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.
CALENDAR
MARCH
4: China Caixin Services PMI
5: UK Services PMI; ISM Non-Manufacturing PMI
6:
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
19:
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
26:
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
APRIL
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
9:
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
25:
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