Tuesday, October 31, 2017

November-December 2017 Outlook: The Art of the Deal

November-December 2017 Outlook: The Art of the Deal
Tue, 31 Oct 2017 12:47 PM EST

For the next couple of months the macro news cycle will be focused on the progress of a number of significant political and economic deals that have been under intense negotiation. From to the tax reform bill in Washington, to the oil producers’ production accord, to the Brexit talks in Europe, key deals with global implications will see major developments in the weeks ahead. Central banks are also in the process of completing their bargain with the markets: having spared the world from a depression by implementing extreme accommodation, some monetary policy authorities have begun withdrawing stimulus now that the danger has passed.

Developments on all of these fronts will play a strong part in market movements as 2017 comes to a close. Interest rates will be gradually rising as central banks wean the markets off accommodation, while the steady rise in stocks could see a correction if the bond yield curve doesn’t steepen or if some political deals and promised fiscal measures hit roadblocks.


Oftentimes deals with international implications can take longer than expected, and the renegotiation of NAFTA is a prime example. Early on in the Trump Administration, Commerce Secretary Ross expressed confidence that a new deal could be inked by year end. The Mexican and Canadian delegations, however, have shown they are not in a mood to be pushed around, and have since demanded that talks continue through March. Ross conceded to this but continues to threaten to drop the trilateral agreement altogether if they can’t come to terms. The latest reports indicate that White House is most keen on getting stricter rules of origin, requiring that 85% of content come from within the three NAFTA countries, perhaps including as much as a 50% US content requirement. This rule is aimed at Mexican factories in particular on concerns that they are circumventing the spirit of the agreement by bringing in excessive amounts of materials and parts from Asia to be finished in Mexico. The next few months may see reports of progress on these targets or more talk about breaking up the ‘Three Amigos’ in favor of new bilateral trade deals in North America.

The tough trade talks are already influencing other areas of policy for Canada and Mexico. Despite a solid economic rebound and some overheating in the housing sector, the Bank of Canada paused its rate tightening cycle in October after two prior hikes. This was at least in part due to uncertainties over the outcome of the NAFTA talks – the BoC doesn’t want to be caught flat footed if the trade agreement is torn up. Meanwhile the Mexican central bank has been raising rates this year to mirror Fed tightening, but has given signals it will not move higher even if the Fed hikes rates in December. The Banxico has stated that the key rate at 7.00% should adequately rein in inflation, and it is now tilted toward patiently considering when it might CUT rates. The main caveat is that the exchange rate stays relatively stable, which may not be the case if NAFTA falls apart.

Backroom Deals

Corporate expectations for deregulation and tax cuts have continued to drive the stock market higher. The failure of the Republican controlled Congress to pass healthcare reform or any other significant legislation this year has not yet discouraged market expectations of a tax overhaul being accomplished in the next few months.

In recent days, the GOP made some genuine progress by passing a budget plan under ‘reconciliation’ that should allow for the tax reform bill to escape filibuster rules and pass by a simple majority. That maneuver opens a route for the eventual bill to pass in the Senate on a partisan basis, if necessary. The House tax plan will be unveiled on November 1, with committee work on the bill to begin the following week.

GOP leaders seem hopeful that tax reform is so urgent that some Democrats will ultimately support the bill, and as things are playing out they may need those votes. If the bill comes down to a party line vote in the Senate, the GOP can only afford to have two of its members vote against the caucus, which could pose a problem as President Trump has an increasingly contentious relationship with several Republican senators who are not expected to run for reelection (Corker, Flake, McCain) and thus could vote against the tax bill if they object to the legislation or merely want to thwart Trump.

The House Republicans seem to have averted a revolt by northeast Republicans who lodged a protest vote against the budget bill because they disliked plans for removing popular state and local tax deductions in the tax reform plan. To appease these members and their constituents, House Ways and Means Chairman Brady said he would restore an itemized property tax deduction to help taxpayers with local tax burdens. This may be enough to bring wayward rank and file members back to the fold, but it illustrates how difficult it will be to find ways to offset the tax relief that is being offered (i.e. to find the so called “pay-fors”). Every current tax break has strong special interest groups defending it, and it is apparent that the Republicans have abandoned any pretense of presenting budget-neutral tax relief.

Tax reform efforts are also likely to suffer distractions from President Trump’s reflexive attacks on the investigation into Russia’s interference in US elections. Special counsel Mueller has begun serving indictments in the Russia probe, which is all but guaranteed to send the President into a new offensive on Twitter. That drama could escalate quickly if Trump decides to fire Mueller, which would cause even bigger political ripples than the termination of FBI director Comey at the outset of the Russia probe. If the President went that far it could create more conscientious objectors among the Republic moderates and reignite talk about obstruction of justice charges aimed at the White House.

By the same token, the tax reform process could be helped by President Trump’s 12 day state visit to Asia scheduled for early November. Facing off with the Chinese on trade and the North Koreans on the nuclear issue should remove the President from the day to day negotiations on the tax plan, perhaps keeping the temperature down and allowing for old fashioned horse trading and even developing some bipartisan support for the bill. House Speaker Ryan is aiming to get the tax bill through his chamber by Thanksgiving (Nov 23).

Deal or No Deal?

In Europe, negotiations over the Brexit have fallen behind schedule with less than 18 months to go. After months with very little forward momentum, UK Prime Minister May kick-started the talks with her speech in Florence, though it is still unclear if a breakthrough is coming. The Britons want to move on to discussions of new trade terms, but the EU is reluctant start that stage of talks until the matter of UK arrears is settled (the ‘divorce bill’). The latest issue to come to the fore is the length of the transition period after March of 2019. PM May is seeking a two year transition with near status quo relations while the EU want the transition period limited to 20 months because it lines up better with EU budget timelines and certain annual quotas.

The UK continues to threaten a hard Brexit with its refrain that “no deal is better than a bad deal,” and recent reports say that the EU is starting to feel the same way. Reportedly the EU has begun contingency planning for a scenario in which Brexit talks fail to reach a breakthrough at the December leadership summit (Dec 14-15), preventing them from moving on to trade talks. Meetings will continue through November including at an EU ministerial level meeting on November 20. By that time if the UK is still refusing to put up a good faith estimate on the Brexit bill, then the EU may refuse to enter phase two. Putting more pressure on the Brexit talks is the Scottish First Minister Sturgeon, who is making noises about a second independence referendum as she is determined to keep Scotland in the EU single-market and to maintain control of her country’s immigration policy.

Europe’s other burning issue of secessionist sentiment, the Catalonia crisis, will also continue to grab headlines, though the worst of it may be past. The Catalan political insurgency appears to have exhausted itself after forcing the Spanish government to invoke never-before-used constitutional measures to reassert control over the rebellious local government. Madrid has fired the Catalan government and imposed its own central administration over the region.

Separatists led by the CUP party will no doubt plan protests and renew calls for ‘mass disobedience’ in Barcelona which could result in bad optics for the central government, especially if protesters class violently with national police. But the aggressive tactics of the separatists seem to be turning sentiment against them, with one recent poll showing that the secessionist bloc would lose its majority in the Catalan parliament. That polling will be put to the test on December 21, when PM Rajoy has scheduled new local elections. If the separatists have rebuilt support by then and win a fresh majority in the Catalan government, it will create new headaches for Madrid and a further distraction for Europe.

Oddly enough, the usually contentious relations between OPEC members appear more harmonious these days than those among squabbling European nations. OPEC and non-OPEC oil producers will come together at the cartel’s semi-annual meeting on November 30 to discuss the production cutting deal that has been successfully implemented by the diverse group. Indications are that the major players are prepared to extend existing production cuts beyond the current end date. Participants have shown admirable compliance levels so far, and last May they agreed to extend the deal by nine months to March of 2018. At the November OPEC gathering, oil producers are expected to agree to another nine month extension through the end of next year. If compliance levels stay near 100%, that period of time could be enough to wipe out excess oil stocks and firm up the floor price under crude, benefitting all producers (not to mention contributing to healthier inflation levels sought by central bankers in the US and Europe).

The Central Bank Bargain

As central banks start to turn over their policy stance, some key personnel are turning over as well. Most immediately, the Fed Chair sweepstakes is expected to have a winner by early November. The shortlist has reportedly been narrowed from five candidates down to two: Fed Governor Jerome Powell and economist John Taylor. If President Trump truly wants to shake up the Fed, Mr. Taylor would be the more obvious choice, given his popularity among conservative Republicans for his rules-based monetary policy philosophy.

But the latest reports say that Trump and his advisors are leaning towards Powell, who is seen as much more of a status quo candidate. Powell is a Republican, appointed to the Fed in 2012 by President Obama as part of a deal to fill out the board of governors. He previously worked in investment banking, and he has expressed some support for easing financial regulations imposed under Dodd-Frank. On the FOMC, Powell has taken a moderate, pragmatic line, backing the consensus for gradual monetary policy normalization. A Powell Fed would likely be viewed as continuity of current policy, a stability that will be welcomed in most corners of the financial markets.

Other central banks are looking toward continuity as well. Recent reports say that the Bank of Japan Governor Kuroda will be reappointed to another 5-year term after his current term ends in April 2018. Kuroda has been instrumental in carrying out the principles of ‘Abenomics’ and now that the Prime Minister has consolidated his power in a snap election this October the BOJ governor is likely to get the nod for a second term.

It may seem a little early to think about ECB succession, but the Europeans tend to decide on top EU posts early on through consensus building and political deal making. As the ECB looks toward winding down QE it will also wind down the non-renewable term of President Draghi, whose 8-year stint ends in late 2019. All indications are that Berlin will demand its turn at the ECB helm, and Chancellor Merkel is said to gearing up to campaign for Jens Weidmann, president of the Bundesbank. The other likely candidate at this stage is Francois Villeroy de Galhau of the Bank of France. If Weidmann gets the post, his more conservative German economic philosophy will set the tone for central bank policy, which could be a good fit for the post-crisis era. He is also apt to support Merkel’s drive for “more Europe”, seeking a more rapid timetable for elevating European institutions that tie EMU nations closer together with Germany at the core.

On the monetary policy front, both the Fed and ECB have started down the path of normalization. The ECB just announced plans to cut its bond buying program in half to €30B per month starting in the New Year, while extending the earliest end date for the program to by nine months to September 2018. That change met expectations and markets took the announcement in stride.

The Fed is a little farther along, having raised rates off the zero bound already and in November beginning the roll off of assets from its $4.5 trillion balance sheet. This ‘quantitative tightening’ process was laid out in June: the Fed said it would start the reduction with a maximum of $10B of monthly redemptions ($6B of Treasuries and $4B of MBS), and ramp that up by another $10B every three months over the next year, bringing the cap to $50B per month ($30B of Treasuries and $20B of MBS). Those caps will thereafter remain in place so that holdings can “continue to decline in a gradual and predictable manner” until the balance sheet gets down to a level where the Fed deems it is “holding no more securities than necessary to implement monetary policy efficiently and effectively.” Fed leaders have made it clear they want this process to operate in the background, ideally with no impact on markets at all. For their part, the markets have appreciated the painstaking transparency provided by the Fed on this process, and so far have been unfazed, but that does not rule out the possibility of new ‘taper tantrum’ as the Fed reduces its participation in the bond market.

Stock markets that have been buoyed by low rates, strong Q3 earnings reports, and the prospect of a corporate tax cut may start to anticipate headwinds from the Fed shrinking its balance sheet and raising rates in earnest, as well as the ECB’s quantitative easing moving toward its end date. Despite the modest increase in rates implemented by the Fed over the last year, there has been some flattening in the yield curve. In mid-October the spread between 2-year and 10-year narrowed to 0.75, the lowest since before the financial crisis. That type of movement could be an early warning sign of an impending recession, though it could also just be a reaction to the Fed’s reversal of its unprecedentedly easy policy. But to ensure the next recession is pushed off as long as possible, global deal makers have to sharpen their pencils and get to work.

1: FOMC policy statement; US House GOP to unveil tax reform bill
2: UK Construction PMI; BOE policy statement; China Caixin Services PMI; Pres Trump to announce Fed Chair nominee
3: UK Services PMI; US Payrolls & Unemployment; US Trade Balance; ISM Non-Manufacturing Index; US Factory Orders

7: China Trade Balance
8: US JOLTS Job Openings; China CPI & PPI
9: UK Manufacturing Production
10: Preliminary University of Michigan Consumer Sentiment

13: China Industrial Production
14: UK CPI & PPI; Euro Zone Flash GDP; German ZEW Economic Sentiment; UK Autumn Forecast (tentative); US PPI; Japan Prelim Q3 GDP
15: UK Claimant Count & Unemployment; US CPI; US Retail Sales
16: UK Retail Sales; Euro Zone Final CPI; Philly Fed Manufacturing; US Industrial Production
17: ECOFIN Meetings; US Housing Starts & Building Permits

21: US Existing Home Sales
22: US Durable Goods Orders; FOMC Minutes
23: Various EU Flash Manufacturing & Services PMIs; ECB Minutes; THANKSGIVING DAY (US)
24: German Ifo Business Climate

27: US New Home Sales
28: UK Bank Stress Test Results; BOE Financial Stability Reports; UK Q3 GDP (2nd estimate); US Consumer Confidence
29: US Prelim Q2 GDP; China Manufacturing & Non-Manufacturing CPI
30: OPEC semi-annual meeting in Vienna; German Retail Sales; Euro Zone Flash CPI Estimate; Chicago PMI
1: UK Maufacturing; ISM Manufacturing PMI

4: UK Construction PMI; US Factory Orders; China Caixin Services PMI
5: UK Services PMI; US Trade Balance; ISM Non-Manufacturing PMI
7: Japan Final Q3 GDP; China Trade Balance (tentative)
8: UK Manufacturing Production; US Payrolls & Unemployment; US JOLTS Job Openings; China CPI & PPI

12: UK CPI & PPI; German ZEW Economic Sentiment; US PPI
13: UK Claimant Count & Unemployment; US CPI; FOMC Policy Statement, SEP & Press conference; China Industrial Production
14: UK Retail Sales; BOE Policy Statement; ECB Policy Statement; US Retail Sales; Japan Tankan Manufacturing & Non-manufacturing Indexes; European Council Meeting (Dec 14-15)
15: US Industrial Production; Preliminary University of Michigan Consumer Sentiment

18: Euro Zone Final CPI
19: German Ifo Business Climate; US Housing Starts & Building Permits; US Consumer Confidence
20: US Existing Home Sales; BOJ Policy Statement
21: Catalonia elections; Various EU Flash Manufacturing & Services PMIs; Philly Fed Manufacturing Index
22: UK Current Account; US Durable Goods Orders; US Personal Spending; US New Home Sales

29: Chicago PMI
30: China Manufacturing & Non-manufacturing PMIs
31: China Caixin Manufacturing PMI