MACRO: Twenty-Eighteen

 Resiliency

This past year turned out to be quite a bit better than many had feared.  The populist-nationalist wave did not sweep across Europe.  It was a key risk a year ago, after the UK referendum and the US election, and spurred underperformance by the eurozone.  The US exited the multilateral Trans-Pacific Partnership (TPP) that had been years in the making, and also the Paris Agreement.   The broadly liberal trade regime, however, and some evidence that a global community persists, even without the leadership of the world’s largest economy, speaks to the resiliency of the institutional arrangements.  

Most of the other parties to the TPP are continuing to pursue an agreement.  To be sure, America’s presence is missed.  One of the first components dropped upon the US exit were worker protections.   There were other efforts on trade, like the EU and Canada free-trade deal and the EU’s trade agreement with Japan, struck at the end of the year.  The Paris Agreement was a voluntary, coordinated effort to address greenhouse emissions. It appears concern has reached sufficient levels that a few state governments – including the most populous state, California – and more than 50 cities committed to adhering to the Paris Agreement standards despite the federal government’s rejection of the accord. 

 

Many of the potentially disruptive actions that were previously suggested by then-candidate Trump have not been implemented.  China has not been cited as a currency manipulator, nor has the US put a punitive tariff on Chinese imports.   The Trump administration has not pulled out of NAFTA, agreeing instead to extend negotiations into next year. 

After the Great Financial Crisis, global trade slowed, and with the rise of nationalism, many feared that globalization was unwinding.  Global trade accelerated in 2017 as world growth increased.  Indeed, for the first time since the Great Financial Crisis, trade appears to have grown faster than world growth.  There is a synchronized global upswing that appears set to continue well into next year.  Even the laggards in Europe, such as Italy and France, let alone Greece, are enjoying improving growth and falling unemployment.  

This is not to ignore potential flashpoints, like North Korea, Venezuela, Afghanistan, and the Middle East.  Resiliency is not without limit.  The US has an investigation into steel and aluminum on national security grounds.  Some of the US demands in the NAFTA negotiations seem almost designed to extend beyond what Canada or Mexico can agree to.  The migration into Europe has shifted from eastern routes to more dangerous courses through the Mediterranean, and immigration remains a divisive issue in Europe and the US.  

Italy’s election, likely in early March, may rekindle political anxiety in Europe.  The US primaries in the first part of next year will set the stage for mid-term elections in the middle of Q4.  Trump is not the only leader whose domestic support is weak.  May lost a parliamentary majority, and the bookmakers have her odds of surviving as UK prime minister at 50/50.   Spain and Ireland have minority governments.  Macron lost favor shortly after his election in May, though he has begun recovering as France is fully participating in the European economic expansion.  Merkel’s CDU/CSU drew the least amount of public support in modern times, and she is struggling to cobble together a new coalition, three months after the election.   Yet there is little evidence that the political uncertainties are having a negative impact on growth.

Continuity: The Powell Fed

Monetary policy among the major industrialized countries will continue to diverge in the year ahead, which is to say that short-term interest rates will likely continue to widen in the US favor.  The Federal Reserve is both raising interest rates and allowing its balance sheet to shrink.  It continues to anticipate that three rate hikes will likely be appropriate in 2018, as they were in 2017, followed by an additional two in 2019 and one in 2020.    In H1 2018, the Fed’s balance sheet will shrink by $150 bln, and in H2 the pace picks up to $270 bln. 

Unwinding the balance sheet is accomplished by not fully reinvesting the maturing proceeds.  It is an unprecedented action.  Some observers had expressed concern that just as the purchases were understood to be the easing of monetary policy when the zero-bound had been reached, the reduction of the balance sheet is tantamount to tightening.  

Our understanding emphasizes the signaling impact of the operations over the material impact.  The Fed has clearly indicated that the unwinding of the balance sheet will be on autopilot and not be impacted by high frequency data or interest rate policy.   It did warn that if rates need to be cut, it will consider stopping the balance sheet operations if the zero-bound is being approached.  The expansion of the balance sheet was about monetary policy, but the unwinding sends no signal about the Fed’s stance.  

We see parallels with the ease in which the Fed has been able to raise the Fed funds target.  Recall that the system is awash with reserves and liquidity, and many observers had been concerned that it would require large open market operations to maintain the target.  The surprise is that even as the cycle matures, the Fed’s open market operations remain modest.  

By the end of 2018, the Federal Reserve will look quite a bit different. There will be a new president of the New York Federal Reserve, the only regional president who is also a permanent voter on the FOMC.   We expect the Federal Reserve under Powell to remain on the current path.  Powell’s leadership will be tested at the end of the monetary tightening cycle, but that is likely to be some time off.     We have been anticipating the real Fed funds rate to peak near zero, which we surmise is close to 2.00%-2.25%.   

Still, we expect greater continuity at the Federal Reserve than the number of personnel changes might suggest.  The new chair seems committed to the course that the Fed is presently on: gradual rate hikes and a pre-set reduction of the Fed’s balance sheet.  Mr. Powell revealed in his confirmation hearings that he thought the financial reforms had strengthened the banking system and resolved the too-big-to-fail challenge.  He is likely to allow for deregulation, focusing on the small and medium-size financial firms. Several large US banks ramped up their trading capacity in 2017, partly on expectations of some relaxation of the Volcker rule.  

Many cite the fact that the market has discounted less than half of the 75 bp the Fed expects to hike as a sign of low confidence in the central bank. We argue that the ease in which it has been able to maintain the Fed funds target speaks to its credibility.   Also, the early unwinding of the balance sheet has been without incident, and the market has not rushed to discount the entire operation and tighten financial conditions, as some investors feared.  

We expect US inflation to increase in 2018, with the core PCE deflator edging closer to the Fed’s target.   The yield curve (2-year to the 10-year) is likely to continue to flatten into the new year, but we think there’s a risk that it may steepen later in the year.  Our base case, barring new shocks, is for the economy to grow around 2.5%.  

ECB:  Everything Can’t be Bought

The European Central Bank (ECB) will continue with its extraordinary monetary policy.  Its balance sheet will expand by another 270 bln euros through the first three quarters.  We suspect the ECB will taper its 30 bln a month purchases in the fourth quarter rather than end them in September, though it is a close call.  We expect a tame core rate to take the shine off any rise in the headline rate, likely driven by higher energy prices.   Despite the broad and robust growth, core inflation in November 2017 stood at 0.9%.  It bottomed in 2015 at 0.6%.  

We are concerned that around the middle of next year, a factor outside the direct control of the ECB may cause the balance sheet to shrink.  What we have in mind is that when the ECB is crafting its guidance for September, the banks will be able to pay back their borrowings under the targeted long-term repo operations (TLTROs).  

Given the negative rates offered by the ECB and the short-end of the curve, ample liquidity, favorable deposit-to-loan ratios, and lukewarm demand for credit from households and non-financial businesses, we suspect some will opt to repay early.   This would have the effect of reducing the central bank’s balance sheet.  The return of a modest portion of the more than 700 bln euros borrowed under the facility could offset months of ECB purchases.  

The ECB’s other measures, including the negative 40 bp deposit rate and the full allotment of refi operations at zero interest rate, will continue into 2019.  The combination of the double dip cycle with the regional economy contracting in 2009 and then again in 2012 and 2013, and the arguably meek response by the ECB at the time, means that the ECB may have hardly begun to normalize interest rates and policy before the business cycle turns.  

With the selection of Portugal’s Finance Minister Centeno to succeed Dijsselbloem as the president of the Eurogroup of EMU finance ministers, a two-year process has begun that will culminate with a new European Commission, ECB President, and European Parliamentary.  The ECB board will change, beginning with the vice president toward the middle of 2018. 

In negotiations to form a coalition government in Germany, the pro-business Free Democratic Party was demanding that countries be allowed to leave the EMU.  Merkel’s position, like the ECB’s, is that monetary union is inviolable.   The Social Democratic Party of Germany (SPD) may push in the opposite direction.  At the SPD conference at the end of the year, the party leader (Schulz) called for a United States of Europe, which of course was immediately rejected by Merkel’s CDU.   

    

The SPD will demand a high price to re-enter another coalition government with Merkel.  Strategically, they need to be able to differentiate themselves.  In addition to domestic social issues, the SPD can demand a ministry that ensures the international stage.  They may be able to work with France’s Macron on the future of the European project after the financial crisis and Brexit.  A shift of the political axis to the center-left will reinforce our expectation that Draghi’s successor at the ECB comes from a core creditor country, most likely Germany.  

BOJ: Yield Curve Targeting

The Bank of Japan’s (BOJ’s) efforts to stimulate inflation shifted from its quantitative and qualitative easing to targeting the ten-year bond yield (+/- 10 bp).  It had already set the deposit rate at negative 10 bp.  This yield curve management requires the purchase of few government bonds, though it continues to buy other assets including ETFs and corporate bonds.  

It should not be surprising if BOJ bond buying under the yield curve management strategy falls to JPY30-JPY40 trillion rather than the declaratory policy of JPY80 trillion.  Some observers have called this tapering, but that is not the signaling impact.  Nor have there been other signs that investors believe the BOJ is reducing its effort to secure greater price pressures. 

BOJ Governor Kuroda’s term is up near mid-year.  A BOJ governor has not served two terms in modern history.  We suspect Mr. Kuroda may be offered a second term.  However, even if he is not, we suspect the activist approach to monetary policy will be shared by his successor. Prime Minister Abe has influenced the BOJ the way that President Trump will influence the Federal Reserve: through the power of appointment.  The BOJ board is now comprised of men with the same general philosophy as Kuroda (whose name means black) rather than his predecessor Shirakawa (whose name means white). 

The year-over-year core rate, which excludes fresh food, rose from -0.2% at the end of 2016 to 0.8% in October 2017.  While still well shy of the 2% target, there has been some significant progress, and we expect more next year.   We expect the spring wage round to agree with something on par with this year’s 2% increase. If the global synchronized recovery continues into 2018, as looks likely, and if global bond yields rise, there is some risk that the BOJ raises its target on 10-year JGBs.

Prime Minister Abe is committed to lifting the sales tax in 2019 to 10% from 8%.  If the previous hike is any guide, the anticipation of the tax increase may boost consumption late next year. There may be some political pressure to delay it again, but the economy is performing better than it has in years. 

UK:  Brexit Drives Investment Climate 

The UK economy is likely to sustain growth near the 2017 pace of around 1.5% year-over-year.  Price pressures should ease, and this will bolster the purchasing power of households, which has been eroded by the decline in real wages.  More than macroeconomic variables, however, Brexit may drive the investment climate. 

Nine months after triggering Article 50, the UK seems woefully unprepared.  The Chancellor of the Exchequer acknowledged that there had not been the formal cabinet discussion of a post-Brexit trade relationship that is desired.  The Brexit Secretary admitted that there were no quantitative studies conducted on the cost of Brexit, nor was there industry impact research.  

It took more than a third of the two-year time limit to address three issues:  its financial obligations, the right of EU citizens in the UK after Brexit, and the Irish border.  Even now, the judgment that sufficient progress has been made for talks to proceed to the next stage does not mean that they have been resolved.  One of the most vexing issues is where to locate the hard border for customs and passport checks when the UK leaves the single market. 

 The EU and Ireland insist that the border cannot be between the Republic of Ireland and Northern Ireland.  The Democratic Unionist Party, which gives May her parliamentary majority, will not accept a hard border between the UK and Northern Ireland.   The UK’s promise of “regulatory equivalence” may be sufficient for talks to progress, but they cannot end there.  

Given the numerous authorities that must approve the new agreement, the EU is aiming to complete the second stage of negotiations, which will focus on the new trade relationship and transition period, by the end of October 2018.  The hard end date is March 31, 2019, two years after Article 50 was triggered.  The EU appears to seek a trade agreement with the UK similar to the one that was struck with Canada in 2017 after several years of negotiating, which nearly failed to be approved unanimously as required.  Talks of a new trade agreement between the UK and EU are unlikely to begin until the March 2018 summit.  The first part of next year will likely be spent discussing the transition period that the UK seeks.  

Former Prime Minister Cameron promised the non-binding referendum on EU membership as a way to heal the fissure within the Tory Party.  Not only did he make the referendum binding, committing the UK to a momentous decision on a 52%-48% vote, but the Tory Party remains profoundly divided.  The divide would be difficult for even the most adroit leader to navigate.  The bookmakers put even odds on May remaining at 10 Downing Street a year out.  May’s Tory Party rivals recognize that the near-impossible must be delivered, and Labour is running ahead in the polls for the first time in years.  

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