A New Divergence?

Do you ever read the last few pages of a fiction book before getting into it?  It seems a bit like watching the economic data now. We know roughly where it is headed, the unknown is precisely how it gets there.

A common criticism of economists is that they are too late in calling a recession.  One observer suggested that banks don't want their economists forecasting a recession. That strikes me as little more than an urban myth.  Non-bank economists, central banks, multilateral institutions, like the IMF and World Bank, also often do not see an economic downturn until it is biting them or their neighbors. At the end of the day, recessions are rare and difficult to forecast.

But this one, which, by some measures, will likely be worse than the Great Depression, has been well anticipated before it began. The January-March quarter was bad, but the April-June quarter will be horrific. The precise details are important on the personal level but in terms of the great flows of capital, not so much. Yet, what may be interesting about next week's US data is it might offer a snapshot of the world's largest economy near the bottom.

The US data will include a glimpse into consumption and output in April, and offer the first indicator for the month of May. Retail sales are around 40% of consumption and likely fell by approximately 10%. That follows an 8.4% decline in March. We already know that auto sales fell sharply in April (the seasonally adjusted annualized rate declined by about 25%). Hence, the new information is the ex-auto component, which is expected to have slowed by more than 6%.

Industrial output may have contracted by more than 10% last month, on top of the 5.4% decline in March.  The capacity utilization rate may fall below the low of the Great Financial Crisis when it bottomed near 66.7. One of the consequences of the decline in production could create shortages and force prices higher. This kind of price increases, from an economic point of view, are not sustainable. April CPI will be driven down by the drop in energy prices. It could fall to around 0.5% from 1.5% in March. The core rate will prove stickier and will only to about 1.7% from 2.1%. 

The pandemic has unleashed powerful deflationary forces. However, the worst is probably in April and early May. That makes the Empire State manufacturing survey at the end of next week the first test of this hypothesis. Recall that it averaged 2.3 in the second half of last year and spiked to 12.9 in February. It fell to -21.5 in March and collapsed to -78.2 in April. With much of the country still closed in the first half of May, it is too early to look for much more than a scant sign of stabilization.

Europe could be on the cusp of a new crisis. The German Constitutional Court (GCC)'s ruling attacks at least two fundamental principles at the heart of the eurozone. First, the GCC challenged the independence of the ECB by encouraging the German government and parliament to press the central bank. Second, the GCC challenged the notion that the EU law has primacy over national law. These seemed like settled "doctrines."

It is a bit like the famous case in the US Supreme Court in the early days of the republic, Marbury vs. Maddison. Marbury was suing Madison, the Treasury Secretary, for not paying him after he was appointed in the waning days of Adams' government before Jefferson took office as the third president. Jefferson wanted to make his own appointments and refused to authorize Madison to pay Marbury's salary. The decision by Chief Justice Marshall is considered a foundation of constitutional law.  Although in the narrow sense it found against Madison, it ruled that the law under which the appointment was made was unconstitutional. The Supreme Court took upon itself the power to decide the constitutionality of the other branch's actions.  

This is the origin of the principle of judicial review in the US. This power over the legality of EU institutions, which the ECB is among them, is a power granted to the European Court of Justice. The GCC ruling is nothing short of a putsch against the EU, a nullification of its ruling affirming the legality of the asset purchases.    

The GCC gave the ECB three months to respond, or it prohibited the German central bank from participating in the bond purchases (Public Sector Purchase Program, PSPP), which accounts for around a quarter of the ECB's current bond purchases.  By not responding to the GCC in any formal way in order not to acknowledge that the ECB is subject to its rulings after the European Court of Justice indicated the asset purchases were within its mandate, it shifts the hot potato, as it were, to the Bundesbank.  Bundesbank President Weidmann, who has disagreed with ECB policy, and even testified against it before the ECJ on a different charge, recognizes the importance of the ECB's independence. 

On behalf of the Eurosystem, the Bundesbank buys Bunds under the PSPP.  If German Bunds were not purchased by the BBK, they could be bought by another as the program is still obliged to follow the capital key. It would leave the GCC challenges unaddressed and would spur others to explore the space that the GCC created for national primacy. The Bundesbank is not prohibited from participating in the Pandemic Emergency Purchase Program (PEPP), but legal challenges may await.  PEPP is not confined to the capital key, which is the first time the ECB has had so much discretion in its purchases. At the same time, rather than have the national central banks make the actual transactions for the Eurosystem, the ECB could centralize the market operations under its auspices, which would be more consistent with the practices of other central banks.  

The US monetary and fiscal response has been more aggressive than Europe's. It has little to do with the fact of the dollar's role in the international economy or some exorbitant privilege that is still alleged. After all, Europe (or at least large parts of it) and Japan can borrow money for less than nothing. The US cannot do this. It is a question of institutional capability and desire. One could say that the US has to go bigger because the adverse shock is bigger. It might turn out to be the case, but look at the recent IMF forecasts. The US is expected to contact less than Europe this year (-5.9% vs. -7.5%) and match its growth next year (4.7%). The US is forecast to contract more than Japan this year (-5.9% vs. -5.2%) and rebound stronger next year (4.7% vs. 3.0%).

The return on capital is superior in the US. Growth likely faster on a two-year view and interest rates are higher, though they cannot be considered high. The S&P 500 (-9.5%)is also performing better than Europe's Dow Jones Stoxx 600 (-18%) and the Topix (-15%), even though the BOJ buys ETFs linked to this benchmark. The NASDAQ is positive, albeit slightly, year-to-date.

This could be setting the stage for a new divergence similar to the aftermath of the Great Financial Crisis, where the US outperformance was significant. The cost will be greater US debt. The CBO projects a $3.7 trillion deficit this year (~18% of GDP) before this next package (phase 4) that could be more than $1 trillion that has begun being drafted. Next week, the US Treasury will raise a record $96 bln in coupons at the quarterly refunding. While the anticipated supply saw the long-end yields rise and the curve steepens, yields by any reckoning are low.

A year ago, the 10-year yield was near 2.4%. Now it is around 6 8bp. The market does not appear satiated, and foreign central banks, which were sellers of Treasuries in March (from their custodial account at the Fed) have returned as buyers. Treasury holdings in the Fed's custody account it maintains for foreign central banks has risen by nearly $34 over the past four weeks. This replaces a little less than 25% of the amount that was sold the previous six weeks.   

Some market participants are taking more seriously the possibility that the fed funds rate turns negative before the end of the year. Starting with the March 2021 contract and running through at least January 2022, the implied yields in the futures market are below zero and as much as minus five basis points. The larger, and arguably more significant market, the Eurodollar futures are not implying a negative rate. The Eurodollar curve bottoms in Q3 next year around 18 bp. That said, the US two-year yield fell to a new record low near 10 bp ahead of the weekend before settling around 15 bp.   

Unlike the US, Europe, and Japan, China's economy is expected to expand this year, albeit slowly. The IMF projects 1.2% growth, while the Bloomberg survey from last month found a median forecast of 1.8%. Nevertheless, China's ability to take advantage is very constrained.  

First, the trade deal with the US hangs by a thread despite some Panglossian statements by trade negotiators. The fact of the matter is that through April, US exports to China have fallen by almost 6% compared to a year ago, and the target lay above the 2017 levels, which was before the tariff escalation began.  

Second, China's prestige has been undermined by how it handled the outbreak of Covid-19.  Many countries have been explicit in their call, and China has pushed back, such as against Australia.  

Third, many countries fearful that Chinese companies, especially state-owned enterprises, will take advantage of beaten-down share prices and swoop in for a wave of acquisition. Policies regarding direct investment have been tightened.  

Fourth, supply chains were already being reviewed last year in light of US tariffs, and the pandemic appears to be an accelerant. The US may soon force medical products and medicine to be re-shored, and Europe is thinking along similar lines. Japan has earmarked funds in this year's budget to help companies who want to move out of China. India has set aside land for the same purpose. 

Fifth, the calendar is not its friend. After the National People's Congress session later this month, Trump is expected to make a more statement about progress on the trade agreement, and, as now required by Congress, the autonomy of Hong Kong needs to be certified. These events take place at a point in the US political cycle, the run-up to national elections when the rhetoric and theatrics typically escalate.  

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