The Week Ahead

We are investing in a world that has not the reached peak of central bank balance sheets. Even with the tapering by the Federal Reserve, it is continuing to buy more long-term assets than it did when QE3+ was announced in late-2012. The Fed’s balance sheet will not peak until at least October. 

The recycling of its coupon payments from its massive largesse could also lead to the expansion of its balance sheet even after QE3+ formally ends. There is much speculation about the ECB’s new willingness to expand its balance sheet, and many expect the BOJ to step up its operations by the end of July.

Moreover, even beyond QE, interest rates are likely to remain low for quite some time still. A Fed rate hike is still more than a year off. The Bank of England may hike rates earlier, but most likely not this year. It is true that some countries, like Sweden, Australia and now New Zealand can have interest rate cycles with the cycle of the larger central banks.

Sweden's tight monetary stance may be responsible for Sweden's deflation, and a rate cut in June remains a strong possibility. Australia has had a complete cycle of rising and cutting interest rates, and now policy is on hold. New Zealand is likely to make the second move in its tightening cycle in the week ahead, but it may pause afterwards.

At the same time, growth prospects are general good. After soft Q1, the US is thought to be accelerating toward an annualized pace of 3% here in Q2. The euro zone appears to be continuing to grow slowly. Japan’s economy is likely to weaken in Q2 due to the sales tax increase, but early anecdotal evidence suggests that as there was not a big run up before, the impact appears to be less than feared. The UK economy is sustaining the growth seen last year and is poised to be the strongest economy in the G7 this year. So says the IMF.

The Chinese economy has slowed, but since the end of H1 12, growth in the world’s second largest economy has vacillated between about 7.4% and 7.9%, according to government figures. Given that the Chinese economy is considerably larger than say in 2000, the recent pace of growth contributes more to the world’s GDP than 10% growth did on a smaller base.

The point is that prospects for world growth are constructive, and monetary stimulus has not peaked. At the same time, the head wind from fiscal policy has diminished. This is true not just in the US, but the euro area, as well. In addition, France and Italy are seeking some relaxation of the EC’s fiscal demands. We note that in the week ahead the EC will announce its formal review of last year's progress on deficit and debt targets.

Taken together, these considerations suggest, however, measured capacity utilization has bottomed and that we are past the peak in the output gap. This implies that we are likely near the low point in the inflation cycle. Consistent with this is the rise in commodity prices. The CRB index is at its highest level since September 2012 and is up 14.7% off the early January lows. Copper and iron ore prices (arguable says more about China's economy) are rising, and oil prices are at the upper end of their five month trading range.

The economic data due out in the days ahead are unlikely to challenge this overall view. The main economic data includes the US durable goods orders, the euro area flash PMIs, UK retail sales and HSBC's flash estimate of China's manufacturing PMI. It will take more than a little deviation from expectations to be truly new news.

Japan's data may be the most important. First, six of the past nine years, Japan's trade position improved in March. However, this year, economists warn of deterioration as exports slow and imports rise. Japanese companies seem largely content to repatriate the foreign currencies it earns through exporting to buy more yen rather than reducing prices to gain market share.

Second, Japan reports national CPI data for March and April Tokyo figures. In recent months, Japan's CPI has stabilized and as a case in point the March core rate is expected to be little changed from the December-February pace of 1.3% year-over-year.

More interesting is Tokyo's reading for the first month of the sales tax increase. The headline rate is expected to surge to 3.1% from 1.3%. Anecdotal reports suggesting businesses are taking advantage of the sales tax increase to push through an increase in prices. This warns of upside risks to the report. Part of the increase in prices above and beyond the sales tax increase may be seasonal. Price increases at the start of the fiscal year are not uncommon. Part of it may be simply opportunistic.

Geopolitical developments are very much part of the investment climate. There are three elements. First, the Geneva accord struck at the end of last week over Ukraine appears to have collapsed. A new round of sanctions is likely, and as the sanctions escalate, opposition by some businesses increase.

Second, at the end of last week, the Obama Administration delayed the Keystone Pipeline XL decision, indefinitely and most likely until late this year or even next year. The pipeline essentially would link Canada's oil sands and the US refineries in the Gulf. The project is politically divisive. It pits labor (pro) against environmentalists (opposed). A delay of some kind was anticipated after a Nebraska (a state that the pipeline is to run through) court had ruled a couple months ago that its Republican governor's consent was not sufficient. The judgment has been appealed to the state's Supreme Court.

Third, US President Obama will be visiting four countries in Asia in the week ahead: Japan, South Korea, Malaysia and the Philippines. Japan and Malaysia are part of the negotiations for the Trans-Pacific Partnership trade agreement. There are reports suggesting a deal may be in the works to break the logjam between the US and Japan. Japan, it is said, would open up its meat, dairy and sugar markets, while retaining some protection for its wheat and rice markets.

Our understanding is that the Abe government sees the international agreement as an important part of its own reform agenda and is another component of the elusive third arrow (the first two being monetary and fiscal stimulus). The real stumbling block, we suggest, is the inability of Obama to secure "trade promotion authority" (fast track) that would allow for expedited legislative process and without which no significant trade agreement has been reached.

Obama's trip has a security component, as well. Many observers are concerned that the US response to Russia may influence China's behavior in the Pacific. The major difference is that the US does not have a security treaty with Ukraine. It does with Japan and the Philippines.

At the same time, it is a mistake to think that the territorial disputes are only with China. After visiting Abe in Japan, Obama will go to South Korea. Japan is claiming territory that South Korea claims. This conflict will prevent Obama from sanctioning Japan's claims. While Obama will reaffirm the US security commitment, he will likely privately urge restraint from needlessly antagonizing China.