Re-Emergence of Divergence Helps Stabilize Markets

The main driver of the investment climate is not so much the incremental economic data as the capital markets themselves. The market turmoil contributed to the tightening of financial conditions, which in turn heightened risks, which monetary officials are committed to resisting.   

Financial markets stabilized last week, but the tone remains fragile.  The damage to the technical condition and sentiment requires further consolidation to rebuild investor confidence. 

The price action should not detract from the underlying signal, which is characterized by the divergence of economic and monetary policy among the high income countries.  Comments by a number of Fed officials, and in particular the leadership, seem to make two key points.  First, prudence suggests the bar to a follow-up rate hike in three weeks is sufficiently high to make it unlikely.  Second, the gradual normalization of monetary policy remains intact. 

The erosion of both market and survey-based measures of inflation expectations have deteriorated.  This alone justifies a cautious approach.  Actual core inflation measures remain firm.  Core CPI rose in January to new three-year highs.  The core PCE deflator, the Fed’s preferred measure, will be reported in the week ahead, and is also expected to have ticked up. 

The US economy practically stagnated in Q4 15, but the prospects have improved markedly despite the market turbulence.  The wealth effect associated with the precipitous decline in equity prices did not curtail American shopping, and that is also likely to be borne out with the January personal consumption expenditures that will be reported next week. 

The increase in jobs and wages is fueling household consumption, not revolving credit.  Consumption rose 3.1% in 2015, the strongest in a decade.  It appears to be tracking close to 3% at an annualized rate now.  Improvement in industrial output and manufacturing will likely be joined by an increase in durable goods orders that will be reported in the new week. 

The pessimists are leaning the wrong way.  Far from being a harbinger of a recession as many warned, the disappointing economic performance at the end of last year was part of the volatility of quarterly GDP figures that may also be part of the “new normal.”  Activity in Q1 16 is re-accelerating, and the economy appears to be tracking growth somewhat above trend. 

If the Federal Reserve’s forecasts for four rate hikes for this year was exaggerated, so too is the market’s refusal to discount a single move fully.   Barring a new negative shock, we expect the Fed to deliver the second hike in the cycle in June.   This is reminiscent of what happened in 2015 when the Fed was dissuaded from hiking rates in September due to falling inflation expectations and market turbulence,  but delivered in December.   Tactical flexibility need not undermine strategic commitments.  

The divergence meme was never simply driven by the Federal Reserve.  It has been more about what other major central banks are doing.  The European Central Bank and the Bank of Japan have yet to reach peak easing.  The most likely scenario is that both ease policy further next month. 

The economic data in the week ahead will pose no obstacle to such anticipation.  The most important real sector data from the euro area will be the flash PMIs.   The weakness in new orders points to continued moderation.  Moreover, the surveys have been running ahead of actual economic performances. 

The Bank of Japan is unlikely to find any consolation in the January CPI report. The risk is that both the headline and core rates eased.  Although the BOJ infrequently (once a year) adjusted its asset purchase program (QQE), the introduction of negative interest rates provides a new tool that may be used more often. 

The sharp decline in Japanese equities and the sharp appreciation of the yen tightened financial conditions for the world’s third largest economy that contracted in two of the past three quarters.  The BOJ is likely to feel compelled to address this.

The yen’s past decline has bolstered corporate profits.  In turn, this has helped fuel a rally in Japanese shares, assisted by BOJ purchases of ETFs.  That was then.  Now, the sharp appreciation of the yen is both cause and effect of the 20% drop in share prices.  The negative rate on some deposits raises concern about net interest rate margins and the profitability of Japanese banks.

However, it is instructive that the Ministry of Finance has not deemed it necessary to intervene in the foreign exchange market.  Even officials' words of caution have been quite mild in tone and scope.  It flies in the face of claims of currency wars that continue to be widely touted.  

Currency war claims were also dealt a blow by the unexpected decision by Mexican officials to hike rates and step up their intervention to defend the peso.   Mexico timed the move well.  A week ago, we suggested that after falling to record lows, the peso was over-extended.  There was a rare double divergence in the RSI and MACDs.  Mexican officials timed their action well, seizing an optimal technical opportunity to surprise the market with maximum effect. 

China has also been accused of currency war behavior because of what by nearly any measure is a small depreciation against the US dollar and on a trade-weighted basis.   It has been spending hundreds of billions of dollars in recent months to support the yuan in the face of selling by Chinese businesses paying down their dollar liabilities and many hedge funds that proudly tout their speculative attack.   We also note that Japanese and Chinese exports disappointed in January and both are falling double-digit year-over-year pace.   

China leads the G20 this year. The first meeting of finance ministers and central banks will be held in the week ahead.  It will not be full of the rancor one would expect if countries were truly engaged in beggar-thy-neighbor policies.   The two agreed upon principles of foreign exchange can be expected to be reiterated.  Currencies are best determined by the market, and excessive volatility should be avoided. 

Chinese officials have indicated that the international financial architecture will be on the agenda during its G20 presidency.  Its criticism of the status quo remains in the realm of rhetoric.  In practice, when it intervenes it sells dollars just like it used to buy them.  The Asian Infrastructure Investment Bank (AIIB) has been officially launched will lend only US dollars, not yuan.  Chinese officials have neither the capacity nor vision of an alternative. 

While investors continue to make sense of the implications of negative interest rates, political issues are of rising concern.  Three stand out.  The Irish election, the UK referendum and the US Presidential election. 

The Irish election is the first since the country exited its assistance program.   The governing coalition is likely to lose its majority. Economic growth leads the region, but the scars are the austerity remain divisive. The main thrust of policy will not necessarily change with the election. However, the polls warn that independent (unaffiliated) candidates may be the big winners, which could make the next coalition somewhat less stable.

The campaign for the UK referendum begins in earnest.   It is not clear that the results of the extended summit changed many minds.    Practically no agreement that could have struck would be sufficient for many of the skeptics.  Similarly, Cameron seemed willing to accept nearly any offer that defended and extended the UK’s right to opt-out of the "ever closer union."  London Mayor Johnson has come out in favoring Brexit.  This was not fully expected and will likely weigh on sterling.  

For investors, the risk of a Brexit is the product of its credibility and capability.   We had thought that the credibility was relatively low.  The events markets suggest around a one-in-three chance.  Talking with clients in the UK, we were struck by how close of a decision many seemed to see it. 

The capability or impact of Brexit would be very grave.   Some large banks have already threatened to leave the UK if the EU is rejected.  A few observers suggest Ireland would be a likely beneficiary as banks seek to maintain a presence in the EU.  We suspect a sharp drop in sterling that we would anticipate if the Brexit camp wins the referendum could spur new interest in UK real estate.   

On the other hand, there is some concern that Brexit could trigger a large, existential crisis for the EU itself.   While it would certainly change the political dynamics, just as the European Union existed before the UK joined, it would most likely exist if it chose to leave.   The UK's presence shapes the EU and helps draw out the tension between a broad and deep union.   

The US presidential election is also increasingly drawing international attention.  The success of Trump was first looked upon as a spectacle, but investors are becoming more anxious.  He is leading in the rest of the states that have primaries or caucuses. However, it does not yet appear to have impacted investment decisions, but could if the party does not begin coalescing around a more moderate candidate.   Investors may find some consolation in the event markets that show a diminishing chances that Trump secures the Republican nomination. 

Despite the flawed nature of her candidacy, Clinton is still is likely to secure the Democratic nomination and also the presidency.   Super Tuesday ( on March 1, there are 10 primaries), we expect the Clinton’s superior organization and funds, and moderate message to demonstrate why event markets regard her as the odds-on favorite. 

There is some interest in the possible candidacy of Michael Bloomberg.  Due to the complexity of the process, a decision will have to be made prior to the Republican and Democratic Conventions this summer.  There are reports that he will announce his decision next month.  The event markets strongly (85%) do not expect him to run.  

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