The Investment Climate and Geopolitics

The high frequency macroeconomic data due out in the days ahead simply do not have the heft to alter investors' perceptions of the macro-economic and financial condition of the investment climate.

That climate can be summed up as such: Growth in the US has picked up markedly after the major disappointment in Q1. The Japanese economy is weakened considerably, which does not mean unexpectedly, is Q2. The UK economy continues its robust performance. The euro zone is limping along. Targeted measures from Chinese officials are helping the world’ second largest economy stabilize, still growing above 7%.

The ECB just embarked on a course that will unfold in the coming months (targeted LTRO), including the consequences of a negative deposit rate. It is not yet, for example, fully appreciated that the ECB accounts beyond for the regional banks. Governments have funds at the ECB. The negative rate will apply to them too.

For its part, the Bank of England’s Carney is signaling the opposite direction. In part due to signals from him, the market has been reluctant to price in much chance of a hike before next May’s national election. He now says that a rate hike make come sooner than the market thinks.

The Bank of Japan continues buy securities at a prodigious rate. Officials are prepared for a contraction in Q2. It is the economic performance in Q3 that is the key to a potential policy response.

We have characterized Federal Reserve policy as essentially on automatic pilot, with $10 bln a month tapering of asset purchases. A contraction that may ultimately be closer to 2% in Q1 is not sufficient to prompt the Fed to reconsider its course. A sustained monthly increase of more than 200k non-farm payroll employment is not enough for the Fed to accelerate its tapering.

When the Federal Reserve meets this week, there is little doubt of the outcome. This deflects investors’ attention from a change in policy to a change in the forward guidance, subtle and otherwise. The Fed will indicate that its highly accommodative stance is still needed. It seems to want that to be the main take-away.

However, what will likely be evident from the forecasts is that there is an increasing sense that the Fed’s goals of full employment and stable prices is being approached. This must be the case as officials begin to prepare investors for the next phase monetary policy.

Unemployment forecasts will likely be lowered as May’s 6.3% rate was already into the Fed’s year end forecast made in March (6.1%-6.3%). If there is a change in the core PCE forecasts, it will more likely be higher than lower. Quantitative easing has caused, helped facilitate, or has been irrelevant, to the recovery of employment and arresting the disinflationary forces (depending on one’s point of view). It will end in a few months.

This does not alter the fact that the Federal Reserve will have to recognize the growth was a significant disappointment in Q1. As a pure accounting function, it will have to cut this year’s growth forecast (central tendency) and dramatically from the 2.8%-3.0% indicated in March. The outer years may also be cut signaling a step toward greater realism from the persistent optimism that just as consistently is revised lower.

There is a committee meeting at the Bank of England June 17, but it is not the Monetary Policy Committee. It is the Financial Policy Committee, and it is through this forum that macro-prudential policies arise. Officials see the housing market as the biggest risk to financial stability.

Despite, or what some cynics may say, because of the IMF’s recent call for to cool the UK housing market, after recently retracted its publicly expressed doubts over the government’s economic strategy, new steps are unlikely to be taken yet. The issue is whether the rise in house prices reflects a growth of risky mortgage debt. It is at least a debatable point as household leveraging appears to have fallen.

There are at least two other forces that seem to be operating. First, the London property market has become an asset in international portfolios. This may loosen the link between the local economy and house prices. This the the real challenge to the likely macro-prudential strategy.  

Second, unlike in the US, and many other countries that had housing booms, the UK has a shortage of houses. The fact that house price increases are concentrated in the south may also reflect where the effective demand is located, which in turn may be an issue of the wealth and income disparities.

Minutes from the MPC meeting earlier this month will be released. Carney’s comments last week may have stolen some of what may kindly be thought of as thunder from the minutes. The tone of the debate is likely to shift in terms of economic slack and timing of the first hike. However, the market reaction to the minutes will likely be most dramatic if there is a dissent. Sterling would likely rally, and short-term interest rate futures would sell off (higher interest rates).

A dissent would likely fan speculation that the first rate hike could take place before the end of the year. We continue to favor the first move in Q1 15. Earnings growth remain pitiful despite the increased employment. It is difficult to be too concerned about inflation when wage growth is so meager. Given the difficulty in measuring economic capacity, especially when such a large part of the economy is services, the benefit of the doubt should be given to slack in lieu of price pressures.

In addition, there are other countervailing economic factors. The strength of sterling is one such factor that may serve to dampen imported inflation, and itself is tantamount to some degree of tightening. Interest rates have risen, which reflects the market doing some BOE’s work, which extends the time that it can stand pat.

Switzerland and Norway central banks hold policy making meetings, but neither is expected change policy. The Swiss first line of defense in case safe haven inflows spurred by by the ECB's actions, is the euro floor/fran cap at CHF1.20.  Only if this is threatened will  the SNB be forced to consider a monetary policy response.

However, the euro is trading well within the CHF1.2150-CHF1.2250 range that with a few exceptions has marked that has confined the price action.  Norway's economy has disappointed, but price pressures are sufficiently firm (underlying rate of 2.3% in May) and base effects point to a further increase in June that the Norges Bank will stand pat.  The euro is absorbing buying near NOK8.10. Yet support has been frayed and this has removed the sting of a convincing break. The next band of support will likely be seen in the NOK8.05-NOK8.07 area.

Geopolitical events loom large.  At the beginning of the year, observers were most concerned about the territorial dispute between China and Japan.  Japan's Prime Minister Abe made facile analogy between 1914, the start of WWI and 2014.  However, events in Ukraine and Russia's annexation of Crimea brought attention to central Europe, where for several years Russia has used the carrot and the stick to cajole when possible, and intimidate when not, several of its neighbors, including Georgia, Moldova, and Ukraine.

Neither of these two issues has been resolved, but a new crisis has emerged that in many ways is even more threatening immediately.  Radical Islamists, a splinter group from Al Qaeda has taken advantage of the lack of support among the Sunnis for the Maliki government and a power vacuum to spread from Syria to Iraq and then sweep south to Baghdad.  After a slow start, the Iraqi security forces moved to deter an attack on the capital.  The money and munitions captured in the military action may greatly enhance their reach and capability

The immediate fear is over a disruption of oil supplies.  At this juncture, the market is appears to be pricing in a risk not the real thing.  The broader geopolitical implications, though are very fluid.  Almost regardless of the particular outcome, Iran will likely see its influence enhanced.

Russia benefits not only from energy insecurity and higher prices, but also by what seems like another setback to US strategic interests.  Moreover, there is some risk that the territorial integrity of Iraq is not preserved and this too serves Russian (and possibly Chinese) interests insofar weakens what both nations seem to think of as the US-led world orders, which does do justice to China's accomplishments and Putin's ambitions.

Higher oil prices can have secondary impacts that lead upward pressure on prices (inflation).  Yet, few countries that are experiencing disinflation (lowflation) will likely welcome the rise in oil prices.  Rising oil prices act as a headwind to growth.  Higher oil prices may weigh on equities and support bonds.