October-November 2013 Outlook: The World Series
With the World Series just around the corner, the baseball playoffs provides an apt metaphor for the global outlook: after a grueling summer of hard fought battles, the real game is just beginning. In the past few months, global markets have been characterized by broad swings, particularly in currencies and government bonds, as markets anticipate tighter US monetary policy. Though the Fed declined to cut back its bond buying program at its September meeting, tapering is in the on deck circle.
Despite nervousness about the impending withdrawal of quantitative easing, there are certainly some bright spots, most visibly in the US stock market. For the second straight year the S&P500 has not retested its January opening level, and barring an outright crash will not do so for the rest of the year, a hitting streak that has only occurred once before, in 1975-1976 (ending with a down day on the first trading day of 1977). The extraordinary longevity of this stock market rally has been supported by monetary policy and nurtured by measured by improved corporate results.
Still the curtailment of QE3 portends the eventual lifting of extraordinary measures by central banks across the globe, shifting focus to fiscal policy authorities who have a lot of catching up to do. After years of central banks propping up the global economy, fiscal policy makers must finally take their turn at the plate. The re-election of German Chancellor Merkel should help move along European efforts to pull together for more Europe, while in the US Congress is taking another stab at a budget deal even as the Fed contemplates its first pull back from extraordinary measures. Meanwhile, Japanese Prime Minister Abe is on the threshold of announcing details of the third arrow of his economic turnaround policy. The direction of the next leg of the world market will be largely dependent on how these policies are crafted and received.
No Joy in Mudville
Looking an awful lot like Casey at the Bat, Washington is about to take its third swing at a budget deal after rebuffing two chances for a grand bargain (resulting in the 2011 sovereign downgrade and the Sequester). The dysfunction on Capitol Hill has reached such a level that it feels as if Congress has turned brinkmanship into the new national pastime. Following what has become standard operating procedure, Congress has squandered the entire summer, again waiting to the last minute to address the budget authorization measure. This time round House Republicans are attempting to use the publics unease with Obamacare and the threat of a government shutdown to gain leverage over the budget process.
In the event of a government shutdown, the Treasury will maintain normal borrowing and debt operations, but the Commerce and Labor Departments have said they will not collect or release data, including the key monthly employment figures due out on October 4. A dearth of hard economic data could spook markets, particularly when the Feds pending decision on tapering is so data dependent. In the end, legislators will likely follow their established pattern, taking the issue to the eleventh hour or beyond, perhaps forcing a brief government shutdown, but ultimately agreeing to some form of stopgap spending bill to keep the government open for a few more months.
But in D.C.s fiscal double header, the stopgap spending bill is only a warm-up to the rubber match, namely the debt ceiling debate. US Treasury Secretary Lew recently stated that his departments extraordinary measures to extend the debt limit will be exhaust by October 17 leaving it with no ability to borrow, and the CBO has estimated that the Treasury will have to begin prioritizing payments or actually default sometime between October 22 and October 31. This gives Congress only a couple weeks to go from loggerheads to an agreement.
Ratings agencies Moodys and Fitch will be watching the proceedings in D.C. as closely as anyone. Their peers at S&P downgraded the US sovereign rating from AAA to AA+ in August 2011 after the original debt ceiling showdown took the reputation of Congress to an all-time low. At the time, S&P made it clear that the downgrade was based largely on the political dysfunction in Washington. The counterintuitive move in the treasury market after the S&P downgrade, with investors plowing even more money into the relative safety of US government debt, may have added to the complacency over the debt ceiling issue among politicians who now might be convinced another downgrade will have no ill effect. They may be right, or a second ratings cut could trigger the disaster that some predicted after the S&P downgrade. No one knows for sure.
In July, Moodys resolved a ratings review by raising its outlook on the US sovereign back to stable from negative, citing an improved debt trajectory (thanks to the blind cuts imposed by the sequester), and indicated it did not see the need for further review in the near term. Fitch, however, warned several times this year that, while it does not anticipate a repeat of the debt ceiling crisis of August 2011, a failure to raise the debt ceiling in a timely fashion would prompt a review and likely downgrade of the nations AAA rating.
This fiscal battle will continue to repeat on instant replay until Congress and the President find the determination to come to a grand bargain for a long term budget. The ultimate shape of such a deal will have to be crafted to satisfy the constituencies of both sides that they did not violate their core values. This might involve restoring military funding lost to the sequester by finding some $200B in additional savings from long standing programs like farm subsidies, while largely preserving Medicare and Social Security entitlements that are sacrosanct to Democrats, and raising select taxes on special government services but labeling them as service fees so Republicans can save face. Until such a deal is struck, the kick-the-can pattern in Washington could continue indefinitely.
While US fiscal policy has been in a shambles, Fed monetary policy has kept a steadying hand on markets. Thus the surprise decision to hold off on tapering bond purchases in September may have further chipped away at the Feds credibility, as the central banks transparency joined its shaky economic projections on the disabled list. Several FOMC members have described the decision not to taper at the September policy meeting as a close call, and in the next breath say that tepid data could justify delaying the process to December or even into early 2014. At the September press conference, Bernanke may have confused things more by insisting that the Fed never said it would taper at that meeting, but also suggesting they could start curtailing QE as soon as the economic data justified it, going so far as to say he could arrange an impromptu press teleconference in October if needed. After muddling its message, the Fed needs to redouble its efforts to clarify its communications.
This effort is especially tricky because no matter how the policy is communicated, markets are naturally forward-looking and will inevitably perceive tapering as a step toward the larger exit strategy. The Fed has done its best to break this link, often reiterating that the end of QE3 is on an entirely separate track than interest rate policy, and more recently downplaying the unofficial 7% unemployment milepost for ending QE that created confusion by echoing the formal 6.5% unemployment threshold for considering tighter rates. The 6.5% threshold has also been softened too in order to convince markets it is not a trigger for a rate hike, the Fed doves are now suggesting that they could wait until well after joblessness moves past that point before tightening.
One uncertainty that will be lifted in October is the question of who will lead the Fed for the next four years. Most Fed watchers think Bernanke has pitched a good game, but it will be up to his reliever to close out the extraordinary stimulus program. In the face of what may have been an embarrassing Senate panel rejection, President Obamas first choice, Larry Summers, stepped aside, leaving Fed Vice Chairman Janet Yellen as the overwhelming favorite to replace Bernanke. In addition to her impeccable economic credentials, as an architect of the Feds strategy to buy assets and keep interest rates low until unemployment retreats below 6.5%, Yellen would clearly create the most seamless and consistent policy transition from the Bernanke era. In the current political climate, her confirmation may face some opposition from Republicans who think Bernanke is too dovish and consider Yellen, a Democrat, as even worse. But she has already developed significant Democratic support in the Senate which should ensure her confirmation. In reviewing his choices, President Obama is not likely to signal for a righty from the bullpen, but the leading alternative candidate now appears to be former Fed Vice-Chairman Donald Kohn, who is highly respected among international central bankers and is seen as apolitical, which may be more palatable to Republicans.
Trouble with the Curve
Emerging markets have been disproportionately hit by the Feds tapering pitch: ever since Bernanke started talking about pulling back QE, emerging economies have taken it the hardest. For example, the Indian rupee and Brazilian real each depreciated by more than 20 percent between May and August, and in that same timeframe the main stock indices in both countries have experienced dizzying gyrations. Commenting on the emerging markets vulnerability to Fed tapering, the IMF recently concluded that tighter US monetary policy could dampen growth in the emerging markets which could in turn engender a global slowdown and compel interventions to prevent excessive volatility.
Even the star player of the emerging markets, China, had a problematic summer. Its economy has been in a bit of a lull, posting lackluster PMI and manufacturing readings for most of the year, causing some analysts to question its 7.5% GDP target. But headed into the National Day golden week holiday in the first week of October, there have been a few signs that these measures are turning upward again. The September HSBC flash manufacturing PMI reading chalked up its second consecutive month of expansion and a six-month high, while the official manufacturing survey has been in a phase of modest expansion for 12 straight months. The Q3 GDP report due in mid-October will tell the tale of whether this recent upturn in economic data amounted to an improving growth trend. Even if it has, Chinas growth will still be challenged headed into 2014 as the government works on reforms aimed at correcting structural problems of overcapacity in some key industries, which will be a long-term benefit but short-term drag on the economy.
Middle East Crisis Goes Into Extra Innings
The batting average for Middle East crisis resolution is very low, but some seemingly positive developments in the most intractable problems of the region have tamped down tensions, at least for the moment. A new round of Israeli/Palestinian peace talks have begun, a tentative UN plan to control and destroy Syrias chemical weapons has averted a US military intervention, protests continue in Egypt but the level of violence has subsided, and Irans new President is suddenly spouting conciliatory words on the nuclear issue.
Irans charm offensive at the UN gathering in late September led many officials to believe that the new Iranian President Rohani may indeed be moderating his governments stance as he seeks to end debilitating sanctions. Rohani promises to present a new nuclear plan at a mid-October meeting with the major powers (P5+1) in Geneva in an effort to achieve quick and tangible results. Much attention will be given to these meetings to see whether Rohani is truly taking Iran in a new direction, or if hes merely presenting the same old delaying tactics with a new face.
Developments in all of these theaters of the Middle East will continue to impact the energy market. For example, as Egypts interim leadership promises the transitional phase of government should end by next spring, any fresh outbreak of violence could renew fears about Suez Canal traffic. Another spot in the region to watch is Libya, which has protests of its own that have disrupted oil production and shipping facilities for months. The fledgling government and state oil company have been unable to prevent political activists and militia groups from disrupting the flow of its coveted oil and the lost revenue (over $100M a day since July) may soon cause budgetary problems that could aggravate the situation.
As unpredictable as Middle East politics, Mother Nature is another wildcard for the energy market. The 2013 hurricane season was forecast to be very active, but so far it has spared Gulf of Mexico oil and gas operations, with its biggest impact being a series of storms in Mexico that caused severe mudslides which could shave a tenth of a percent off of that nations GDP. There are still two months before the Atlantic hurricane season ends (November 30), and with eight years gone by since Katrina, the Gulf may be due for a disruptive storm.
Breaking Europes Slump
In recent months Europe is most notable for how quiet it has become. After two years of going from crisis to crisis, things have finally stabilized in the last year. Euro Zone unemployment appears to have leveled off at just above 12% and most of the continent has returned to modest GDP growth after a shallow double dip recession. Spains banking troubles have diminished, Greece is digging out of its hole a little faster than planned, Cyprus is out of the headlines, and Ireland is working toward fully returning itself to the debt markets for funding.
This period of relative calm has allowed the ECB to quietly withdraw from headline-grabbing discussions of untested policy options like negative deposit rates. Instead the central bank has been able to turn to inside baseball consultations on aspects surrounding European banking system reform. Officials are delving into increasingly technical discussions of the single supervisory mechanism (SSM) for banks that is set to go into effect for the largest institutions next year, and the related asset quality review that is currently being conducted at those banks. There is also some low-key talk that the ECB may consider launching another Long Term Refinancing Operation (LTRO) to ensure banks liquidity.
Unfortunately, Europes political scene is less placid. After inconclusive Italian elections in February, the sparring parties agreed to support centrist Enrico Letta as Prime Minister, allowing government business to resume. But a legal and political battle over former PM Berlusconis seat in the Senate may unravel this delicate coalition. Several times, members of Berlusconis center-right PDL party have threatened withdraw support for the government unless the former PM is pardoned from his legal troubles and his Senate seat is preserved. The most recent squawking from the PDL has PM Letta fed up, and he is now demanding a confidence vote, saying we either renew support and put Italys interests first, or we can end this government experience. If the PDL decides it doesnt want to play ball with a non-partisan like Letta, it is unclear who would be able to lead a new government in Italy, potentially sending the Euro Zone back into crisis mode.
The political process has gone more smoothly in Germany, where Chancellor Angela Merkel was just re-elected to a third four-year term. Her party had its best showing since 1990, but its former coalition partner, the FDP, failed to reach the 5% threshold needed to be seated in the Bundestag. Thus Merkel will have to form a coalition government with the main opposition SPD party or with the Greens. The most likely outcome appears to be a grand coalition with the center-left SPD, which is eyeing the finance or labor ministry portfolio as a down payment for its cooperation. To entice the SPD, Merkel allies have already suggested some concessions on taxes and minimum wages, which should smooth the process of establishing a coalition by mid-November when the SPD party convention would vote on approving a unity deal.
A Rare Triple Play
Japans days of political turnover appear to be at an end, as Prime Minister Abe has solidified his hold on the government and pushed ahead with his eponymous economic program aimed at snapping the nations economic growth back into the Big Leagues. The three arrows of Abenomics are massive monetary stimulus to beat deflation with the side effect of a weaker yen, a deficit-financed supplemental budget filled with new public works spending, and a reform program to boost growth and competitiveness by stimulating private investment (upon winning the bid for the 2020 Summer Olympics, Abe called the Tokyo Games the unofficial fourth arrow, acting as a natural bookend to judge Japans progress seven years hence).
At the outset of Abes shock and awe plan many observers, including the IMFs chief economist, called the policy risky given the frontloading of monetary stimulus, and some volatile moments in the Japanese markets seemed to bear out this assessment. But this volatility has eased the Nikkei index has found a range between 13,000 and 15,000 and the yen has settled near parity and it appears some progress is being made toward the goals of Abenomics. Many economists questioned whether the target of reaching 2% inflation within two years was realistic, but progress is being made. CPI data has risen for three straight months and national core CPI hit 0.8% in August, the highest rate since the start of the 2008 global financial crisis.
The biggest fear for Japan, with its enormous debt market, would be another sudden uncontrolled jump in interest rates like the one seen in May, when the key 10-year rate nearly doubled in a matter of days. If rate rises are not more gradual and supported by a commensurate rise in economic activity it could turn the three arrows into three strikes, shattering Japans faith in Abenomics.
This is what makes the implementation of Japans impending consumption tax increase such a delicate matter. On October 1, Abe is expected to formally approve a two-stage sales tax increase starting early next year. Reports indicate that Abe will try to offset the impact on consumers by offering a stimulus package and corporate tax cuts that will be structured to motivate employers to pass the benefits on to employees who will then spend it into the economy. This will be the first big test of Abenomics for investors who are concerned that the program has relied too heavily on financial engineering and wont gain traction unless there is follow through on structural reforms. Some skeptics are already predicting that the BOJ will be forced to add more quantitative easing as early as Q4 to keep the plan in motion.
If policy makers can clear up some uncertainties, markets could see a real Fall Classic, but if they start chalking up more errors, the next few months could get ugly. This summer the odds of another Euro Zone meltdown or an economy-damaging US budget stalemate looked low, but simmering disputes have erupted again into new potential crises.
If Italys political feuds erupt into full blown turmoil, it could undo a years worth of recovery in Europe. The real risk would be another sovereign downgrade which could cause funding costs to soar. Japan also carries the risk of bond markets coming unhinged if the third phase of Abenomics turns out to be a bloop single instead of a home run.
In the US, a robust stock market headed into another round of solid quarterly earnings reports could lead Congress to underestimate the impact of another scrap over the debt ceiling. The anticipated kinks in the start-up of state health insurance exchanges mandated by Obamacare to begin on October 1 could also lend Republicans some ammunition to continue their fight. But a rookie Fed Chairman on the mound will not be able to pitch the economy out of a jam if Congress toys with default.
Very low inflation gives the Fed leeway to continue QE indefinitely, but the perception that the FOMC misled markets about a September taper may increase the pressure to communicate more precisely about the schedule for tapering. It also may be that the FOMC held off entirely because of the uncertainty around the budget battle in Washington and could move ahead with the taper once that sticky situation is resolved.
Though the Fed, and now other central banks, are promising rates will stay ultra-low for a long time, at some point markets will again focus on tapering which could cause some fresh volatility as weak hands are forced out. Turning off the QE tap will only be the first step in a long process of central banks unwinding five years of extraordinary stimulus, and how the market contends with it will shed some light on how the global economy will fare in the post-steroid era.
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