We identify six key issues facing investors:
- US economy
- Brinkmanship in Athens
- Cyclical recovery in Europe
- BOJ policy response
- RBA meeting
- Oil prices
US Economy
The March jobs data was a disappointment. The question is its significance. From a macro point of view, we would not place much emphasis on any one high frequency data point. From a technical point of view, it may encourage a continued consolidation/correction of the dollar's Q1 gains, not only against the major currencies but also against many emerging market currencies.
The US dollar's strength in Q1 was not matched be the economic performance. The weakness in Q1 already prompted the Federal Reserve to lower its growth projections, though Yellen has noted that even with the downgrade, it expects above trend growth for the year. The poor employment report is unlikely to change this assessment. The Fed's Labor Market Conditions Index has already picked up a moderation in the labor market in Q1, where the monthly average has increased by 4.4 compared with 6.5 in Q4 14. The weekly initial jobless claims and continuing claims show underlying strength. The JOLTS report is expected to confirm this. Sectors like construction and leisure/hospitality, which are the most sensitive to weather were exceptionally weak in March.
We are reluctant to read too much into the weakness in Q1 economic activity. Over the last five years, there has been a clear pattern of weakness in the first part of the year. Consider than growth in Q1 has averaged 0.6% (quarterly annualized pace) compared with almost 2.9% for all the other quarters. In three of the five years, growth in Q1 was the slowest for the year (2010, 2011, 2014) and in one year it was the second weakest (2013).
Fed officials have argued that the headwinds in Q1 will prove transitory. This seems to be the most likely scenario. That said, the implications of the jobs report, especially the 0.1% fall in the average work week, suggests the quarter ended on a weak note. This would seem to have already been largely discounted by the market which means that March data may have less impact on prices. There will be headline risk from the minutes from last month's FOMC meeting, but in terms of policy insight we would put more emphasis on the speeches by the Fed's leadership in the coming days. NY Fed President Dudley speaks twice in the week ahead, after both Yellen and Fischer have given several speeches since the FOMC meeting.
Brinkmanship in Athens
The game goes on. Athens has submitted no fewer than four different reform proposals. Each has successively been larger and more detailed. The official creditors think more concessions can be made. While the pressure on the new government remains intense, the ECB is drip-feeding authorization for increased ELA funds.
In this game of brinkmanship, it is in the interest of both sides to claim a brink is at hand to try to force the other into new concessions. Some Greek officials have emphasized the week ahead is such a brink. There are two key events.
First on April 8, Greece will auction 6-month T-bills. Greek banks can only buy a limited amount, given the restrictions on what they can do with ELA funds (namely not finance the government). Greek officials appear to be hoping from additional good will gestures by China and, perhaps, Russia. Reports indicate that since the Greek government relented in its opposition to privatization, especially the leasing of the port of Piraeus to a Chinese company, China may have bought more than 100 mln euro of Greek bills at a couple of auctions. A little money from Russia could also go a long way. Greek officials have been talking with both countries.
Second, on April 9, Greece has a 360 mln SDR payment due to the IMF. Greece has a currency mismatch and euro's depreciation the past year has increased the cost of servicing its debt. The 5% appreciation over the past couple of weeks is a small consolation. There have been some threats that Greece would not make the payment. This is part of the brinkmanship tactics. Exploiting the legal grace period would not be surprising. After this payment, the pressing challenge will be rolling over maturing T-bills before the end of the month "review" half-way through the four-month extension granted at the end of February.
Cyclical Recovery in Europe
The cyclical recovery in the euro area will likely be confirmed by the March service and composite PMI reports. Based on the flash reports, both are at their highest level since the time series began three years ago. Of the large countries, France is the clear laggard. After a difficult start to the year, Italian numbers have begun looking better. The decline in the euro, interest rates, and oil appears to be favoring Germany the most. German industrial orders have been following a saw-tooth pattern alternating months of increases and declines. They fell 3.9% February and are expected to have risen 1.5% in March.
Industrial production itself has been more consistently expanding, but last year's monthly average was only 0.1%, and this required a 1.0% rise in December alone. Over the past two years, it has averaged 0.2% a month. Output decelerated to 0.6% in February, and further slowing is expected in February to its longer-term average.
The eurozone reports February retail sales in the middle of the week. Few appreciate how strong eurozone retail sales have been. Consider that the three month average stands at 0.7% and the six month average is 0.4%. The three month average is the strongest since records began in early 2000. The six month average matches the record peak seen in early-2001 and again in early-2005. However, the shopping spree may have ended in February when retail sales are expected to have fallen by 0.2%.
That said, barring a significant surprise, the eurozone is expected to have grown faster than the US in Q1 15 as it did in Q1 14. The decline in the euro, oil and interest rates continues to provide stimulus the region. Money supply growth has accelerated; bank lending is improving, and financial conditions more broadly are supportive. The ECB continues to purchase public and private securities, and the account of the recent ECB meeting suggests officials are well aware of the formidable structural constraints.
Outside of the euro area, the UK reports March service PMI, and February industrial production and construction spending data while the BOE holds an MPC meeting. The UK economy appears to have expanded around 0.5-0.6% quarter-over-quarter in Q1. The economic data is expected to be broadly consistent with this estimate. The MPC is on hold, and we expect it to be a unanimous decision. Political considerations are overwhelming pure economic considerations in the run-up to next month's election. Currency volatility is elevated, and this is likely to persist for the next several weeks as investors seek protection in the options market.
The market is likely to be sensitive to any disappointment with Sweden's economic news and there is a full slate in the week ahead. The economic reports include industrial production and orders, service output, and household consumption. Nearly all the February data are expected to have decelerated from January. The Riksbank meets again toward the end of the month. It is not expected to cut the repo rare from its -25 bp level, but disappointing data could keep the door open, especially if the krone remains considerably stronger than it was when it surprised the market with negative rates in early February.
Norway reports industrial output and inflation figures. January output was exceptionally weak, and the Norges Bank did not respond, perhaps in part because a February recovery is expected. Although many countries are experiencing deflation or lowflation, Norway is not one of them. Its headline CPI was up 1.9% in the year through February and is expected to have poked through 2.0% in March. The underlying rate, which excludes energy and adjusted for taxes, is expected to ease to 2.3% from 2.4%.
BOJ Policy Response
Since the BOJ met, last investors have learned that inflation has slowed further to stand at zero when adjusted for fresh food prices and last year's sales tax increase. February industrial output fell nearly twice what economists expected. The Tankan survey showed sentiment remains poor and businesses plan to cut capex this year.
There appears to be growing pressure on the BOJ to ease policy further. However, if increasing its annual monetary base target from JPY60 trillion to JPY80 trillion has not done the trick is there much reason to expect JPY100 trillion would be any more effective?
BOJ Governor Kuroda wants to look beyond the recent weakness in inflation, which appear largely oil-related. He also wants to see the spring wage round. Several auto companies have already indicated intentions to raise wages. Kuroda, like other policy makers, are convinced that when last year's precipitous decline in oil prices drop out of the base effects, underlying inflation will be more evident. If the BOJ does choose to increase its asset purchases, which does not appear imminent, we suspect it would consider regional government bonds, which are mostly infrastructure related, and equity ETFs, though the Nikkei is near 15-year highs.
Reserve Bank of Australia meeting
Indicative pricing suggests the market has gone a long way (70-80%) toward pricing in a 25 bp rate cut at this week's RBA meeting. Economists seem less sanguine as shown in the surveys pointing to a stand pat decision. The continued collapse of iron ore prices suggests that the negative terms of trade shock is an ongoing challenge.
We think the RBA decision is a closer call than the market. We are also concerned that there may be a "sell the rumor buy the fact" type of activity on a rate cut, which some will likely see as the last in the cycle. Speculators in the futures market have slowly been begun picking a bottom to the Australian dollar, which fell to new multi-year lows in the second half of last week. Even at 2.0% the RBA's cash rate would be highest among the high income countries, and it sports an AAA rating as well.
The failure to deliver a rate cut this week could also see the Aussie strengthen, but under that scenario the upside looks more limited. Many players will feel more confident of a May cut, especially if the accompanying statement is at all encouraging.
Oil Prices
The preliminary and framework agreement tentatively reached over Iran’s nuclear program does not mean sanctions will be immediately lifted. The political opposition in Washington and Tehran, let alone Jerusalem and Riyadh should not be under-estimated, could still scupper the deal.
Nevertheless, the prospects of more Iranian oil adding to the world’s surplus output is negative for prices, especially for Brent, with which it competes most directly. Middle East and Asian refineries are preparing for seasonal maintenance. By increasing supply, it may also weigh on prices. We are also concerned that hedges put on last September-October have begun rolling off, and the establishment of new hedges may weigh on prices.
After being nearly halved over the past six months, the shuttering of US oil rigs has begun slowing. The growth in US output has peaked or nearly so. At the same time, the capital life blood of many shale producers will be reduced as banks reassess the value of the collateral (oil reserves) used to secure funding. This may lead to more industry rationalization through liquidation and acquisitions.
The sharp drop in oil prices in the second half of last year has been the single biggest factor driving down measured inflation. As the year progresses, it will slowly drop out of year-over-year comparisons. Toward the end of the year and into next year, price pressures globally will intensify even if the price of oil does not increase much from here.
