The investment climate has proven extremely difficult for investors to navigate. Fed tapering and better world growth was to lead to higher interest rates. Yet interest rates for the developed world have fallen sharply in recent weeks. Aggressive quantitative easing by the Bank of Japan was widely understood to be yen negative, yet the yen is the only currency to have been stronger than the dollar in January. Toward the emerging markets, investors were to take a more differentiated approach. Countries with large current account deficit were particularly vulnerable, yet it appears that the entire asset class was tarred with the same brush. Reports suggest that ETF for Mexican equities (EWW) showed the largest outflow, which seems counter-intuitive, especially since the higher wages and economic slowdown in China appear to work to its benefit.
We identify, discuss and assess nine event risks of global investors in the week ahead.
Emerging Markets (High Risk): The MSCI Emerging Market equity index peaked in 2011 and is off a little more than 20% since then. Last month, it fell 6%. Investors’ post-2009 love affair with emerging markets is over. The fact of the matter is that most were emerging markets 20 years ago and are likely to be emerging markets 20 years from now. There were two attractors—liquidity and structural reforms and we suspect, as is their wont, investors have tended to emphasis the latter and under appreciate the former. One clear implication is that real interest rates will have to rise through most of the emerging market universe. And this will have negative knock-on effects for growth.
However, due to some structural reforms, including more flexible currency regimes, somewhat deeper capital markets, and the accumulation of reserves, which can be understood as a type of self-insurance, many emerging market countries are better able to cope with a capital outflows. The key to whether investor panic leads to a crisis seems to be largely a function of the response by policy makers. The IMF/World Bank and the US Treasury have urged developing countries to take advantage of the signals to strengthen their own policy reaction. They might as well be shouting in the wind.
Portfolio Allocation (High Risk): In addition to sizeable outflows from emerging market funds that have been widely reported, there have been three other notable portfolio adjustments. First, anecdotal reports indicate that in recent weeks, several large asset managers have shifted from stocks to bonds. In this context, we note that US Treasuries had their single best month in January since the middle of 2012. To the extent there is foreign investment component, we note that due to relative volatilities, foreign fixed income investment tends to carry a higher hedge ratio than foreign equity investments. Second, after strong foreign interests in recent months that has helped drive Spain and Italian rates to record lows, some large asset managers have reportedly begun adjusting positions on valuation grounds. Third, Japanese investor appetite for foreign bonds that was evident in the second half of 2013 appears to have waned in January, as they turned net sellers again. For their part, foreign investors have slowed their purchases of Japanese shares.
Trade Promotion Authority (Low Risk): Within 24-hours of President Obama’s State of the Union Speech in which he called on Congress to grant him Trade Promotion Authority to complete the negotiations for Trans-Pacific Partnership and the Trans-Atlantic Trade and Investment Partnership, Senate Majority Leader Reid underscored his opposition. Even though the risk that TPP, which was initially to be completed last year, is further delayed is high, the risk to investors appears minimal. Yet, it speaks volumes about the outlook for fresh initiatives ahead of the November election and the consequence of the erosion of support for President Obama. Note that this follows the recent refusal by Congress to ratify the long planned increase in the IMF’s quota. Some observers talk about a new wave of isolationism in the US, but sometimes in the past, isolationism was a shroud to cover unilateralism.
China (Near-term Low Risk): The Lunar New Year celebration will keep China out of the spotlight in the coming week. It will report the service sector PMI reading first thing Monday in Beijing, but other than that, it will likely be out of the news in the coming days. The official manufacturing PMI was reported at 50.5, which was in line with expectations, but is the lowest reading since last July. Output hit a four month low and new orders slipped to six month lows, though both are still above the 50 boom/bust level. Employment and export orders were below 50.
Reserve Bank of Australia (Medium Risk): The RBA is the first of the three central bank meetings from the high income countries. There is little doubt that policy is on hold with the cash rate at a record low 2.5%. The credit expansion, the somewhat higher than expected CPI inflation figures, and the roughly 8% decline in a trade-weighted measure of the Australian dollar over the last four months remove the sense of urgency to cut rate further. At the same time, the weakness of the labor market, the softness in producer prices (pipeline inflation?) and the erosion of the terms of trade, means the RBA is unlikely to close the door completely on another rate cut, which now seems more likely in Q2 than Q1. We attribute a medium risk to the prospect of a more neutral sounding RBA statement. We note that central bank officials have cited $0.8500 and $0.8000 as targets for the exchange rate.
Bank of England (Low Risk): The Bank of England is securely on the sidelines. BOE Governor Carney has already indicated that the next step in the evolution of forward guidance will be announced with the quarterly inflation report on February 12. Contrary to claims that Carney is jettisoning the forward guidance, we expect the BOE to drive home the point that the 7.0% unemployment rate was a threshold not a trigger for tighter policy. In effect, the BOE will say, we re-examined the economic conditions in light of the threshold being approached and we continue to judge the economy as recovering but still in need to very low interest rates. The September short sterling futures contract rallied in January and the implied yield is 16 bp lower than it was in late-December at an implied yield of about 64 bp. It can fall toward 50 bp bank rate on dovish comments and data that suggest the economic activity is leveling off, which is expected to be seen in the PMI reports in the coming days.
Euro Area PMI (Low Risk): The flash readings steal much of the thunder from the final reports that are out in week ahead. The focus will be on Spain and Italy for signs of continued recovery. The manufacturing PMI for the euro area is at its best level since 2011, which has lifted the composite as well. The service sector has lagged, though the flash reading put it at four month highs. We note that the criticism of the lack of progress reform in the German service sector appears to be on the rise.
ECB Meeting (High Risk): The two pillars of ECB monetary policy, money supply and inflation, disappointed on the downside. This has spurred speculation that the ECB will take action at its meeting on February 6. A large German bank has forecast a small cut in the 25 bp repo rate and, more important, a move to a negative deposit rate. Others have predicted an end to the efforts to sterilize the SMP purchases. Since EONIA has traded above the repo rate, we think a repo rate cut is largely immaterial. Cutting the 75 bp lending rate would be more significant in capping the increase in EONIA. A negative deposit rate could be potentially very disruptive as it puts the ECB in unprecedented territory. Even Japan through its deflationary years never adopted a negative deposit rate.
The ECB does not need to open the can of worms by formally ending its sterilization of the SMP sovereign bond purchases. It would likely be highly controversial as some (read Germany and its creditor allies) may see it is an illegal monetization of sovereign debt. It can take a stay with its more passive of failing to attract enough interest in its sterilization operations. This would be less controversial but effective in providing more liquidity on a weekly basis. We see ECB officials more concerned about lending to the SME sector. In one of the more important discussions at Davos, Draghi indicated a willingness to consider buying bank bonds, backed by loans to households and SMEs. Though it does not appear imminent, development along these lines seem more promising.
US Jobs Data (High Risk): The market generally anticipates a dramatic recovery in non-farm payrolls in January after the disappointing 74k increase in December. However, there is substantial risk that the frigid temperatures in the Midwest, South and Northeast will make for another disappointing report. Last month, we noted how well the ADP estimates had anticipated the official data, just in time for the large miss (ADP Jan estimates was 238k, while the private sector NFP grew by only 87k). Having been burned last month, investors will likely put less weight on it this time. The market will quickly look at the weather distortions and make adjustment accordingly. Before the Fed meets again (mid-March), it will see another jobs report, so the policy implications of a disappointing report may not be that great. Most investors and observers see the bar relatively high against the Fed deviating from the tapering strategy outlined by the FOMC in December. There is also substantial risk that without emergency unemployment benefits being extended there may be an unusually large decline in the unemployment rate as more people leave the labor market. Arguably the Fed’s forward guidance anticipates this possibility by saying rates will remain low even after unemployment falls through the 6.5% threshold.
While the employment report is the last major event of the week, at the start of the week, the US reports January auto sales. The consensus calls for a 15.7 mln unit selling pace after the disappointing 15.3 mln unit pace in December. If true this would put the January sales about the average in H2 13. However, there is risk of disappointment due to weather disruptions and this would weigh on the retail sales report (January 13), which already are looking soft even excluding auto sales. Lastly, the debt ceiling debt poses headline risk, though distortions to the short-dated T-bills appears to have eased somewhat.