying scenario in which Janet Yellen gets
reappointed. Though Yellen has not commented on her tenure beyond saying that
she intends to stay through the end of her term in February, even if Trump offered
her a chance at a second term, this scenario seems unlikely after Vice Chair
Fischer resigned and given the political pressure being exerted on Yellen to
decline on the grounds that staying could be taken as an endorsement of Trump.
The European Central Bank is also preparing for the reversal of its
historically easy monetary policy, now that the economic recovery in Europe has
taken hold. Notably euro zone unemployment has reached an eight
year low at 9.1%, even though inflation continues to lag the near 2% target.
Amidst the improved data, the euro has strengthened nearly 15% this year, an FX
move that some analysts equate to as much as 50 basis points of monetary policy
tightening. The currency appreciation may also be in anticipation of an ECB announcement
on the wind down of its quantitative easing program that has been operating
since early 2015.
At this month’s ECB policy meeting, President Draghi expressed comfort with the
expected October timing on a QE announcement, though he gave himself some
wiggle room in the event of unexpected macroeconomic events that could cause a
postponement. Market watchers will have to gauge events and data over the next
month to determine whether they believe Draghi has the resolve to begin
dismantling the QE program without further delay.
It’s still not entirely clear whether the ECB will provide a full accounting of
the plan at the October 26 meeting or just give broad strokes that can be
fleshed out by the mid-December meeting. The latest press reports say that the
ECB governing council has been discussing four scenarios for QE including a
possible 6-month or 9-month extension of the program (from the tentative
December end date), as well as a reduction in the bond buying pace to
€40B/month (from current level of €60B). Concurrent reports say that the
2018-2019 inflation forecast will be cut slightly, perhaps signaling no great
rush to unwind accommodation.
The winds are shifting at other central banks as well. Though the Bank of Japan
has maintained its soft pledge to increase Japan government bond (JGB) holdings
at a pace of roughly ¥80T annually, in reality it has been slowing the pace of
purchases all year. The BOJ has the flexibility to increase bond purchases – as
it did in early July to respond to a spike in the 10-year JGB yields to 0.105%
– but the overall trend remains downward. Meanwhile the Bank of England is
making noises about rate policy again. Since its March meeting, the BOE has had
at least one hawkish dissenter calling for a rate hike. Governor Carney
punctuated the September meeting by stating that a rate adjustment may be
needed in the coming months, so the BOE may now be on track to raise rates even
before the Fed tightens again.
SEPTEMBER
1: US Payrolls & Unemployment; ISM Manufacturing PMI
4: UK Construction PMI; US Memorial Day holiday
5: UK Services PMI
6: US Trade Balance
7: ECB Policy Statement & Press Conf; Japan Final Q2 GDP; China
Trade Balance (tentative)
8: UK Manufacturing Production; UK JOLTS Job Openings; China CPI & PPI
11:
12: UK CPI & PPI
13: UK Claimant Count & Unemployment; US PPI; China Industrial Production
14: UK Retail Sales; BOE Policy Statement; US CPI
15: US Retail Sales; US Industrial Production; Prelim University of Michigan
Confidence
18: Euro Zone Final CPI
19: German ZEW Economic Sentiment; US Housing Starts & Building Permits
20: US Existing Home Sales; FOMC Policy Statement & Press Conf
21: BOJ Policy Statement & Press Conf; Philadelphia Fed
Manufacturing Index
22: Various EU Flash Manufacturing and Services PMIs; PM May’s speech on
Brexit from Florence
23: New Zealand elections
24: German federal election (Bundestag)
25: German Ifo Business Climate
26: US Consumer Confidence; US New Home Sales
27: US Durable Goods Orders
28: US Final Q2 GDP; China Caixin Manufacturing PMI
29: German Retail Sales; UK Current Account; UK Final Q2 GDP; Euro Zone Flash
CPI; US Personal Spending; Chicago PMI; China Manufacturing &
Non-Manufacturing PMIs
OCTOBER
1: Japan Tankan Manufacturing & Non-Manufacturing Indices
2: UK Manufacturing PMI; US ISM Manufacturing PMI
3: UK Construction PMI
4: US Services PMI; US ISM Non-Manufacturing PMI
5: ECB Minutes; US Trade Balance; US Factory Orders
6: US Payrolls & Unemployment
9:
10: UK Manufacturing Production; UK Goods Trade Balance; US JOLTS Jobs Openings
11: FOMC Minutes
12: US PPI; China Trade Balance (tentative)
13: US CPI; US Retail Sales; Prelim University of Michigan Sentiment
15: China CPI & PPI
16: US Empire State Manufacturing
17: UK CPI & PPI; German ZEW Economic Sentiment; US Industrial Production
18: UK Claimant Count & Unemployment; US Housing Starts & Building
Permits; China Q3 GDP; China Industrial Production; China
19thNational Congress of the Communist Party of China opens
19: UK Retail Sales; Philadelphia Fed Manufacturing Index
20: US Existing Home Sales
23: Various EU Flash Manufacturing & Non-Manufacturing PMIs
24:
25: German Ifo Business Climate; UK Prelim Q3 GDP; US Durable Goods
Orders; US New Home Sales
26: ECB Policy Decision & Press Conf
27: US Advance Q3 GDP (1st reading)
30: German Retail Sales; US Personal Spending; China Manufacturing &
Non-Manufacturing PMIs; BOJ Policy Decision & Press Conf
31: Euro Zone Flash CPI Estimate; Euro Zone Prelim Q3 GDP; US Employment Cost
Index; Chicago PMI; US Consumer Confidence; China Caixin Manufacturing PMI
NOVEMBER
1: UK Manufacturing PMI; US ISM Manufacturing PMI; FOMC Policy Decision
2: UK Construction PMI; BOE Policy Decision & Press Conf
3: UK Services PMI; US Payrolls & Unemployment; US ISM
Non-Manufacturing PMI; US Factory Orders
