The Past is Not Passed: 2017 Spills into 2018

The New Year may have begun in fact, but in practice, full participation may return only after the release of US employment data on January 5.  The macroeconomic and policy tables have been set, though interpolating from the Overnight Index Swaps market, there is 45% chance the Bank of Canada hikes rates at its policy meeting near the middle of the month.

In the currency markets, sentiment appears to be as uniformly dollar negative as it had been positive a year ago.    More important for the near-term price action, there have been powerful but extended trends over the past two-three weeks as participation thinned.  Consider that the Canadian dollar appreciated nine of the past 10 sessions.  The Australian dollar rose in 13 of the last 15 sessions.

It is too difficult to find a consistent narrative of what the market is saying.  The rally in industrial metals and equities suggest an economically optimistic outlook.  However, the rally in the US Treasuries and the flattening yield curves in most advanced economies would seem to be consistent with downside risks.  There is no sign in recent data that the synchronized upturn is slowing.  In fact, on balance, data from Q4 suggests, growth may have accelerated. 

The flash PMI for the eurozone is expected to be confirmed in the coming days.  The composite firmed to a new cyclical high 58.0 from 57.5 in November. It averaged 56.0 in Q3.   The composite PMI was at 54.4 at the end of 2016.   Not only has economic activity quickened but it also broadened.  Italy and France, and no less than Greece are participating. 

Data over the last couple of weeks suggests that what might have begun as an export-led growth in industrial output and capital investment has spread to consumption.  Overall household spending rose 1.7% year-over-year in November. This is the second strongest pace in more than two years. 

China, the world's second-largest economy, is also finishing the year on a firm note.  The official manufacturing PMI slipped to 51.6 in December from 51.8 in November.  The Q4 average was 51.7 after 51.8 in Q3 and 51.5 in H1.  The non-manufacturing PMI edged up to 55.0 from 54.8.  It averaged 54.7 in Q4 and 54.4 in Q3, following a 54.5 average in H1.  

Of the large countries, India's economy may be the most concerning.  After a good H1 2017, the economy struggled in Q3.  The composite PMI posted the year's high of 51.7 in June before falling below the 50 boom/bust level in July and August. The recovery in September and October (51.3) fizzled out in November (50.3).  The December reading is due January 4.   

The minutes from the December FOMC meeting that delivered the third hike of the year will be scrutinized for clues into the bar for a March move.  Assuming that there is no practical chance of a hike at the next FOMC meeting, the market appears to have discounted a little less than a 60% chance of a March hike. 

The US jobs data is the economic highlight of the holiday-shortened first week of the New Year.  Even modest disappointment with the December report will not prevent 2017 from being the seventh consecutive year the US economy created more than two million jobs.  A little more than 8.5 mln jobs were lost 2008-2009 and 18 million jobs have been created since.  

Job growth is expected to have cooled in December after two months in which 472k net new jobs were created.  Newswire survey put the median guesstimate near 190k.  Manufacturing has been on a hiring binge, with 54k new positions in October and November.  Another 20k are expected to have joined the payrolls in December Through November, the manufacturing sector jobs have risen by 16k on average.  Last year, there was an average loss of 1k manufacturing jobs.  

In November, the work week ticked up to 34.5 hours.  It is the third time in 2017 it has risen there, but each time it was quickly turned back.  Some observers suggest there needs to be a sustained increase in the work week to boost the likelihood of wage pressure.  Average hourly earnings need to rise by 0.3% in December to keep the year-over-year rate steady at 2.5%.  

US auto sales are not particularly interesting presently. Sales had slowed in the March through August period. The terrible destruction of a couple of storms helped boost auto sales, and arguably, save the year. Through November the pace has averaged 17.11 mln (annualized pace) vehicles. This is the lowest in three years (17.45 mln in 2016 and 17.40 mln in 2015). December auto sales are expected to be around the 17.5 mln unit pace.  

Geopolitical developments in recent days will be part of the talking points to start the New Year.  In particular, reports that to show Russia and Chinese ships transferring fuel to North Korean vessels.  Meanwhile, large urban protests in Iran, ostensibly over rising food and fuel prices, are apparently capturing the imaginations of many observers. The details are not particularly clear, and the press converge appears laced with ideological assumptions.  The protests may have begun out orchestrated, but appear to metastasized into a something else.  The demonstrations seem smaller than in 2009 (Green Movement).  The government's response has thus far been restrained.   

Meanwhile, four political issues in Europe that are unresolved at the end of 2017 need closure in early 2018.  Catalonia new regional parliament will take office January 17.  The government it will create is not clear.  Once the independence issue is subsumed by other issues, it is not clear the programmatic basis for a coalition of the independent-minded parties, whose views seem to extend across the political spectrum.

Germany has been unable to put together a government following the late September elections.  The demand by the SPD for dramatic European integration cannot be accepted by the CDU/CSU Mathematically, appears to be three alternatives: A coalition government, a minority government, or new elections.  The first is proving difficult.  Merkel appears to have ruled out the second.  Given that CDU, CSU, and SPD did the worst in modern history in the September election, a return so soon to the polls may be a nuclear option.

Brexit negotiations shift to the terms of the transition period after the end of March 2019 that the UK seeks.  The UK is going to want to maximize its new position, while the EU wants to maintain the integrity of its institutions.  After March 2019, the UK is not in the single market, but during a transition period, it will act as if it does without having a say in the formulation of new rules.  

 If the UK were to strike a new free-trade agreement with a third country, wouldn't that leave the EU vulnerable to disruption?  Shouldn't the European Court of Justice still have sway where it currently does?  And if the UK will still have access to the single market, ought it not abide by the EU's immigration policies?  

The EU-Polish conflict may come to a head in January.  The EU objects to the government's judicial reforms, which undermines the independence of the courts. Poland is of no mind to comply. The EU's ability to escalate is limited by the need for the decision to be unanimous.   

The confrontation with Poland is part of the broader fissure with the Visegrad countries (Poland, Hungary, Czech, and Slovakia). When the Soviet Union collapsed, there was a brief moment when nationalism and democracy coincided, but the former appears more dominant currently than the latter, and this rattles Western European sensibilities.  

A new political story for 2018 will be the Italian elections on March 4.   They will be the first under a new electoral law.  Part of the purpose of the new electoral law is to provide for more stable governments.  However, the camel that is the horse made by competing interests and motivations, may not be up to the job.  

Polls suggest that no party or block will achieve a majority.  A coalition government then is most likely come March.  A broad coalition of center left and center right--a different shade of gray than the current government, excluding the 5-Star Movement--is the most likely scenario.  The uncertainty, however, may see Italian assets underperform in the first part of the New Year, potentially creating new opportunities for Q2.   

With US tax changes having been legislated late in 2017, the debate over the implication and meaning for US companies as well as subsidiaries and branches of foreign companies operating in the US will continue.  The repatriation of foreign earnings will be monitored closely.  The political agenda shifts to Trump's infrastructure initiative.  The conventional wisdom is that it will be difficult for Democrats, especially Senators from states that Trump carried in 2016, not to support an infrastructure bill, ahead of the midterm elections.  

Although the US Administration's actions on trade did not match some of the fiery rhetoric in 2017, it is still the early days.  NAFTA negotiations resume this month.  The US appears frustrated that Mexico and Canada are not making counteroffers on some of its more aggressive demands.  A risk of a collapse in talks seems to be elevated at the start of the New Year.  US-China trade tensions also seem set to escalate. 

Even if the precise calibration is not knowable, we suspect many of the macroeconomic relationships hold, and that the business cycle has not been repealed, even if elongated and flattened.  We think underlying price pressures are already increasing and expect this to be more evident in the coming months.  We anticipate global higher interest rates and wider differentials favoring the US. The US agenda of deregulation, corporate tax cuts, including fully expensing capital investment, and protectionist threats will attract capital.    

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