Four Keys to The Week Ahead

There are four events that will shape market psychology in the week ahead.  They are Yellen's speech to the NY Economic Club, US jobs data, eurozone March CPI and PMI, and Japan's Tankan Survey.  

The broad backdrop is characterized by the rebuilding of risk appetites since the middle of February, though the MSCI emerging market equity index put in its low on January 20, as did the CRB Index.  The price of oil appeared to bottom then as well, but it retested the lows in mid-February and made a marginal new low.  

The easing of monetary policy by the ECB, BOJ and PBOC helped rekindle the risk appetites. The Federal Reserve hinted, and then acknowledged formally in mid-March that the four rate hikes that had seemed reasonable in December were less so now.  At the same time, fears that the US was slipping into a recession were exaggerated.  

It turns out that US Q4 growth was not as poor as it initially appeared.  The first estimate was 0.7% at an annualized pace.  The first revision brought it up to 1.0%.  The second revision, released before the weekend, puts it at 1.4%.  To be sure, although twice the initial estimate, Q4 GDP is still disappointing.  However, if trend growth is around 2%, then an occasional quarter like this ought to be expected.

The cause of the revision from 1.0% to 1.4% is worth considering.  It was primarily driven by an increase in consumption.  Consumption of services were revised from 2.1% to 2.8%.  Overall consumption rose 2.4% rather than 2.0%.   This is important. Consumption is the main engine of growth. The key to consumption is income, and the key to income is employment.  Disposable income has also been bolstered by the drop in gasoline prices.  

Employment growth has been extremely steady, despite what appears to be month-to-month vagaries. Consider that the three-month average of non-farm payroll growth through February stood at 238k. The average over the past 24-months has been 242k.  The consensus is for March nonfarm payrolls to grow a little more than 200k. 

The fact that full employment is being approached is not evident in hourly earnings data, which is expected to sustain the 2.2% year-over-year pace.  We expect average hourly earnings to begin rising again in Q2.  

One of the concerns about the labor market is the decline in corporate profits reported alongside the second revision of GDP.  Corporate profits fell 7.8% in Q4 15 and 11.5% over the course the year.   The idea is that squeezing profit margins will see businesses retrench; slowing their hiring and investment plans.  

At the start of the year, the tightening of financial conditions, including picked up in the Fed's Survey of Senior Loan Officers, and, of course, the falling stock market, fanned fears of an impending recession.    US equities have recovered, financial conditions have eased, the VIX set five-month lows last week, and corporate premium over Treasuries has narrowed.  Emerging markets, which had been hemorrhaging, have rallied back, outperforming the developed markets here in Q1 (+2.3% vs. -1.3% using MSCI indices).  

Now it is the decline in corporate profits that is worrisome for those looking for evidence to support recession fears.  We plead mitigating factors before giving the last expansion rites.  The drop in profits was exacerbated by the $20.8 bln settlement regarding the Gulf oil spill.    Also, the bulk of the decline was due to the energy sector.  The good news is that oil prices have stabilized, and technological advances point to some efficiency increases.     

As we have seen, the weakness of the manufacturing sector coincided with the drop in oil prices and the rise in the dollar.  The recent regional Fed manufacturing surveys suggest the long-awaited recovery may be at hand.  

Yellen speaks to the NY Economics Club on March 29.  It is her first major event since the FOMC meeting and follows comments by at least four regional Fed presidents sounding somewhat less dovish than the market understood by the FOMC statement and the dot plot.  A fifth President, Chicago's Evans, seen more dovish than the troika of Yellen, Fischer, and Dudley, endorsed two hikes.  

Based on our conversations, we suspect that market talk of significant rifts within the FOMC are exaggerated.  If the FOMC was dovish, and we still have problems thinking of two rates hikes this year as being dovish, especially given what other central banks are doing, then is seems like a strategic retreat rather than a turn.    

A communication or management analysis might conclude that the Fed has overpromised and under-delivered.  A compelling way to address the questions of its credibility is to under-promise and over-deliver.  Yellen herself indicated at her press conference that the April meeting was live. There is no reason to expect Yellen to back away from this in her remarks in NY.  

The June meeting may have much to recommend itself.  There would be data on the economy in Q2. The economic projections will be updated.  There is a scheduled press conference.  There are two drawbacks of the June meeting.  First, the market will anticipate it too much, and it will not answer the credibility issue.  For that, it needs to surprise the market or sufficiently large part of it.  

Second, by waiting until June, the Fed may make itself hostage to market conditions a week ahead of the British referendum. The referendum could be a dramatic event.  There have been extreme moves in implied volatility, which in effect increases the price of insurance as the perceived need for insurance has risen.    

Yellen's comments should not be expected to deviate much from the FOMC statement and her remarks at the press conference.  She is managing the transition and the beginning of the normalization of monetary policy with a broad consensus.  There was no dissent in December when rates were hiked.  There was not dissent in January.  KC Fed President George was the sole dissent in March.  She favored a hike.   

With the aggressive action by the ECB on March 10, and with the corporate bond purchases and new TLTRO yet to be launched, the next several central bank meetings are not truly live.  This also may neuter the significance of the next string of economic data.    

Many discussions talk about the state of the eurozone economy as if it were Japan, struggling to sustain positive growth.  The eurozone growth was 1.6% last year after 1.0% in 2014 and 0.6% in 2013.   While measures of trend growth vary, the 1.6% pace is probably not far from it.  

The flash manufacturing PMI rose to 51.4 from 51.2. The risk of the final report seems to be on the downside as we think about the political stalemate in Spain and the push back against Renzi's reforms in Italy.  The manufacturing PMI averaged 52.8 in Q4 15.  Based on the flash, it had slipped to 51.6 in Q1 16.  

News that the flash eurozone February CPI fell to minus 0.2% from 0.4% may have encouraged the sense of the ECB's urgency.   The consensus expects a small upward revision to minus 0.1%.  The point, however, is that there is not a serious risk of sustained deflation in the euro area.  Core prices are expected to be revised to 0.9% from 0.8%.   They have been remarkably steady at 0.9%.  It is the three, six, and 12-month average.   

We note that money supply (M3) growth has also been extremely steady at 4.9%-5.0% over the same period.  The February money supply and lending report will be released on March 29.   Lending remains only slightly positive. 

Speculators in the futures market are holding a near-record amount of gross and net long yen.  On the other hand, portfolio managers have been selling yen.  Japanese institutional investors have stepped up their buying of foreign bond, set a new weekly record earlier this month.  Foreign investors have continued to liquidate their Japanese equity holdings, and also set a weekly record for sales earlier this month. 

Japan's data schedule tends to get busy at the end of the month, and next week is no exception.  However, February data, which includes employment, industrial output, retail sales, and household spending, are unlikely to move the BOJ.  The Tankan Survey is different.  It is forward looking.  Here the news will not be very favorable.  Not only did sentiment among large and small business likely deteriorate, but expectations will warn that the June survey also will probably weaken.   Capex is expected to be scaled back. The Reuters survey produced a median expectation for capex to rise 10.1% rather than 10.8%. The Bloomberg survey respondents expect a larger pullback to 9.4%.  

Talk emerged last week that the Abe government has decided to postpone the sales tax increase, which has already been postponed, was to be implemented April 2017.  The formal announcement would be announced at the May G7 meeting that Japan hosts.  Although Abe is driven by domestic considerations, he can tell the G7 that Japan is doing it in the spirit of cooperation following the G20 meeting. 

Japan's problems would not be solved if the yen's gains in Q1 were reversed.  However, a resumption of the yen's uptrend would aggravate its problems.  The channel here is not so much exports. Given how much the media and some analysts harp on exports, one can be forgiven for not appreciating that Japan only exports about 15% of GDP, roughly the same as the US, and less than half of Germany and some other European countries.  

The yen's appreciation translates into less foreign earnings for Japanese multinationals.  MOF data suggests that sales by Japanese companies abroad surpassed exports for than 15 years ago.   Japan's current surplus is driven by the investment income, not the trade balance.  The yen's appreciation depresses the value of those royalties, licensing fees, profits, dividends and coupon payments earned abroad.

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