Saturday, January 5, 2019

January-February 2019 Outlook: New Year’s Resolutions January-February 2019 Outlook: New Year’s Resolutions
Fri, 04 Jan 2019 7:41 AM EST

The New Year has started on unsteady footing, tipsy from swallowing months of uncertainty about the global economy; market sentiment has shifted and thrust many stock indices into an official bear market. The bugaboos that have haunted the markets all year – Brexit, slowing global growth, dysfunctional politics, dwindling central bank largesse, and trade conflicts – have finally taken their toll and shaken the risk-on regime that has held sway for most of the last decade.

2018 was the worst year for US stocks in ten years, seeing the S&P500 contract by more than six percent. With traders looking to technical levels and other guideposts for sentiment, the adage ‘As January goes, so go the markets’ may seem more relevant this year. The last time US stocks fell in January was in 2016, and should it happen again this year the stock market pain could create a self-reinforcing downward spiral, bleeding into confidence indicators and even the hard data. Investors are now trying to suss out if corporate earnings peaked for the cycle in 2018, and await fundamentals to reassert themselves in commodity and stock markets, hoping to overcome the eroding sentiment that has dragged down asset prices in the last couple of months.

Many of the big picture issues overhanging the markets will finally be resolved in 2019…for better or for worse. If enough fall on the happy side of the resolutions ledger, the global economy and markets could put their party hats back on and revel in more prosperity in the New Year. If not, these issues could linger as an unshakable hangover, and 2019 will be characterized by a bear market and possibly recession in some economies.

Global Trade: The Clock Strikes Midnight

The S&P500 has tumbled more than 10% since President Trump declared himself a “tariff man” in early December, and a self-imposed clock is ticking down to early March when a temporarily postponed tariff increase could go into effect, opening up an all-out trade war. Market optimism about the US reaching a trade deal with China has faded and its becoming clearer that tariffs are contributing to a slowdown in China that is spilling over into the global economy. The latest sign was the December reading of the China Caixin manufacturing PMI, which entered contraction for the first time in 19 months. A holiday quarter earnings warning from Apple added to the angst about the health of the Chinese economy. It also raises the question of how many other companies, especially in tech, will follow suit with lowered guidance in the weeks ahead, laying blame on China and trade tensions.

We will get a read on the state of the trade discussions on January 7 when a delegation from the US will meet with counterparts in China. The US group is being led by a deputy of the US Trade Representative, so no breakthroughs are expected, but it could set the table for higher level talks. Expectations for this “mid-level” meeting are low, giving it the potential for a positive surprise should delegates come away with evidence to support the so-far unsubstantiated optimistic tone Presidents Trump and Xi have cast on negotiations.

US Politics: New Year, Same Old Problems

With mounting political woes at home, President Trump may be eager to claim a big victory on trade, even if it means reaching a deal with China that is suboptimal. Both countries are starting to feel the effects of the trade war and would like to alleviate that economic pain, but unlike President-for-life Xi, Trump is subject to domestic political pressures as he plots his run for reelection in 2020. A breakthrough on trade relations with China would be just the thing to win back any wavering Trump voters, but the deadline of three months from the December 1st G-20 meeting means things will have to move quickly. The White House has a poor record on meeting its own time tables and will be adjusting to a new political landscape in Washington as the Democratic-controlled House will convene three days into the New Year.

The first test for the new Congress will be the government funding standoff over border security funding, and it will quickly clarify how the next two years will play out in Washington. Neither the President nor the Democrats appear willing to give any ground, and Trump has conceded that the shutdown could last a “long time” though the pressure will build over the weeks as constituents begin to complain about missing government services (and Wall Street laments missing government economic data). The President will get to make his case directly to the people during the State of the Union address (Jan 22). On Capitol Hill, it appears that Republican Senators will content themselves with seating conservative federal judges, while the House Democrats may be tempted to use their subpoena powers to open new probes of the Trump administration, even as they eagerly await the findings of the Mueller investigation.

Ahead of the Mueller report, the White House needs to work on its communication strategy. Trump’s unprecedented jawboning of monetary policy is poking at central bank independence, even as the President’s own tariff policy could conceivably drive up inflationary pressures that would give the Fed more reason to raise rates. Then there was the ill-conceived Christmas Eve statement from Treasury Secretary Mnuchin that spawned new concerns about the credit markets that no one had been contemplating until that moment. This came amid reports that Trump was talking to aides about potentially firing the Fed Chair after the December rate hike.

Central Banks: The Party’s Over

Markets have had an adverse reaction to the notion that they are losing the support of central banks as the Fed said rates would continue higher into the neutral zone and the ECB wrapped up its QE program buying. Central bankers have responded with the message that monetary policy will move very deliberately, staying attuned to incoming data as they work to normalize policy after a decade of extraordinary accommodation. These efforts by the central banks to slowly take away the punch bowl may be impeded by the softer economic outlook for this year and warning cries from the markets.

Wall Street operators that had pinned their hopes on an extension of the ‘Fed put’ were disappointed with Fed Chair Powell’s December press conference performance, in which he indicated that the central bank will not necessarily ride to the rescue if the stock market weakens. Powell also gave the impression he would keep the Fed balance sheet off the table as a potential policy tool, saying the balance sheet reduction would continue on ‘auto-pilot,’ draining another $600B from the reserves this year. By some estimates that will add the equivalent of three 25 basis point rate hikes in addition to any FOMC interest rate hikes. Days later NY Fed President Williams tried to massage the message, providing assurances that the Fed does listen to market participants, but with little effect. The markets want to hear Powell revise the communication himself.

Powell will have his first chance to reconsider his messaging on January 4, when he participates in panel discussion with the predecessors who created the policies he is working to unwind, Chairs Yellen and Bernanke. If Powell takes a more conciliatory tone toward the worries that are buffeting the markets, it could alleviate some bearish sentiment. This might come in the form of walking back the ‘auto pilot’ comment, perhaps simply by indicating that the Fed stands ready to use all available tools if the situation requires it. On the other hand, Powell might feel he has already thrown a bone to the markets by ratcheting back the rate hike forecast for 2019 from three to two, especially if he is convinced that economic growth remains on a solid track.

Speculation about whether President Trump might actually try to fire the Fed Chair has added some uncertainty. The Administration does have the authority to remove the Chairman “for cause,” but that suggests some type of malfeasance, so it seems unlikely that the President could find grounds for a firing. If he still tried to sack Powell it could lead to an unprecedented legal battle between the White House and the Fed that would only undermine confidence and market sentiment. This seemed to be the conclusion drawn by White House economic advisor Kevin Hassett when he declared just after Christmas that Powell’s job is “100% safe,” even though the President never publically denied the report that he contemplated firing Powell.

The European Central Bank will soon undertake its own leadership change (though by contrast it is planned). ECB President Mario Draghi’s term expires on October 31, which might spark some uncertainty about the continuity of ECB monetary policy. Draghi has been a steady hand and markets appreciated his strong language (“whatever it takes”) at key points during the financial crisis, but it will be up to his successor to tackle the task of normalizing monetary policy over the next few years. Germany was due for its turn to lead the ECB, but Berlin now has its sights set on securing the EU Presidency, diminishes the chances that Bundesbank President Weidmann will be tapped to lead the ECB.

The current frontrunner to replace Draghi is Erkki Liikanen, who just recently stepped down as Governor of the Bank of Finland after 14 years in the post. Liikanen is also a veteran of European politics, having entered the Finnish parliament at age 21, eventually serving as the country’s finance minister before taking a stint as a member of the European Commission. Surveys of economists depict him to be a strong compromise candidate, who can mediate between the demands of nations like Germany to begin the wind down of extraordinary stimulus as soon as possible, and countries like Italy that are concerned their economies could teeter without ongoing monetary support. If he is the eventual selection for the post, Liikanen’s political and monetary policy experience should help him navigate the north-south antagonisms in the euro zone.

The ECB also must continue to keep a watchful eye on Italy. After the populist government in Rome backed down in its budget standoff with Brussels, Italy is still contending with weakness in its banks, which are suffering from the bad decisions that created a mountain of non-performing loans. Banca Carige, Italy’s tenth largest bank, is drawing a lot of attention as it struggles with its NPL problems. The bank has been placed under temporary administration by the ECB, and the Italian PM and Economy Minister say they are watching developments at the bank “personally.” It’s not 2008 again, but further erosion of confidence in the banking system in Italy could spread across borders quickly in Europe, creating headaches for other enfeebled banks including Deutsche Bank.

Heading for the Brexit

Another lingering problem for Europe is the UK’s planned withdrawal from the EU, which could see a make or break moment mid-month. On January 15, the House of Commons is set to hold its “meaningful vote” on PM May’s Brexit proposal, and by all accounts she is short by dozens of votes. Efforts to get further assurances about the backstop from Brussels have won over many uncertain Conservative party members, but many Euroskeptics remain fixed against the deal on the table. The remaining three dozen or so MPs that May needs want her to convince the EU to grant the UK the power to unilaterally leave the backstop. There’s no real chance that Brussels will budge on that issue, as the EU has firmly held solidarity with Ireland. If PM May’s efforts get her close to the vote count she needs, there is an outside chance that the March Brexit date could be delayed to give her more time to lobby MPs, but that would require agreement from all 27 EU states and May has asserted that she will not tolerate a delay.

That leaves only a few options for May’s government as the vote approaches. Some supporters are reportedly urging the PM to call the vote as many times as needed to wear down MPs and get a majority, perhaps voting on the issue dozens of times in succession. The other proposal being mulled would have May announce a specific date on which she would resign, allowing new leadership to take on the next step of negotiating future trade relations with the EU. Both strategies are uncertain at best, and chances of a ‘hard Brexit’ appear to be rising quickly as March 29 approaches.

A final option has been opened by the European Court of Justice. Late last year the ECJ ruled that the UK can unilaterally cancel the Brexit process without consulting the other EU 27 members. This opens the possibility for the UK government to give up on the treacherous implementation of the non-binding Brexit referendum. This course back to the status quo is unlikely, however, as PM May has vowed to move forward with “the will of the people” and even the ‘loyal opposition’ Labour party has remained loyal to the cause, with only a handful of MPs publically calling for a new referendum. This unwavering support for Brexit increases the likelihood that the UK will crash out of the EU with no governing agreement if the Parliament rejects May’s negotiated deal.

Inflation: Watching the Ball Drop

Upward inflation pressure has not been an issue for central banks in the developed economies, as wages growth has remained slow and new tariffs have not had a major impact on price pressures yet. The fading price of oil will help keep inflation in check, but it may have other implications.

Crude prices were almost halved during Q4 as North American production continued to ramp, offsetting the output constraints implemented by OPEC and its partners. The precipitous price drop has created concerns about the debt load in the energy sector. If WTI crude should slide below the $40/bbl level, it could induce a panic that some energy sector firms will default, which would send ripples across the debt market.

The next OPEC Monitoring Committee meeting on January 18 will give an early gauge on how the new 2019 production targets are progressing. A new round of cutbacks began on January 1, but their impact may vary based on how fast some members fully implement them, particularly Russia, which has said it could take months for its private oil firms to achieve their targets.


The stock market looks like it may lose some more ‘weight’ in early 2019, as many national economies will shed tenths of GDP due to tariffs, political disputes, and slightly tighter monetary policy tipping the scales of growth to the downside. The major banks will kick of earnings season in the third week of January, and analysts at those same banks have already slashed their forecasts for earnings growth to single digits, while the selloff in the S&P500 has essentially priced in zero profit growth for 2019. The stock market has come off the boil, but with the US economy still solid, bargain hunters may nibble at equities early this year, and could turn bullish again if some of the major uncertainties are lifted.

The collapse of crude oil prices has been a strong indicator of market sentiment, signaling downbeat expectations for the 2019 economy. But the energy market could help restore some confidence if the OPEC cuts establish a floor or actually push prices higher. The last time oil prices dipped this low central banks were content to attribute it to ‘temporary factors’ (factors that lasted for well over a year), but an absence of any significant energy inflation could contribute to a more dovish rate policy outlook.

Those voices calling for the Fed to put policy on hold in December weren’t realistic in thinking the central bank could turn policy on a dime. Chair Powell simply couldn’t justify going from expectations for several more hikes to none in a single meeting. But by slow increments Powell could move toward more dovish messaging if incoming data prescribe it. After the adverse reaction to the December rate announcement, the Fed may shift to a “pause” at one of the FOMC meetings during Q1. The tightening already exhibited by the markets coupled with the ongoing uncertainty about the global economy and the impact of escalating tariffs would give the Fed cover to formally change its policy stance.

The expansion of FOMC press conferences to eight from four per year will provide Powell with greater flexibility in his communication strategy, allowing for more rapid course corrections. If the market’s bellyaching turns out to be more than just indigestion, Powell will show more temperance. Some market gauges are fostering speculation that the Fed could actually cut rates in early 2020 as it starts sniffing out a recession. That would imply the FOMC continuing to turn more dovish over the course of this year.

China’s central bank may look to create more liquidity via additional cuts in its reserve ratio requirement after four RRR cuts last year amid slowing growth. The PBoC could also take the more drastic measure of cutting its key one-year lending and deposit rates, which have not been lowered since a series of cuts in 2015 amid the Shanghai stock market bubble bursting after a surprise devaluation of the yuan [**Note: On Jan 4, the PBoC cut RRR by 100bps].

In Europe, the ECB will tread cautiously in light of downside risks which unofficially include the installation of a new central bank President. Meanwhile, the Brexit has no real upside for markets, only the risk of more uncertainty if it fails to get legislative approval. In the end PM May could have to sacrifice her political future to get approval, and the next Tory leader will take up the even more difficult task of negotiating the shape of future relations and trade with the Continent.

Back in Washington, the longer the partial government shutdown drags on and the more bitter the dispute, the greater the chance it will start hurting growth and confidence. The ultimate resolution may come in some version of the deal discussed a year ago that would exchange border security funding for a resolution of the DACA (‘Dreamers’) immigration issue.

Among the global concerns that could see some resolution in the next few months, resolving the trade dispute between the world’s two largest economies is paramount and would be the best catalyst for markets this year. President Trump’s impulsive communication style could work against him during this sensitive period of the trade talks, especially if he is distracted by domestic political skirmishes and the turnover in his cabinet. The 90 day grace period on imposing new tariffs ends in March so the time table is short, but if there is demonstrable progress in talks those tariffs could be postponed again, which is probably the best case scenario for now. On the other hand, if talks go nowhere, a jump to 25% tariffs on most Chinese goods coming into the US could well trigger a recession by the next New Year.

2: UK Manufacturing PMI
3: US ISM Manufacturing PMI; New US Congress convenes
4: UK Services PMI; EU Flash CPI Estimate; US Payrolls & Unemployment; Fed Chair Powell speaks

7: US ISM Non-manufacturing PMI; China Trade Balance
9: FOMC Minutes
10: BOE Credit Conditions Survey; ECB Minutes
11: UK Nov GDP; UK Manufacturing Production; US CPI; Preliminary University of Michigan Consumer Sentiment

14: Fed Chair Powell Testifies before Congress
15: UK Parliament vote on Brexit plan; US PPI; China Industrial Production
16: UK CPI; US Retail Sales; China Q4 GDP
17: Philadelphia Fed Manufacturing Index; US Housing Starts & Building Permits
18: UK Retail Sales; OPEC Monitoring Committee meetings

22: German Ifo Business Climate; UK Unemployment; German ZEW Economic Sentiment; World Economic Forum (Jan 22-25); BOJ Policy Decision; US State of the Union Address (tentative)
23: Various EU Flash Manufacturing and Services PMIs
24: ECB Policy Decision
25: US Durable Goods Orders

29: US Consumer Confidence
30: German Preliminary CPI; US Advance Q4 GDP; FOMC Policy Decision; China Manufacturing & Non-Manufacturing PMIs
31: EU Flash Q4 GDP; US Personal Income & Spending; US Core PCE; US Employment Cost Index; Chicago PMI
1: UK Manufacturing PMI; EU Flash CPI Estimate; UK Payrolls & Unemployment; US ISM Manufacturing PMI

5: UK Services PMI; US ISM Non-manufacturing PMI
6: EU Economic Forecasts
7: BOE Policy Decision
8: Preliminary University of Michigan Consumer Sentiment

11: UK Manufacturing Production; UK Preliminary Q4 GDP
12: China Trade Balance
13: UK CPI; US CPI; Japan Preliminary Q4 GDP
14: Germany Preliminary Q4 GDP; EU Flash Q4 GDP; OPEC Monitoring Committee meeting; US PPI
15: UK Retail Sales

19: UK Unemployment; German ZEW Economic Sentiment
20: US Housing Starts & Building Permits; FOMC Minutes
21: Various EU Flash Manufacturing and Services PMIs; UK Inflation Report (tentative); ECB Minutes; Philadelphia Fed Manufacturing Index
22: German Ifo Business Climate

26: US Consumer Confidence
27: US Durable Goods Orders; China Manufacturing & Non-manufacturing PMIs
28: German Preliminary CPI; US Preliminary Q4 GDP (2nd reading); Chicago PMI
1: UK Manufacturing PMI; EU Flash CPI Estimate; US Personal Income & Spending; US ISM Manufacturing PMI

5: UK Services PMI; US ISM Non-Manufacturing PMI
7: ECB Policy Decision; China Trade Balance
8: US Payrolls & Unemployment; Preliminary University of Michigan Confidence

12: UK Q4 GDP; UK Manufacturing Production; UK Annual Budget (tentative); US CPI
13: OPEC Monitoring Committee meetings; US PPI; China Industrial Production
14: US Retail Sales; BOJ Policy Decision

19: UK Unemployment; German ZEW Economic Sentiment; US Building Permits
20: UK CPI & PPI; FOMC Policy Decision
21: UK Retail Sales; BOE Policy Decision; Philadelphia Fed Manufacturing Index
22: Flash Manufacturing & Services PMIs for various EU states; German Ifo Business Climate

26: US Durable Goods Orders; US Consumer Confidence
28: German Preliminary CPI;US Final Q4 GDP
29: UK BREXIT; UK Final Q4 GDP; EU Flash CPI; US Personal Income & Spending; Chicago PMI