Four Changes to the Investment Climate
There are four changes to the broad investment climate.
1. The ECB has stepped up its threat of unconventional action and may have purchased a two month grace period.
2. Confidence in the US economic rebound from sub-par growth in Q1 is strengthening.
3. After a strong start, the major developed countries' equity markets appear poised to correct lower into the start of the US earnings season.
4. While geopolitical risks with Russia have stabilized albeit at elevated levels, the risks in Asia are rising.
How is this for coincidence? The German newspaper, Frankfurter Allgemeine Zeitung (FAZ), broke two stories before the weekend. In one story, the paper quoted BBK President Weidmann and EU Economics Commissioner Rehn arguing against the push from France for greater leeway on its fiscal targets.
In another article, reported, without citing a source, that the ECB has modeled a one trillion euro QE program that would boost inflation between 0.2% and 0.8%. When queried by other journalists at a different forum, ECB Vice President Constancio denied knowing about the report, though seemingly, by implication, not the research.
One cannot help but suspect it is purposeful leak that is meant to reinforce the Draghi's effort to step up his attempt to hold the market at bay. At last week's press conference, following the ECB meeting, Draghi escalated his verbal jousting increased calls for action, including by the head of the IMF.
To appreciate what is going on, consider the contrast: in recent years, the Federal Reserve has been dominated by a single individual--Volcker, Greenspan, Bernanke--. The ECB is much more of a collective. We suspect that Draghi is slowly shepherding the national central bank presidents onto the QE path. Because of the Easter quirk, there is reason to suspect that April will see an uptick in CPI (the flash reading is due on April 30)) from the flash 0.5% March pace.
Judging from economic surveys, many economists expect Q1 to be the low point in the inflation, i.e., the greatest risks of deflation. The creditors in the euro area, especially Germany, are wary of pursuing unconventionally inflationary policies just as inflation begins to rise on its own accord.
This analysis points to a new realistic window for ECB action seems not in May, which would be many observers tendency (just push out the expectation another month), but in June. This seems to be also along the line former ECB board member Bini-Smaghi suggested in a newswire interview, as well.
The possibility of QE will help support peripheral bond markets. Although some US credit spreads are back to levels seen since before the crisis, Spanish and Italian premiums over German remain substantially above pre-crisis levels. The premiums now are around 150 bp. For many years, into 2008, Spain and Italy a smaller premium than France pays now. Indeed, according to Bloomberg generic bond data, between 2003 and 2006, there were brief periods when the Spain would trade through Germany (lower interest rate).
We note that there were some technical changes in the ECB's collateral rules that went into effect last week. These changes will increase the haircut on Spanish and Italian T-bills used for collateral. It appears to be instrument specific and will not impact residual maturity of bonds. Reports suggest that this may not have much impact as Spanish and Italian banks use bills for managing liquidity more than collateral. On the hand, changes may also make more assets eligible for use in ECB operations.
We took the middle ground between those who suggested that the weakness of the US economy was only weather-induced and those who said the weakness showed that the economy was addicted to QE. We recognized that other influences, such as the build of inventories in H2 13 and the tax break on corporate investment brought forward some projects, also slowed the economy. We also recognized that some housing data had peaked in H2 13 and were already softening before the turn of the year.
However, weather also contributed to the sub-par performance and last week's news, both the surge in auto sales and the constructive employment report, point to an economy regaining traction. In particular, we note that the participation rate rose to 63.2%, a six month high, without an uptick in the unemployment rate. We appeared to have been too cynical in our anticipation that the loss of emergency jobless benefits would generate further declines in the participation and unemployment rates. The workweek increased to 34.5 hours, the best since last November.
If the US economy expanded around 1.75% in Q1, then it appears that growth can return toward 3.0% here in Q2.
This keeps the Federal Reserve's path clear. Tapering continues apace. Indicative interest rates for the end of 2015 (look at both the Eurodollar and Fed funds futures strip) finished last week at their lowest levels since the FOMC meeting on March 19 and Yellen's press conference. A rate hike in H2 2015 still seems like the most likely time frame, assuming no significant shocks, which would include renewed decline in core inflation.
The decline US interest rates before the weekend was more a function of the drop in equity market than the US economic news. The NASDAQ fell 2.5%, which is its third steepest drop since the start of 2012. It peaked a month ago. It finished last week below its 100-day moving average fore the first time since the end of 2012. The S&P 500 posted its record high before the weekend, but proceeded to sell-off and finished below last Thursday's low. Technicians refer to this price action as a key reversal. There are also bearish divergences in some technical indicators like RSI and MACDs.
Given the magnitude of the sell-off in US equities and the appreciation of the yen, the Nikkei and other regional markets are at risk of steep losses at the start of the week. More interesting will be the European bourses reaction. On one hand, the risk of QE and lower interest rates would seem to encourage equity market flows.
On the other hand, consider the performances just since mid-March: the Italian and Spanish markets are up about 10.5%. The German DAX is up 9% and the French CAC up 7.5%. Spain and Italy's markets are above the top of their Bollinger Bands, (two standard deviations above the 20-day moving average). France and Germany are flirting the top of their bands. Given that the UK's FTSE has not fully participated in the latest leg up, gaining less than half of the CAC's rise, it may hold up better, if a correction sets in. And it looks to us as if the risks of such a correction have increased. It is not uncommon, it seems, to see reversals at the start of new quarters or as the US earnings season begins.
The dispute over islands in the South China Sea appeared to pose the greatest geopolitical risks before Russia's take-over of Crimea. While the tensions with Russia remain at high levels, they have stabilized. There is risk that the breakaway province of Moldova, on the east border of Ukraine, Transnistria, becomes a new flash point.
If Q1 was about Europe, Q2 might be about to Asia. Later this month, President Obama will visit South Korea, Malaysia, Japan and the Philippines. The Japan-China dispute had appeared the most pressing.
Unbeknownst to many, the dispute with between China and the Philippines has escalated and is, arguably, surpassing the dispute with Japan. There have been two developments that have escaped the notice of many observers.
First, China tried in vain to stop the Philippines from re-provisioning a garrison it created on the disputed Second Thomas Shoal in 1999. That China failed does not necessarily mean that it will give up, expressing it displeasure at the Philippines insistence of using force to resolve the dispute. It does not like fait accompli.
Second, the Philippines also pressed its legal case, filing a 4000-page opening argument with the International Permanent Court Arbitration at The Hague. China is not happy about this either. The sovereignty of the disputed islands is outside of the court's jurisdiction, but it can decide whether it is really land or not, as they are often submerged. If it is not land, then the Philippines' claim is stronger. But not just the Philippines' but Vietnam, Malaysia, Brunei, Indonesia, and Taiwan's claims may be stronger, as well.
At the end of last week, the US State Department's point man on Asia, Assistant Secretary of State for East Asia, Daniel Russel warned China not to take inspiration from Russia's annexation of Crimea (we anticipated this here). China took exception with the official remarks, Make no mistake about: although Russia's threat in Europe is real and will not go away as long as Putin rules, the geopolitical problems in Asia are even more vexing. Yet, what Kissinger once purported to have asked about Europe (who do you call?) is more applicable to Asia now.
It is not just the US adversaries that ought to act in a restrained fashion, but so too should US allies. The nationalization of disputed islands by Japan prodded China with a stick. The Philippines are flaunting their security pact with the US to embarrass China. The US and China would have preferred to let sleeping dogs lie. But now that they have been awoken, they may come back to bite in the period ahead.
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