Wednesday, May 8, 2019

May-June 2019 Outlook: And They’re Off! May-June 2019 Outlook: And They’re Off!
Wed, 08 May 2019 10:48 AM EST

After stumbling in the final furlong of 2018, risk appetite is off to the races again in the first four months of this year. A yield curve inversion spurred fears that a recession was looming and heading into first quarter earnings season there were concerns that corporate results would flat line. But with Q1 now in the books, earnings have been better than expected and economic growth appears to be firming up.
A number of risks to the economic outlook appear to have been scratched from the lineup: the Fed and other central banks have stopped tightening policy, global growth indicators have been mostly better than expected, Brexit has been postponed, and US/China trade talks seem to be making headway. Minimizing these concerns has led to the better risk appetite in recent months, but as we have just witnessed this past weekend, sometimes the longshot comes through, so it’s only prudent to consider the outlying alternatives. A number of potential political, monetary, and economic missteps could still befall the markets and shake the current generally positive outlook.

Politics: Putting on Blinders

The political environment in western democracies has been like a rain soaked track in recent years – conditions are sloppy and mud is splashing everywhere (much to the delight of Russia and other actors that have sought to exacerbate those muddy conditions). In these circumstances, it has become more and more difficult for political opponents to work across the aisle, but there are still some opportunities for bipartisan deal-making.
The US political environment was not cleansed by the Mueller report, it has only gotten dirtier. Instead of making any direct recommendations about how the President should be treated based on the evidence, Mueller left it up to Congress and the new Attorney General to decide. This left the White House to trot itself into the winner’s circle declaring “total exoneration,” while Congressional Democrats disqualified the AG’s interpretation of the text and are now calculating the political odds around dragging out the Russia investigation with endless hearings or a slap on Trump’s wrist via an impeachment that the Senate will never act on.
While relations between Capitol Hill and White House are as contentious as ever, both sides are still trying to make a show of bipartisanship, expressly on an infrastructure initiative. Initial meetings between the President and senior Democrats came away with a call for a $1-2 trillion investment package to rebuild America’s transportation and communication networks. However, the politicians have not agreed yet on any funding mechanism, and many Republicans are already bucking the idea of a gasoline tax. The debt ceiling is the other big issue to watch this summer in Washington. The threat of a US default has been used as political leverage in the past (most notably in 2011 when a standoff resulted in S&P downgrading the US sovereign rating to AA+), and in the unpredictable state of national politics in the Trump era, the risk can’t be ignored as a longshot.
The elections for European Parliament in late May are becoming another contentious horse race. Conservatives in the UK are upset that they will have to participate in the elections because of the Brexit delay, stiffening their resolve to throw PM May out of the saddle.
Unable to whip her own party into passing the Brexit bill, the PM is now using the carrot to bring the opposition on board. The latest reports indicate that PM May is prepared to concede on workers’ rights and a Customs Union in order to get support from the Labour Party for a Parliamentary stamp of approval for the Brexit deal. The key point for the PM appears to be getting a deal approved before EU parliament members are seated later this year, in an effort to save some face within her own party. The same report says that Labour leader Corbyn is now deciding whether to make the deal or drag it out through EU elections in order to inflict maximum political damage to the Conservatives, a tactic that could scuttle the chances of an agreement altogether.
At this point, PM May faces long odds on staying in her post through the end of the year. She has already offered to step aside once she has steered the UK into a Brexit deal, but some Tories still want her to specify a resignation date. The question this summer may be who even wants to lead the Conservatives after the savage rebuke the party received in recent local elections from rank and file members grown disillusioned with the infighting among MPs.
The EU elections could also be a new marker for the state of the nationalist movement across Europe. Notably in France Marine Le Pen’s far-right National Rally party is leading President Macron’s En Marche by a nose in the polls ahead of the continental elections. Le Pen is working hard to capitalize on the ‘yellow vest’ protests and a win for her party could reinvigorate the nationalist movement across Europe that sired the Brexit referendum and the maverick Italian government that is butting heads with Brussels while cultivating ties with Moscow.

Monetary Policy: The Race is Canceled

Amidst last year’s “synchronized global growth” scenario, it appeared that central banks were jockeying to see who could win the policy normalization race, but emerging concerns about weak growth and inflation led them to rein in any hawkishness. The assurance of continued easy monetary policy has done more than anything to run off recession fears.
The Federal Reserve made arguably the quickest policy reversal in its history this past winter, but it’s still not clear if the central bank will give the markets (and White House) the rate cuts they want. The FOMC’s May 1 statement chose to emphasize the weaker growth indicators rather than trumpeting Q1’s 3.2% advance GDP reading, and also announced a surprise 5 basis point cut in the IOER that is used to guide rates into the target range. Some Fed watchers saw the IOER cut as a signal that the Fed’s next rate move is tilted toward a cut, but Fed Chair Powell took pains to stress that the IOER move was a “small technical adjustment,” and not a policy shift. Powell also reiterated that the Fed would be patient, saying there is no strong case for moving rates in either direction right now. That, coupled with his explanation of below target inflation being caused by “transient” factors, may put a damper on market expectations for a 25 basis point rate cut later this year.
After Powell staked out his position, Fed doves made the case that inflation expectations may be running too low. Fed Presidents Evans and Bullard both took note of the recent weakness in core PCE readings, saying that the Fed can’t claim victory on its inflation mandate and hinting that they might support future rate cuts in order to spur inflation toward the target. Evans further suggested that the Fed might need to aim at above 2% inflation to get back to the target level. Bullard indicated he would be open to a rate cut in the autumn if inflation remains subpar, saying that a rate cut during ‘boom times’ would show the Fed is serious about achieving its inflation target. More weak PCE data in the months ahead could embolden the doves to lodge a dissent later this year.
In a less dramatic fashion, the Bank of England also slowed its normalization process, as it awaits a resolution on Brexit. This month’s meeting of the BOE resulted in a less hawkish statement than expected, now indicating that it may just need one more hike to get inflation in check (versus the prior forecast of one hike per year for the next three years). If the Brexit process turns out to be a smooth ride, the BOE could always revert to its original strategy.
Over in its lane, the ECB has not only put normalization back in the stable, it’s trotting out new stimulative measures as well. In March the ECB froze any rate hikes at least until next year, pushing it back from prior guidance of summer 2019. And to ensure ample liquidity to commercial banks, a third round of targeted long-term refinancing operations (TLTRO-III) will be loaded into the chute in September, in time to replace the last of the TLTRO-II low-interest loans that will mature next year. Many healthier European banks may refuse to take the restricted loans, and the ECB will have to make the case that the liquidity program is not just a thinly veiled effort to prop up ailing Italian banks that are still at risk of being taken behind the barn and shot. It’s also worth noting that Mario Draghi’s 8-year term as ECB President ends in October, so these new policy operations will be guided by his yet-to-be named successor.
As always, growth and inflation are the driving forces in the monetary policy race. Both factors have been running slow for most of the G20 economies, but recently tabulated Q1 data has shown some promise.
Preliminary readings on Q1 GDP in China and the Euro Zone were slightly better than expected and the BOE has raised its growth forecast for the UK. The advance reading of US first quarter GDP was even better, coming in at over 3% -- especially impressive considering GDP has usually stumbled out of the starting gate for the last ten years running. The more cautious market touts note inventories played heavily into the elevated US number, and that the implications of the partial government shutdown may not have been fully read into the advance data, so the second and third revisions of GDP might be ratcheted back. Notably the Atlanta and NY Fed estimates for Q1 GDP both ended on 2.7%.
Inflation has also been problematically low for most global economies, even after a decade of extraordinary stimulus. Euro zone CPI was better than expected in April, led by a jump in German inflation, though still hovering well below target. US core inflation data has tailed off in recent months, leaving the Fed nonplused again.
One factor in contributing to muted inflation last year was depressed oil prices, but energy prices have perked up lately. The slow choking off of Iranian oil and the potential for Venezuelan and Libyan supply to drop suddenly are upside risks to the oil market. In response to the tightening net of US sanctions, Iran is threatening to block the Straight of Hormuz and to resume certain nuclear enrichment activities. Meanwhile the Maduro regime’s days appear to be numbered which could result in more Venezuelan production disruptions in the near term, while Libya’s undeclared civil war disrupts oil fields on a day-to-day basis. Extreme weather is always a upside risk to energy prices as well, so market participants need to keep abreast of meteorological models as the Atlantic hurricane season kicks off on in June.
There is also a case for downside risks in oil prices as OPEC and its partners reconvene in late June (June 25-26) to discuss the production cutting agreement that has been the stabilizing force behind the market for two years. Member states agreed to an additional 1.2M bpd in cuts at the beginning of the year and will decide in June whether to keep production reined in. Under public pressure from President Trump to cut prices, Saudi Arabia has resisted raising production stating merely that it will meet market demand. Russia continues to cooperate but seems more eager to reopen the taps, concerned that US shale producers are gaining too much advantage from the discipline that OPEC+ is showing.

Global Trade: Run for the Roses

Perhaps the biggest geopolitical issue hanging over the economy is the rewriting of the global trade regime. Central to this is the negotiation of a new trade agreement between the world’s two biggest economies. White House officials have been trumpeting progress in the deal talks with China for several months, but negotiations are getting trickier as they round the final bend. Reportedly China has backtracked on some earlier commitments, prompting President Trump to order a new round of tariffs imminently. China retaliated by shrinking its delegation in Washington this week, all but assuring a final deal won’t close this month as the White House had hoped. The timing of new North Korea missile tests coinciding with this trade talk ‘impasse’ also raises suspicions that China is demonstrating what its lack of cooperation could mean. Although the rhetoric is clearly getting tougher, most experts are still convinced the trade deal will reach the finish line.
The risk factors around the anticipation of a Sino-US trade pact mostly come down to the final details and the timing of the deal. That is to say the quality of the actual agreement matters. Although President Trump has proclaimed it will either be a “great” deal or no deal, there have been reports over the last several weeks that the Washington negotiators were mulling certain concessions to get an agreement done quicker. For its part, China is said to be particularly resistant to demands for stronger commitments on technology transfers and IP protections that would require significant changes in domestic law and enforcement.
If the actual terms of a new trade deal aren’t as rosy as the White House has been boasting, markets may express their displeasure. At the other end of the spectrum, there’s also a chance that the terms could be unexpectedly difficult for China’s economy to adjust to, perhaps saddling one of the world’s growth engines with more new regulations than it can’t handle in the short term.
Even if the US and China successfully negotiate a deal, global trade tensions won’t cease. The White House has made it clear that Europe and Japan are next on its list for trade overhauls, and the North American trade deal (USMCA) is still not officially in the books. As Japan and Europe open trade discussions with the US, they are already balking at threats of new auto tariffs. Meanwhile, the USMCA is facing challenges from Congressional Democrats who want more assurances on labor rights and environmental impacts, and Mexico and Canada continue to complain about Section 232 steel tariffs. Tensions over these trade issues may overshadow other considerations at the upcoming G20 summit in Osaka (June 28–29).

Predictions: Down the Stretch…

With economic growth potentially about to break into a canter again and central banks keeping policy normalization entirely off the track, the bulls look to have the advantage in the near future. Yet, despite the positive catalysts, more volatility should be expected, as uncertainties remain.
First, the rapid Fed reversal since December has underpinned the risk-on tone of the markets, but the betting seems to be shifting away from the rate cut scenario that some market watchers want. Chair Powell’s insistence that core inflation weakness is “transient” casts doubt on the prospects of the Fed lowering rates to spur inflation. However, Fed doves are still making the case for a cut if inflation can’t pick up the pace, and Powell has now demonstrated that he is open minded about quick shifts in policy, despite the chance that such moves can erode confidence in Fed forecasting.
Inflation should get a boost from the energy market if OPEC+ can keep its alliance intact past June. Lower flows from Iran could allow other producers to modestly raise output without violating the spirit of the production cutting agreement. The growing animus between the US and Iran governments should not be ignored on the chance that President Trump’s more bellicose advisers push him into a military confrontation for security or political reasons.
Trump’s re-election aspirations hinge upon the economy remaining strong, and a China trade deal could be the key to defeating the growing field of Democratic challengers. Some show of bipartisanship through an infrastructure package could also help his chances, though the odds of a deal with the Democrats diminish every day that the 2020 election draws closer. The Democratic hopefuls will hold their first debate late next month (June 26-27), and their swipes at the President may ruin Trump’s already limited appetite for compromise. Trump is feeling his oats after the 3.2% advance Q1 GDP print, but watch for the GDP revision on May 30 – if it sees a substantial downside revision to below 3%, the White House may be more willing to get back to horse trading.
Markets have been pricing in a favorable outcome to the US/China trade talks, but are now coming to grips with fact that reaching a final deal will be challenging. Pricing in the trade tensions again may lead to a short term correction in markets as traders hedge against the possibility of an all-out trade war. But those tensions could be resolved fairly quickly if the trade discussions in Washington (May 8-10) go well enough to allow the White House to back off threatened new tariffs with another postponement.
Despite the recent posturing, the baseline belief is that both Presidents Trump and Xi are champing at the bit to reach an accord and that once it is announced, risk assets will see more upside. However, there has been so much anticipation of a sweeping trade agreement that the actual deal announcement may become a ‘sell the news’ moment. That would particularly be the case if the deal is judged to be less than favorable for the US. But for now, as long as talks don’t break down entirely, markets probably won’t price in a lot of downside risk.
Ultimately, it may be a weaker Chinese economy that becomes the next dampening effect on risk appetite. Amid the economic softness brought on by the US trade conflict, Beijing has been ramping up stimulus efforts again. That has translated into some improved economic data points in recent weeks, but stimulus is only a temporary fix for the drag that a full rework of the US/China trade relationship could have on China’s economy.
In the longer term, the trifecta of demur monetary policy, improving growth and favorable resolutions of trade disputes could secure a prosperous economic and trading environment for several years to come. However, when running for the roses, be cognizant of the thorns.

1: US ISM Manufacturing; FOMC Policy Statement & Press Conf; China Caixin Manufacturing PMI
2: UK Manufacturing PMI; BOE Policy Statement
3: UK Services PMI; Euro Zone CPI estimate; US Payrolls & Unemployment

5: China Caixin Services PMI
7: China Trade Balance
8: ECB Minutes; China CPI
10: UK GDP; UK Manufacturing Production; US CPI; Preliminary Univ of Michigan Sentiment

14: UK Unemployment; China Industrial Production
15: Euro Zone Flash GDP; US Retail Sales
16: US Housing Starts & Building Permits; Philadelphia Fed Manufacturing
17: UK Retail Sales

21: German ZEW Economic Sentiment; UK Inflation Report hearings
22: German Ifo Business Climate; UK CPI; FOMC Minutes
23: Various European Flash Manufacturing & Services PMI; European Parliamentary elections (May 23-26)
24: US Durable Goods Orders

26: France holds EU Parliamentary elections
28: US Consumer Confidence
30: US Q1 GDP; China Manufacturing & Non-manufacturing PMIs
31: German CPI; US Core PCE; US Personal Income & Spending; Chicago PMI

1: Hurricane season begins
2: China Caixin Manufacturing PMI
3: UK Manufacturing PMI; US ISM Manufacturing PMI
4: Euro Zone CPI Flash Estimate
5: UK Services PMI; ISM Non-manufacturing PMI
6: ECB Policy Decision & press conf
7: US Payrolls & Unemployment

10: UK Q1 GDP; UK Manufacturing Production
11: UK Unemployment; US PPI; China CPI
12: US CPI; China Trade Balance
13: UK Retail Sales; China Industrial Production
14: US Retail Sales; Preliminary Univ of Michigan Consumer Sentiment

18: German ZEW Economic Sentiment
19: UK CPI; FOMC Policy Statement & press conf; BOJ Policy Statement
20: BOE Policy Statement; Philadelphia Fed Manufacturing
21: Various European Flash Manufacturing & Services PMIs; German Ifo Business Climate

25: Semiannual OPEC meeting (June 25-26); US Consumer Confidence
26: US Durable Goods Orders
27: US Final Q1 GDP
28: UK Final Q1 GDP; Euro Zone Flash CPI Estimate; US Core PCE Price Index; US Personal Income & Spending; Chicago PMI; G20 Meeting in Osaka (28-29th)
29: China Manufacturing & Non-manufacturing PMI
30: China Caixin Manufacturing PMI