Updating the Big Stories Early in 2015

The greatest risk to the divergence theme is not that the BOJ and ECB would abandon their unorthodox monetary policy.  It was that the consensus would swing against ideas that the Federal Reserve would raise rates near mid-year.

The greatest risk to the divergence theme is not that the BOJ and ECB would abandon their unorthodox monetary policy.  It was that the consensus would swing against ideas that the Federal Reserve would raise rates near mid-year.

The continued drop in oil prices, and  last week’s news that US average hourly earnings growth slowed to their weakest rate in two years have fueled a dovish push back.  The string of data in the days ahead will provide them with more ammunition.  Producer and consumer prices likely fell in December.  Retail sales likely slowed.   

This may encourage some consolidation of the dollar’s recent gains, which means a heavier tone for the greenback.  Momentum already seemed to have stalled in the second half of last week.  The same is true for equities.  The quarterly earnings season starts in earnest with Alcoa.  Following the guidance, earnings expectations have continued to drift lower, some citing the strength of the dollar as a factor depressing the translation of foreign earnings into dollars.  

Nevertheless, we are reluctant to sway.  These developments do not pose a serious threat to the divergence theme.  The Federal Reserve targets core inflation for good reason.  Headline inflation may fall, but core inflation is likely to prove sticky.  One of the important factors here is the rise in housing costs.  

We already know that auto sales slowed sequentially from November, and the drop in gasoline prices will weigh on the headline retail sales report.  However, excluding autos, gasoline, and building materials, which are included in different measures that feed into GDP calculations, retail sales are still expanding at a respectable rate.  Moreover, it is largely without the use of revolving credit.  

There is no getting around the disappointing hourly earnings growth.  However, it is only one measure of labor costs and one month.  We will be more concerned if it repeats in the coming months with confirmation in other reports.  Broader measures of the labor market, also reported next week, expect to show continued improvement.  

The preliminary negative print in the euro area will likely receive confirmation this week.  It will strengthen investors’ conviction that the ECB will broaden the assets it purchases to include sovereign bonds as early as January 22.  Nevertheless, it is important to remember that at his December press conference, Draghi made a point of not committing to that meeting (hinting that March 5 meeting action was also possible).  

Although it received considerably less attention, the core rate of inflation in the euro ticked up to 0.8%, its highest rate in three months.  The ECB has painted itself into a bit of a corner by not interpreting its mandate for price stability to mean core price rather than headline.  Such a focus led to policy miscues in the recent past.  What prevents it from correcting its course seems to be more inertia and ego than economic logic.  

On Wednesday, the Advocate General of the European Court of Justice will offer a preliminary opinion about the Outright Market Transaction scheme.  Recall the ECB approved Draghi’s initiative over the Bundesbank’s objections.  Disgruntled Germans took the case to the national court, and Bundesbank President Weidmann testified, seeking to court action to do what he failed to convince a majority of fellow EMU central banker to do.  Although the opinion this week will not be binding, it will reveal how the Court is likely to decide.  Its formal decision expects to come near midyear.  It could shape some elements of the ECB’s bond buying program, like risk sharing elements.  

Sweden and the UK will also report their latest inflation figures next week.  Sweden expects to move deeper into deflation territory.  The year-over-year rate may fall to -0.5% from -0.2%.  This will likely push the Riksbank into unorthodox monetary policy at its February 12 meeting.  There does not seem to be a strong inclination to buy its sovereign bonds, which are yielding 81 bp at the end of last week.  It could use its forward guidance to push out the first rate hike from H2 2016 of its last indication, and link the decision to a specific level of inflation.  It could lengthen repo/loan facilities.   

The UK CPI is likely to fall below 1.0%. This would force BOE Governor Carney to write a letter to Chancellor of the Exchequer Osborne to explain the undershoot.  However, this is mostly political theater.  We would not expect a policy response.  Unlike the dissents at the Federal Reserve, the two dissents at the Bank of England actually advocate an immediate hike.  The dissents are unlikely to sway from the drop in oil prices, though investors will have to wait until the minutes release on January 21.  In addition, we recognize the risk that the core measure of UK’s CPI may tick up to 1.3% from 1.2%.  

Japan’s economic data are unlikely to move the market much.  It begins the week with its November current account balance.  The November balance has deteriorated from October for the past seven years and it expects to do so again.  The trade deficit expects to narrow slightly. The dramatic drop in oil prices, even in yen terms, points to some improvement in Japan’s trade balance going forward.  

The direction of the equity markets is key for the yen.   Simply looking at direction, the dollar moves against the yen and in the same direction as the Nikkei 97% of the time (60-day rolling basis) and the S&P 500 88% of the time.  The returns of dollar-yen and the returns of the Nikkei and S&P 500 (correlations run on percentage change of each) is 0.45 and 0.56 respectively, both of which are at the upper end of the ranges since the election of Prime Minister Abe in late 2012.  

Although oil prices have been falling for six months, the world is still in the early days of the adjustment process.  Competition for market share is intensifying.  OPEC producers, led by Saudi Arabia, are still increasing discounts to the official selling prices for the US and Europe.  At the same time, the US government has informally eased rules to export lightly processed crude (condensate).  Canada’s exports to the US appear displacing some of Latam and African producers. 

The US rig count continues to fall, but much more is likely if oil prices stay low and/or fall further.  There are still about 1482 oilrigs operating in the US (excluding rigs offshore).  Based on past experience, some oil experts, like T.Boone Pickens, warn that the rig count could fall to 1000 before the end of the cycle.  In addition, because of the advent of horizontal drilling, the relationship between rig count and actual output might not be as tight as it has been in the past. 

Lastly, investors continue to watch European political developments.  In Greece, the latest polls continue to show Syriza winning a plurality of votes at the January 25 election.  Prime Minister Samaras’ New Democracy has not been able to close the 2-3 percentage point lead.  Even with the 50 bonus seats given to the party that gets the most votes, it appears Syriza may not secure a majority in parliament.  If it fails to do so after three days, the party with the second highest vote count will get a chance.  New Democracy may be able to do so, avoiding another election. 

European politics will remain an important issue for investors after the Greek election.  Italy’s president will soon resign, and this will begin what could be a protracted process to pick his successor.  It is a more complicated process than in Greece, where a super-majority of parliament chooses the president.  In Italy, more than just parliament is involved.  In addition, given the fractious nature of Italian politics, the role of the President is more important than constitutional powers of the office. 

Spain holds local elections in May and national elections in November.  Investors have already begun monitoring the polls.  A poll out last week from La Razor, a conservative newspaper, showed the ruling PP in first place followed by the Socialists and the insurgent Podemos is third place.  However, a poll over the weekend by Cadena Ser, a radio station, put Podemos in first place.  Another poll, conducted by Metroscopia for the left-center newspaper El Pais, published on Sunday also showed Podemos with a plurality of votes.

What are We Watching? is republished with permission from Marc to Market