Throughout the last few months, we have identified three forces that are shaping the investment climate: the economic and monetary divergence that favors the US, the decline in commodity prices, and a slowing of China. These forces remain very much intact, and if anything, have strengthened and reinforcing each other.
The unexpected upward revision to Q3 US GDP is likely to be matched by a downgrade in Q3 eurozone GDP (to 0.1% from 0.2%) in the week ahead. The slowdown in China, coupled with falling house prices, rising bad loans, and low inflation prompted the PBOC to deliver its first rate cut in a couple of years, and is spurring speculation of a cut in the required reserve ratio in the coming weeks.
There are two ways that the precipitous decline in energy prices and commodity prices more broadly, will impact the world economy. US policy makers will likely emphasize the spur to growth. The IMF, for example, estimates that a $10 fall in oil prices boosts world growth by 0.2%. The decline in gasoline prices can be expected to boost discretionary spending by American households, who have largely forsworn the use of revolving credit (credit cards) during this expansion cycle.
On the other hand, European and Japanese officials will find in the decline in energy prices an additional obstacle in their mission to arrest the disinflation or deflationary forces. Under Trichet, the ECB failed to look past the increase in oil prices in 2008, and hiked interest rates on the eve of a great economic downturn from which is has not yet escaped. It is likely to repeat that from the opposite direction now. It is likely to see the deflationary impact of the drop in energy prices rather than enhancing growth prospects.
The ECB meeting is one of four major central banks that meet in the week ahead (Australia, Canada, and UK central banks meet as well). It is the only one that could do something. Some believe that the Draghi and Constancio have expressed a sense of urgency that is consistent with announcing a sovereign bond purchase program at this week’s meeting. We are less sanguine.
Moreover, we do not think that sovereign bonds are the next asset that the ECB will purchase. We think the supra-national bonds have much to commend themselves. The ECB is already buying covered bank bonds, and with the Asset Quality Review and stress tests behind us, a case can be made for uncovered bank bonds. The idea of buying corporate bonds has also been floated.
There is scope for some disappointment if our assessment of the ECB is correct and now sovereign bond purchase scheme is unveiled. The euro could bounce and peripheral bonds may see some profit-taking after ten -year yields have fallen to record lows. However, the forward guidance, and specifically the promise to do more if needed (to expand its balance sheet), which appears to have unanimous support, may prevent a significant reversal. January or February may be a more likely time frame for more action. The second TLTRO (expected take down 120-150 bln euros) on December 11, and the progress on the covered bond and ABS purchases will likely confirm that a wider range of assets need to be purchased if the ECB is going to meet is balance sheet goal. In addition, pay down of the outstanding LTROs may weigh on the balance sheet, even if some is replaced by other refi facilities.
The other central banks that meet are unlikely to do anything. The Reserve Bank of Australia’s statement is likely to be dovish, though Q3 GDP to be reported next week is likely to show a respectable 0.7% quarterly pace. Still, the RBA can be counted on to continue to warn that the currency is over-valued given the decline in commodity prices and the terms of trade. What it is less likely to talk about is the attractiveness of its relatively high-yielding triple-A rated bonds for large pools of capital, including other central banks.
While a rate cut by the RBA next year is gradually being priced into debt markets, the Bank of Canada seems steadfastly on hold. Although price pressures ticked up, Governor Poloz argues to look past what he says is a transitory in nature. Canada reports its November jobs report at the end of the week. After strong growth in September and October, a softer report is expected. On the other hand, at the same time as its employment report, and despite the drop in oil prices, Canada will likely report a further rise in its trade surplus from the C$700 mln reported in September.
Our analysis shows a more complicated role of oil for the Canadian economy than many suspect. In the east, for example, Canada imports more expensive Brent. Canada is also the destination of US exports, being a loophole in the US restrictions). The market nevertheless treats the Canadian dollar like a petro-currency. However, to the extent that parts of the real estate market and consumer debt were built on prospects of peak-oil, the secondary impact of the drop in oil prices could have serious implications for the Canadian economy.
The Bank of England meets. It is not going to do anything. It won’t say anything. In a couple of weeks, with the minutes, we’ll likely learn that the two dissents persist to favor an immediate hike. The market does not believe they will convince their colleagues, and to the contrary have steadily pushed out the first rate hike as reflected in rally in the December 2015 short-sterling futures contract.
More important than UK monetary policy, will be fiscal policy. Chancellor of the Exchequer Osborne delivers the Autumn Statement. With the drop in oil prices, which means lower North Sea oil tax revenue, there is little scope for pre-election fiscal gifts. Indeed, despite the talk of austerity, the UK budget deficit for fiscal year that ended in April was 6.6% of GDP. The appropriate comparison is the US, where the deficit has fallen from over 10% of GDP to less than 3% in the last fiscal year. The UK structural deficit has hardly been addressed, and the Prime Minister’s push to deny immigrants from the EU welfare benefits (employed or not) for the first four years that they are in the UK is not a real answer.
In Japan, the BOJ focuses on the core inflation measure, excluding the impact of the April 1 sales tax increase. In Japan, the core measure includes energy. Over the last several months, core inflation so measured has slipped below 1%, and a further decline looks likely as the decline in energy is larger than the decline in the yen’s exchange rate. There is increasing talk that the BOJ will likely be forced by the middle of next year to boost its efforts yet again. The lower house election in a fortnight is the next main focus. The key issue is not if, but how many seats the LDP loses.
The US monthly jobs report is still arguably the most important high-frequency data point. This may be surprising for two reasons. First, the Federal Reserve has played down what this report measures. Yellen has preferred a wider range of indicators of the labor market. Second, the monthly non-farm payroll growth has been remarkably steady. The three-month average is 224k. The six-month average is 235k, and the 12-month average is 226k. And remember millions of people losing and landing jobs over the course of the month, what we see is just the net figure.
Roughly half the decline in the US unemployment rate can be accounted for by the decline in the participation rate. However, in October jobs report (in early November) saw a decline in the unemployment rate even though the participation rate rose. One month can be a fluke. This will be monitored closely going forward. In any event, point is that the Federal Reserve’s appears continue to have under-estimated the improvement in the labor market.
It is noteworthy too that the improvement in the labor market has been steady despite the volatility in the economy. Although Q3 GDP was unexpected revised up, the economy appears to have slowed further in Q4. It will interesting to see if the Beige Book picks up on this. The Atlanta Fed’s nowcasting model has the economy tracking 2.3% in Q4 through November 26.
The decline in oil prices has contributed to the decline in US 10-year yields. The yield fell more than 14 bp on the week to finish at 2.16%. It ranks as one of the biggest weekly declines this year. Although the S&P 500 made new record highs before the weekend, it reversed and finished the holiday-shortened session near its lows. While we would not want to read too much into that action, it does seem that the S&P 500 have lost some momentum that may foretell a near-term pullback. The energy sector accounts for an eighth of the S&P 500, but there are plenty of offsets (intense energy consumers, like airlines).
Lastly, we note the three electoral decisions over the weekend. First, it appears that Swiss voters handily rejected all three referendum issues that it faced this weekend. This included the much-publicized measure that would have required the central bank to cease selling gold, boost gold holdings to 20% of reserves and repatriate its gold that currently sits in foreign vaults. Swiss voters also reject efforts to cut annual immigration by 75%. The third motion that was rejected was aimed a abolishing a tax perk for wealthy foreigners.
Second, the election in Taiwan has resulted in a stunning loss of the ruling Kuomintang. Premier Jiang Yi-huah quickly indicated plans to resign. The Democratic Progressive Party will head the next government. A key issue, according to local media, was the trade agreement struck with China last year. Taiwanese President Ma Ying-jeou has promised to respect the electoral outcome, which can only mean some dilution in the effort forge closer ties with the mainland. Over the last six years, nearly two dozen agreements have been struck. A rearguard action to secure and protect what has been achieved will likely dominate the agenda until the 2016 presidential election.
At the tine of this writing, the outcome of the general election in Moldova is not known. Russia is using various elements of power to cajole and intimidate Moldova. It want Moldova to postpone implementation of the trade agreement with the EU. To drive home is message, it has banned agriculture imports from Moldova, including wine, meat, fruit and vegetables. It has also threatened to support the full independence of the Trans-Dniester region, in which it has fostered a break away movement.
Note that Trans-Dniester region is not participating in this election. This is part of the larger attempt by Russia to regain a sphere of influence, which includes Ukraine, Georgia and Moldova. A pro-European coalition government is the most likely result of the election.
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