Week Ahead: Fed Meets amid Plunging Oil Prices

The fundamental issue confronting investors is about supply and demand. In recent weeks, as energy prices and other industrial commodity prices fell, investors focused on supply. The stimulative effect of the fall in prices, and the likely policy response by some major central banks, such as the ECB, and possibly the BOJ. This was good for equity markets and weighed on the euro and yen.

However, this changed abruptly last week. Several developments took place that shifted the focus to the weakness of demand. OPEC and IEA cut their forecasts for oil demand next year. China reported an unexpectedly large fall in imports and slower real sector performance. Meanwhile, reports suggest China may reduce its growth target next year from 7.5% to 7.0%. This follows on the heels of the recent cut in the ECB’s GDP projections for the euro zone. The Bundesbank also halved its German growth forecasts.

Ultimately, we suspect the second narrative is not as compelling as the first. The downward revisions of demand were already foretold by the IMF and OECD, which had cut their world growth forecasts weeks ago. A slowing of the Chinese economy has also been widely recognized. It is hardly new news.

The same can is true of the ECB staff’s new GDP forecasts. Is sluggish growth really surprising under the tutelage of order-liberal austerity? Moreover, we note that these new forecasts did not include the growth (or impact on prices) of a significant decline in oil prices since the OPEC meeting. Growth projections will likely be raised if the decline in energy prices is sustained.

Given the magnitude of the equity markets advance and euro and yen declines since the last swoon in the first half of October, a technical correction might not have needed much of a spark in the first place. Year-end portfolio adjustments, realizing some winners, perhaps to offset some losses, as in the energy patch. As violent as the price action has been in recent days, the fundamental theme of divergence remains intact. Even if these counter-trend moves cannot always be anticipated, they should be incorporated into investors’ strategies. Assuming one’s understanding the primary drivers has not changed, these setbacks offer important opportunities.

The key event next week is the Federal Reserve’s last meeting of the year. It will include updated macroeconomic forecasts, and be followed by a Yellen press conference. As the Federal Reserve has done in the past, it should be expected to look largely past the deflationary implications of the decline in energy prices, and the short-run volatility in the equity market.

With the asset purchases over, the FOMC statement can be simpler. The economic assessment may be upgraded. The labor market has continued to improve, though not yet to acceptable levels. Inflation is not trending toward the FOMC’s target.

In terms of forward guidance, there are three phrases that are important. The first is the characterization of slack in the labor market. Is is still “significant”? We suspect that this phrase will be left in if the Fed adjusts the second phrase. It involves the length of time between the end of QE and the first hike. Is it still a “considerable time”?

Many observers have argued this phrase has largely been gutted already of any real meaning. However, its absence would raise confidence in a rate hike in the middle of next year. Recall Yellen’s faux pas at her first press conference. She veered away from strategic ambiguity to define “considerable” as around six months. Given the recognized importance of communication in this period of reliance on forward guidance that important changes in phrases and policy will be followed by the Chair’s press conference, like this week.

The third important phrase comes at the end of the statement. Even after the inflation and unemployment are consistent with the Fed's mandates, economic conditions may warrant a lower Fed funds rate than officials would regard as the long-term equilibrium rate. This suggests the terminal rate for this cycle will likely be lower than in past cycles.

The Fed also will announce new forecasts—the famous dot plot. The general direction of forecasts may be interesting, but this tool has a high noise to signal ratio. The fact of the matter is that the Fed forecasts have consistently been too high for inflation and unemployment. Both of these will likely be cut. It will be interesting to see if the Fed lowers its equilibrium rate down from the current 3.75%, which the market sees nearer 2.25%.

III

The Japanese election was largely a foregone conclusion. The LDP and Komeito coalition will retain its super-majority. Conventional wisdom is that this will permit Prime Minister Abe to pursue the weakest of his initiatives, the structural reforms the third arrow (the first two are fiscal and monetary stimulus).

This mistakes the problem. Abe already enjoys a super-majority, and the structural reforms remain the least effective of this three-prong economic strategy.

The problem is that even though the DPJ secured a majority for several years, Japan remains very much a one-party state. It continues to be dominated by the Liberal Democrat Party. Even now, despite lack of strong public support for Abenomics, the DPJ, and other small opposition parties fail to make much headway. They have failed to articulate a compelling alternative to Abenomics.

The biggest obstacles to Abe's success appear to be largely internal to the LDP. Like most if not all large parties, the LDP is a coalition. The kinds of reforms that Abe is pushing for goes against the interests of some of the LDP's traditional supporters, like the agricultural sector.

Look at Abe's cabinet itself. It is divided between the old guard, former prime ministers and privileged families, and agents of change. Simply put then, Abe's third arrow is compromised because the LDP itself is divided. It is not clear, especially given the low public support for Abenomics itself, whether the election itself will shape the internal tension within the LDP.

It may take some time to see if the election results changed the balance of power within the LDP. The changes to the cabinet ministers and the debate over the supplemental budget may be early tells. Abe's political agenda, which includes restarting nuclear plants and allowing Japanese defense forces to be used to protect allies, is also controversial and will require the expenditure of his political capital.

Abe is not the political risk-taker that it seemed to some when he initially called snap elections. It is Greece Prime Minister Samaras who has taken significant political risks by bringing forward the presidential selection process. It could lead to national elections, in which his party (New Democracy) is trailing behind the opposition Syriza. Syriza wants to roll back much of the austerity, and the international official creditors restructure Greece's debt to ease the burden.

Greece's parliament will have three chances to pick the next president, starting December 17. The first two rounds require a the support of 200 of the 300 members to support the candidate. In the third and final round 180 votes needed. The governing coalition has 155 seats. There are 46 swing seats, and that is where Samaras is battling.

The drama climaxes in the third round that will be held on December 29. Political insiders suggest that Samaras needs to secure at least 15 more seats in the first couple of rounds (to give 170 votes) for him to have a chance in the third round. We anticipate it will come down to the wire. The risk of failure and the eventual election of a Syriza government will keep investors on edge.

Many see Syriza issuing unacceptable demands on its official creditors that renew the risk of a Greek exodus from EMU. There are two significant developments that have changed since the earlier existential issue. First, with a primary budget surplus Greece is in a considerably better negotiating position. Second, the creditors will feel strengthened by the institutional capacity built over the last couple of years that will leaves Europe much better able to cope with the consequences of a Greek exit.

Samaras took a significant political risk, but it is not necessarily suicidal as it is being portrayed. Syriza may be ahead in the polls, but its lead is not insurmountable, and more importantly, would need coalition partners. It is not clear who this could be. The opposition in Greece is very ideological and very fragmented.

Even if Syriza holds on to its 5% lead over the ND, it still is well short of a majority. It may be the biggest party, but Syriza may not be able to put together a coalition. It may not lead the next government after all. This does not mean that Greek assets cannot sell-off further. To the contrary it warns that Greek assets may dramatically overshoot before recovering if the center prevails.