Dollar: State of Play

The start of a new calendar year does not necessarily mean the rise of new market drivers.   In fact, the key issues investors face at the start of 2016 are the same that dominated Q4 2015.  

These issues center around pace of Fed tightening, the outlook for the world's second largest economy and its markets, the impact from the drop in oil prices, and commodity prices more generally, Europe will deal with the centrifugal forces that threatening it, and whether Japanese economy can find better traction.  

Here is a thumbnail sketch of the drivers of the investment climate to help you find your sea legs after the holidays:

US

Some soft data has the Atlanta Fed GDPNow tracker indicating that growth may be slowing to 1.3% before Christmas compared with 1.9% in the middle of December.  The market does not appear convinced that the Fed will hike rates again in March.  

The implied yield on the March Fed funds futures contract is 43 bp.  Fed funds effective average in December was 20 bp through December (not the nearly 25 bp Bloomberg WIRP page had assumed) and has not averaged the middle of the 25-50 bp range even once since the rate hike.  

A favorable monthly jobs report on January 8 would encourage participants to take more seriously the prospect of a hike at the mid-March FOMC meeting.   Although monthly nonfarm payrolls growth may slow over the course of the year, the pace may be sufficient for additional declines in unemployment measures.  The consensus anticipates 200k net new jobs in December.  If true it would be the third consecutive increases of 200k or more after soft reports in August and September. 

Investors will be particularly sensitive to wage growth as the Federal Reserve is appears to be putting much stock in the idea that a tighter labor market will push wages up, and this will lift core inflation over time.  The year-over-year pace of average hourly earnings may accelerate to 2.8% in December from 2.3% in November.  This is largely a function of the base effect. The January comparison is more difficult, and the year-over-year pace should revert to the mean.  That said, some 14 states and several cities hiked the minimum wage as of January 1.  

The combination of the knock-on effects of the energy sector hit, the dollar's appreciation, and weak world demand, the US manufacturing sector has nearly stalled.  The December manufacturing ISM is likely to be below the 50 boom/bust level for the second consecutive month. The service sector appears considerably stronger.  The Bloomberg consensus expects it to tick up to 56 from 55.9 in November.  If it does, the Q4 average (~57) will not be as high as Q3 (~58.7), but it will be higher than the H1 average of 56.6.  

Lastly, we note that December appears to have been the fourth consecutive month that US vehicle sales reached an 18 mln unit annualized pace.  Cheap financing, 2.3 mln new jobs created through November, and the low gasoline prices facilitated what appears to have been a record sales year. 

China   

The Chinese economy appears to be stabilizing, but keeping the onshore (CNY) and offshore (CNH) in line is proving difficult.  The official manufacturing PMI edged up to 49.7 from 49.6 in November, while the service PMI rose to 54.4 from 53.8.  Although the comparison is fraught with problems, similarity between the US and Chinese readings is striking.   The Caixin measures are at lower levels, but are expected show an expanding service sector and a third consecutive improvement in the manufacturing sector.  

Other data may also be constructive. Foreign exchange reserve may have risen in December for the first time since April.  The euro and yen's gains (2.8% and 2.4% respectively) against the dollar likely helped.  The contraction in exports is expected to have slowed for a second month (-6.0% year-over-year vs. -6.8% in November and -6.9% in October).  The contraction in imports is largely a function of prices, not volumes.  Consumer inflation is expected to have accelerated to 1.7% from 1.5% while deflation at the producer level continues unabated.  The last time China reported an increase in producer prices on a year-over-year basis was January 2012.  

China has apparently tried indirect intervention in the offshore yuan market.  This has not generated lasting impact.  At the end of last year, China punished a couple foreign banks and has suspended their settlement of offshore yuan for three months.  The goal is apparently to prevent gaming the market and speculating on the further yuan weakness.  Yet since the start of November, the dollar has risen about 2.8% against the yuan.  The most powerful thing the PBOC can do to stop the pressure on the offshore yuan is to indicate by deed that it is no longer guiding the onshore yuan lower.  

The near-term outlook for Chinese equities is clouded by the end of the IPO ban and the freeze on sales by large shareholders.  The Shanghai Composite rose 9.4% last year, which was 25% above the August lows.  Before Christmas, it turned back from the upper end of its two-month trading range

EMU

The eurozone's macroeconomic condition is improving.  The growth has been improving since Q2 2013.  After rebounding from the 2009 contraction, the eurozone experienced a double-dip as growth faltered in 2012 through Q1 2013.  The modest pace of activity of 0.3%-0.4% looks set to continue. Credit conditions are improving, and lending to households and businesses are increasing, albeit slowly.   The asset purchase plan was extended in December and the deposit rate cut to minus 30 bp.

Final December PMI readings will be reported.  Political uncertainty in Portugal and especially Spain (including Catalonia) may have weighed on sentiment. Germany's factory orders are expected to have built even if marginally on the 1.8% rise in October, after falling each month in Q3.  Its industrial output also likely accelerated.   German retail sales are expected to have risen 0.5% in November, recouping the 0.4% decline posted in October.  Such monthly increase is consistent with a year-over-year increase of 3.7% (compared with a 1.9% 24-month average).  Eurozone retail sales are expected to have risen 2.0% from last November 2014. 

The base effect of 2014 drop in energy prices and the weakness of the euro are likely to begin seeping into measures of consumer prices.  The year-over-year rate for the EMU may have doubled in December to a 0.4%.  It matches the highs from July and October 2014, which are the fastest pace since June 2014.  The core rate is expected to have ticked up to 1.0% pace from 0.9%.  

In addition, to the refugee/asylum seekers challenge for Europe, there a several other issues that may unsettle investors.  First last month's national elections in Spain has failed to produce a majority government or even a minority government, for that matter.  

A caretaker government, until fresh elections can held, is not particularly encouraging for investors, as the economy loses a bit of momentum.  Reforms can only be delayed.  Meanwhile, Catalonia is also struggling to put together the local government.  If no resolution is found by the end of next week, new local elections may be mandated.  

Portugal's central bank took made a controversial move at the end of last year.  It inflicted losses on some senior bond issues (5 of 52), as it attempts to strengthen the balance sheet of a recently reconstructed bank (Novo Banco) after the ECB's stress test uncovered gap.   In addition to the apparent violation of the principle of pari passu that requires equal treatment,  investors are troubled by the seemingly last minute announcement, catching many by surprise.  

The Bank Resolution and Recovery Directive (BRRD) will begin being implemented now.  It serves two objectives.  It protects taxpayers overall investors and creditors.  To be sure, taxpayers are still ultimately on the hook, but the pecking order has been strengthened.  In addition, the BRRD does this in a harmonized way.  It serves as another part of the emerging banking union.  The implications of the BRRD may surprise investors.  Investors in the same class (such as senior bonds) apparently can be treated differently if certain conditions are met, such as equitable distinctions, justified in the public interest and proportionate, while not discriminating by nationality.  

Since the volte-face by Greek Prime Minister Tsipras last summer, the implementation has gone rather smoothly.  Too smoothly.  To maintain his waning domestic support, Tsipras appears to throwing down the gauntlet.  The issue is pension reform.   While many of challenges are widely known, but what we suspect is under-appreciated is that in the dysfunctionality of Greek institutions, pensions seem to absorb some of the real costs of unemployment.  Unemployment compensation programs eventually end.  Pensions don't.  Pensioners are taking care of unemployed adult children. 

Japan

The world's third-largest economy is struggling to find much traction after emerging from the sales-tax increase hit.  Its budget deficit is large at roughly 6.5% of GDP.  It has by most reckoning full-employment.  Its current account surplus has returned to around 3% of GDP, the largest since 2010.  Trend growth is estimated around 0.5%.  

The BOJ is expanding its balance sheet at an unprecedented pace. It recently announcing it would extend the maturities of government bonds it buys.  In the past, this was regarded as more aggressive. It is also ensuring that the shares freed up in the unwinding of bank holdings do not add to the supply of equity by acquiring a roughly equal amount in addition to its current purchases.  

At the end of the year, local press reports warned that the BOJ is considering cutting its inflation forecast for FY2016 (begins April 1) to 1% from 1.4%.   The BOJ targets a measure of core inflation that excludes fresh food though it also is understandably paying close attention to the measure excluding energy as well. However, the BOJ is far from achieving its target.  The yen's flat performance last year warns that whatever lift was coming from imported inflation via a weaker currency, will likely fade.  

With its credibility on the line, the BOJ may chose to expand its operations.  If Abe calls for a lower house election at the same time as the upper house election, as has been rumored since mid-2015, in the summer of 2016, it also adds to a powerful force desiring a more robust economic performance.  

Oil  

There were four big developments in the oil market at the end of last year.  First, not only did OPEC fail to agree to cut output to support prices, but it also failed to provide any quota.  Its failure to agree on a new General Secretary has also left the impression of a cartel in disarray.  Second, as part of a omnibus fiscal bill, the ban on US crude oil exports will be lifted.  

Third, the ban on Iraqi oil sales will also be lifted, it appears, as early as the middle of this month.  Fourth, thus far, at least, it has been an unusually warm winter in most of the US.  This reduces heating oil needs.  On the other hand, flooding in the Midwest is threatening pipelines, likely adding to inventories.  

The market may be vulnerable to a short squeeze.  The flooding is likely to prove a temporary disruption.  More seasonal weather is forecast in around ten days.  The export of US crude is likely to be much less than many seem to anticipate.  There are long-term contracts.  US shale is not typically the low-cost producer, and then transportation and storage costs needs to be taken in account.   Lastly, the new supply of Iranian oil has long been anticipated.  The market may be prone to "sell the rumor buy the fact" type of activity.    

The CRB Index finished 2015 at its lowest level since 2002.  The Journal of Commerce Industrial Price Index is at its lowest level since 2009.  This is a headwind on commodity producers and countries that are reliant on commodities in emerging market and frontier economies.  Couple that with slow world growth, a rising dollar, and rising short-term US interest rates.  

The headwinds on emerging markets looks set to continue.  Countries with compromised political leadership in addition to economic challenges may be particularly vulnerable.  A lurch to the right in Poland, following the national election, and new finance ministers in South Africa and Brazil at particularly nerve-wrenching times are the recent highlights.  

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