Tuesday, March 6, 2018

March-April 2018 Outlook: The Shape of Water

TradeTheNews.com March-April 2018 Outlook: The Shape of Water
Mon, 05 Mar 2018 23:21 PM EST

For two years, equity markets rose steadily, matching the longest streak ever without a correction. This extended one-way market was devoid of volatility and became very predictable. That period ended abruptly in February when global stock indices tumbled into a correction brought on by worries about higher interest rates and exacerbated by complacency (manifested in a complete malfunction in some of the financial instruments used to bet on volatility). Before last month, the markets were like a flood tide steadily inching higher and raising all boats, but now predicting the market is suddenly like describing the shape of water: amorphous and inconstant.

The prospect of a trade war has prolonged the volatility into March and may wash over market sentiment for months to come, potentially sending ripples through the delicate negotiations over NAFTA and the Brexit. Further, the threat of a wider trade war or even a shooting war with North Korea may alter the calculus of central banks as they plot their return to normalized policy. These political challenges along with concerns about rising interest rates will continue to churn markets for the foreseeable future.

Monetary Policy: “Get Out”

The Fed and other central banks have patiently waited for the moment when they could begin to get out of their extraordinarily accommodative stance and finally normalize monetary policy. After a decade of near- or sub-zero rates and an array of experimental quantitative easing measures, we are entering the era of 'quantitative tightening' (as dubbed by bond baron Jeffrey Gundlach). The Fed has started to shrink its balance sheet and has been raising rates for more than a year, while the ECB and BOE are starting to plan their own exit strategies. In the years ahead, the great unwind of government bond holdings by central banks will distort yield curves as central banks reduce their holdings of global sovereign bonds from the current 33% back toward a pre-crisis sovereign holdings that were less than half that percentage.

The Fed is leading the cycle and as its new Chairman Jay Powell takes office, he faces the task of removing accommodation in such a way as to lift inflation back to the 2% target level without extinguishing growth prospects (by raising rates too fast) or letting the economy overheat (by raising too slowly). In his first appearance before Congress, the plain speaking Fed Chair unnerved markets with his hawkish demeanor (relative to former Chair Yellen). Powell said he has no concern about the flattening yield curve and sees little chance of a recession in the next two years. Further, he stated that the data and fiscal stimulus enacted since December made him more confident that inflation is moving to target and that the Fed now must “strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis.” The choice of the word “overheated” firmed up market expectations for three Fed rate hikes this year (as reflected in Fed funds futures), and got some market participants thinking about a four-hike year.

Better growth, higher wages, and firming oil prices could collaborate to spark faster inflation in 2018, presenting a challenge for Fed policy. GDP forecasts from the New York and Atlanta Fed Banks both see 3% or better growth in the first quarter. Average hourly earnings were better than expected in January, rising 2.9% year on year, matching the highest wage inflation since 2009. And there is growing demand for commodities: Copper and WTI crude prices have recently touched 3-year highs. Outside of exogenous events, a Fed overreaction to these improving trends could be the biggest risk to the building economic cycle. If inflation makes a sudden resurgence it could spook the Fed into raising rates faster to blunt it. Markets that have gotten so used to cheap credit could tighten up as borrowing rates hit milestones not seen in a decade.

Fed fund futures show the markets are anticipating rate hikes in March, June and then December. The persistent weakness in the greenback confirms that this rate path is baked in and at this point any monetary policy surprises will probably come from the other global central banks. For the most part, those other central banks are holding their policy steady, with only minor tweaks to lessen accommodation. The European Central Bank is debating whether it should clarify when rates will rise (likely not till 2019), the Bank of England could raise a second time in May, and the Bank of Japan remains committed to ultra-loose policy even though economic conditions have improved.

The demise of the deflationary threat to Japan has some market watchers thinking about when the Bank of Japan will start to unwind its extraordinary accommodation. A surprise cutback in Japanese government bond purchases in early January sparked some speculation that the BOJ was preparing its exit strategy. Contributing to that sense, there have also been a few BOJ policy board members questioning the necessity of the BOJ’s buying of exchange traded funds (ETFs) in the midst of a global rally in stocks. These notions were quashed in a recent speech by BOJ Governor Kuroda. Having secured a second 5-year term, Kuroda stood his ground, emphatically stating that the BOJ will continue “powerful monetary easing” to achieve its price goal. Though headline CPI hit its highest level in nearly three years at 1.4% in January, it remains well short of the target. Still Kuroda does have an eye toward the future, saying that easing will not continue once CPI reaches 2% in “stable manner,” and that normalization, once it begins, will be very gradual.

The BOE took back one 25 basis point cut last November, lifting the base rate to 0.50%. At the same meeting the BOE established that future rate hikes would be “gradual and limited,” now a familiar phrase from central banks. Then in February, after some better than expected growth data, the BOE took a more hawkish lean, hinting that more rate hikes may necessarily occur earlier and to “a greater extent” than envisioned just three months ago. That reckoning sent the pound sterling to its strongest level against the dollar since the June 2016 Brexit vote. In the days since the BOE’s February statement, the bank’s chief economist Haldane has put a finer point on the policy. Haldane noted the central bank is in “no rush” to raise rates, and that rates won't remotely go back to levels seen in the past, but any inflationary threat to the cost of living will be met with more rate hikes. With that said markets are now betting that the next 25 basis point hike will arrive in May.

In the euro zone, the ECB remains satisfied with the effects of its policy on improving growth and investment. As for normalization, the governing council is unanimous in its view of policy sequencing, saying that interest rates will not be hiked before the bond buying (QE) program is completed. The devil is always in the details as members are now debating whether to clarify the current interest rate guidance that rates will stay at current levels “well past” the end of the QE program, which would be in September at the earliest, and is likely to stretch to year end. Some board members see the “well past” language as too vague and worry that it will generate unwanted volatility. The counterargument is that setting a clearer date for rate liftoff in Europe could stifle the economic progress that’s been made, as industry and markets worry about a date certain for higher rates. Whatever the decision, the ECB has to be cautious about constructing its exit strategy because it must account for a scenario in which the Brexit is not well managed.

Brexit Talks: “Dunkirk”

It’s not certain that this is another Dunkirk moment for the UK, but many Britons already feel regrets about the referendum that began the nation’s 21st century retreat from continental Europe. Though not under direct fire from the Germans this time around, Britain looks indecisive at times and the exit talks are getting bogged down. This may have contributed to the February market correction that saw European bourses post their worst month since June 2016, when Brexit referendum shocked the world.

A Eurogroup meeting on March 12 will be a key moment for the Brexit negotiations. At this meeting the Europeans will set the guidelines for their transition-period discussions with the UK, aiming for a fully crafted withdrawal agreement by October or November. Both sides are still talking tough: the European’s chief negotiator has said that a transition is NOT a given if disagreements persist, while the UK Brexit Minister’s refrain continues to be that “no deal is better than a bad deal.” Substantial differences do remain on trade issues such as the arbitration mechanism, and the thorny Irish border issue is still not fully resolved.

Even the length of the Brexit transition period remains in dispute, and this may be the next milestone to watch for in the talks. So far, the Europeans have argued for the transition period to be as short as possible, favoring a 21 month stretch ending after 2020, which coincides with the end of a multi-year budget round, simplifying financial matters. On the other side of the table, the Britons are pushing for a more flexible Brexit implementation period of two-years or more to ensure they can make all the necessary preparations, including an overhaul of physical port infrastructure to cope with a dramatic increase in customs checks (work that has not begun yet, nearly two years after the referendum). The EU has signaled it may grant some flexibility on this issue, but that will require the UK to give some concessions such as withholding restrictions on free movement of EU citizens in the country during the transition. If dealmakers can’t forge an acceptable agreement on this timing issue, it will undoubtedly set back the even more complex trade talks that need to take place.

Trade War: “Phantom Thread”

The ‘invisible hand’ in economic theory that brings markets into equilibrium has been manipulated for the last ten years by central banks showering the global economy with massive stimulus packages. But just as that era is beginning to end, a very visible hand is tugging at a phantom thread that could unravel the entire global trade apparatus that has been painstakingly woven together over the last seven decades.

Since entering office over a year ago, President Trump has railed against “unfair” trade deals, but there was little action beyond lip service. In February, however, the Commerce Department issued its long awaited analysis on industrial metals trade, and the President pounced. Without much apparent consultation with advisors or Congressional leaders, Trump announced tariffs on steel and aluminum that were even higher than the Commerce Department’s minimum recommendations (at 25% and 10% versus the proposed 24% and 7.7%). Notably Trump chose a global tariff scheme over other proposals that would have set import quotas or used more targeted tariffs to punish problem producers. Commerce Secretary Ross defended the plan, saying the tariffs need to be global to ensure the worst offenders get squeezed and arguing the impact on consumer prices will be negligible, perhaps raisings costs by 1% on products from cans to cars.

President Trump’s decision to impose tariffs on industrial metal imports was a boon for the US steel and aluminum industry, but it has already sent a chill through in the broader markets on worries about higher basic materials costs and the threat of a trade war. The plan has been panned by many economists who equate tariffs with taxes, the WSJ described it as “folly”, and the stock market that Trump uses as his personal performance indicator dropped markedly. Shortly after President Trump cavalierly leaked his decision on tariffs, senior officials from the EU, Canada and other trading partners condemned the plan and assured there will be consequences if the US follows through. The EU indicated that it would impose duties on popular US brands such as Levi’s and Harley Davidson as well as on bourbon, a major export from Senate majority leader McConnell’s home state.

The new tariffs could be the last nail in the coffin of the North American Free Trade Agreement. The seventh round of NAFTA trade talks is underway in early March, and the negotiations remain tense amid reports the US is making onerous demands that Canada and Mexico seem unwilling to concede to. The imposition of a flat global tariff on steel and aluminum from the US’ two closest trading partners could be enough to extinguish hopes for a NAFTA renegotiation.

There may still be a glimmer of hope if the Trump administration shows some flexibility. Already industry voices ranging from Alcoa to the United Steelworkers Union are calling on the White House to exempt Canada from the new tariffs. An exemption would not be unprecedented as Canada and Mexico were spared from steel tariffs the last time the US resorted to the tactic in 2002, during the Bush administration. The auto industry is applying pressure too, worried about higher materials costs, but more importantly concerned that its longstanding and intricate cross border supply chain won’t be disrupted. Senior Republicans in Congress, including Speaker Ryan, as well as some major campaign donors are also urging the President to reverse or modify his decision.

But it may be hard to deter Trump as he pursues his vision of revitalizing the US steel industry. His initial reaction to the criticism was to tweet "trade wars are good, and easy to win." Trump may be gambling that corporations will absorb higher costs from their tax cut profits and that trading partners will fear losing access to the world’s biggest market. Unfortunately it appears other nations are ready to call his bluff, and Trump has responded to this by threatening to raise duties on automobiles shipped from Europe. A worst case scenario would be a trade war escalating to the point where the Trump administration withdraws from the WTO, an organization whose members largely comply with its rules, which are the cornerstone for most global trade agreements. Unraveling the WTO would lead to major disruptions in global trade that could set off a new recession.

Geopolitics: “Darkest Hour”

The darkest hour for the global economy and markets is not likely to come in disputes between the US and its allies, but in confrontations with enemies and rival powers. So far, President Trump has not applied that same bravado toward conventional wars as in trade wars, but he does seem bent on finding adversaries to measure himself against. Conflicts with China, North Korea, Iran and Venezuela all have the potential to disrupt orderly global markets.

So far China has taken a typically understated tone in response to the US tariff threat, responding that it may take measures to protect its own interests. The new metals tariffs won’t put a dent in the US trade deficit with China, which directly supplies less than 3% of US steel imports. Critics of the President’s plan say it should be more targeted, aimed squarely at China’s exports and its violations of intellectual property. Even though China does not want a trade war, if it finds itself singled out in this way, it is likely to retaliate. One option for China could be to slow purchases of US treasuries, which have already become less attractive assets as the face a bear market (with the 10-year yield approaching the a key 3.00% level and the 30-year testing major resistance at 3.22%). But whatever the response, it would invite further tit for tat escalations between the world’s two largest economies, an unwelcome scenario for the global outlook.

Tangling with China on trade is also counterproductive to contending with the nuclear threat from North Korea. The spectacular Winter Games in PyongChang brought with it a period of détente, as athletes and delegates from the North joined the festivities. Skeptics see the easing of tensions as the same old script from the North: conducting provocative tests of its WMD programs until sanctions are enacted, and then making conciliatory gestures in an effort to gain relief. The South Korean government is taking the lead for the moment, exploring talks with Pyongyang. But as the aura of the Olympic moment fades, chances for a political breakthrough dim along with it. Annual joint military exercises between the US and South Korea that were postponed as a good faith gesture for the Olympics will resume sometime after the Paralympic Games end on March 18. Meanwhile the Pentagon continues to refine plans for a potential military strike on the North’s weapons facilities.

The other remaining member of the once so-called “Axis of Evil,” Iran, will also be getting new attention from the White House in the months ahead. In mid-January President Trump signed another 90-day waiver on Iran sanctions, but stated that it would be the last time he will extend the waiver. To keep the US as a participant in the nuclear accord the White House is demanding that the deal be reopened to make the terms tougher and permanent with no sunset clause. Having set a countdown clock, President Trump says he will withdraw from the Iran nuclear deal immediately if he believes a revised agreement is not within reach. US officials say they are working with European partners on new provisions for the nuclear deal but there are no signs that any real progress is being made or that any allies want to revisit the nuclear agreement at this time. The Trump Administration’s end game appears to be goading the Iranians into tearing up the treaty and restarting their weapons program, giving the US an opportunity to confront Iran, but Tehran is more likely to use the US move as a talking point and perhaps as an excuse to cheat around the edges of the accord.

Venezuela may also become a political flashpoint as long-simmering tensions could come to a head around the April 22 presidential election. The political opposition has already said it will not participate in what it considers a sham election after President Maduro reorganized the government to ensure he would hold on to power. The violent protests seen last year may flair up again around the election, which could lead to disruptions in Venezuela’s two million barrels-per-day supply of oil. Recent reports citing unnamed US officials say the White House is mulling sanctions aimed at pressuring Maduro. This could involve restricting insurance on oil shipments or even a complete US embargo on Venezuelan oil – a measure that would cause at least a short term oil market shock.

President Trump also imagines enemies within US borders. His original deadline to end DACA renewals for the so-called “Dreamers” was set for March 5, but a federal court has blocked that move, ordering renewals to continue. In the meantime Congress has made no visible progress on a broader immigration deal after the President torpedoed a bipartisan effort last month. The issue continues to be entangled with government funding measures and the latest stopgap spending bill will run out on March 22. If the administration and the Democrats can’t come to terms on immigration before then, a longer government shutdown may result. Estimates are that each week of a shutdown can shave a tenth of a percent off of quarterly GDP. That would squander much of any effect from the tax cut that is so far Trump’s signature political achievement.

4: China Caixin Services PMI
5: UK Services PMI; ISM Non-Manufacturing PMI
7: UK Annual Budget Release; China Trade Balance
8: ECB Policy Decision & Press Conf; BOJ Policy Decision
9: UK Manufacturing Production; US Payrolls & Unemployment

12: Eurogroup March Meeting
13: German ZEW Economic Sentiment; US CPI; China Industrial Production
14: US Retail Sales; US PPI
15: Philadelphia Fed Manufacturing Index
16: Euro Zone Final CPI; US Housing Starts & Building Permits; US Industrial Production; Preliminary Univ of Michigan Consumer Sentiment

20: UK CPI & PPI
21: UK Claimant Count & Unemployment; US Existing Home Sales; FOMC Policy Statement & Press Conf
22: Euro Zone Manufacturing & Services PMIs; German Ifo Business Climate; UK Retail Sales; BOE Policy Statement
23: US Durable Goods Orders; US New Home Sales; US stopgap spending measure expires

27: US Consumer Confidence
28: US Final Q4 GDP
29: German Preliminary CPI; UK Current Account; UK Final Q4 GDP; US Personal Income & Spending
30: Chicago PMI; China Manufacturing & Non-manufacturing PMIs

1: China Caixin Manufacturing PMI
2: UK Manufacturing PMI; US ISM Manufacturing PMI
3: German Retail Sales; UK Construction PMI; China Caixin Service PMI
4: UK Services PMI; Euro Zone CPI Estimate; US ISM Non-Manufacturing PMI
5: ECB Minutes
6: US Payrolls & Unemployment

10: German ZEW Economic Sentiment; US PPI; China CPI & PPI; China Trade Balance
11: UK Manufacturing Production; US CPI; FOMC Minutes
12: BOE Credit Conditions Survey; US Import Prices
13: Preliminary Univ of Michigan Consumer Sentiment

16: US Retail Sales
17: UK CPI & PPI; US Housing Starts & Building Permits; US Industrial Production; China Q1 GDP; China Industrial Production
18: UK Claimant Count & Unemployment; Euro Zone Final CPO
19: UK Retail Sales; Philadelphia Fed Manufacturing Index

22: Venezuela presidential election
23: Euro Zone Flash Manufacturing & Services PMIs; US Existing Home Sales
24: German Ifo Business Climate; US Consumer Confidence; US New Home Sales
26: ECB Policy Decision & Press Conf; Durable Goods Orders; BOJ Policy Decision
27: UK Prelim Q1 GDP; US Advance Q1 GDP

30: German Retail Sales; US Personal Income & Spending; Chicago PMI; China Manufacturing & Non-Manufacturing PMIs; China Caixin Manufacturing PMI