Drivers for the Week Ahead

Blog icons-DRIVERS

  • Macron is going to be the next president of France 
  • US retail sales and CPI data should demonstrate that the economic headwinds were transitory  
  • The Bank of England meets and issues its quarterly inflation report 
  • The Reserve Bank of New Zealand meets this week and policy is on hold 

The dollar is mostly firmer against the majors in the wake of Macron’s victory. Kiwi and the yen are outperforming, while the euro and Swiss franc are underperforming. EM currencies are mostly softer. MXN and IDR are outperforming, while ZARA and the CEE currencies are underperforming. MSCI Asia Pacific was up 1.4%, with Japan markets rising 2.3% after returning from holiday. MSCI EM is up 0.7%, with Chinese markets falling 0.7%. Euro Stoxx 600 is down 0.3% near midday, while S&P futures are pointing to a lower open. The 10-year US yield is down 2 bp at 2.33%. Commodity prices are mixed, with oil flat, copper down 1.3%, and gold up 0.5%.

Sometimes there seems to be a single factor of overwhelming influence in the capital markets. We have maintained that to the extent one exists, it was divergence as the Federal Reserve is well ahead of the other major central banks in the beginning to normalize policy.

The rise in US interest rates and the related increase in dollar’s exchange value was an integral part of how the global recovery was to strengthen. The below PPP exchange rates in Europe and Japan and the continued pursuit of aggressive, unorthodox monetary policy should help pave the way for stronger recoveries.

And indeed that seems to be the case. The eurozone expanded slightly faster than the US last year, and in Q1 17, it grew nearly as much as the US did an annualized pace (0.5% quarter-over-year vs. 0.7% annualized). The Japanese economy is also finding better traction. In addition to valuation considerations, another factor drawing money to European equities this year is that it being behind the US also meant the potential for P/E expansions. Emerging markets also drew investment, after recent drawdowns, as two threats eased. US bond yields had trended lower, and the Chinese economy appeared to stabilize.

Macron is going to be the next president of France. The euro is down today due in part to profit-taking, as the overall significance of his win cannot be known with any degree of confidence until next month’s parliamentary election. Macron comes from the pro-business wing of the French Socialist Party. The Socialist Party is, in essence, a social democrat party, with the propensity to create factions and new parties. Macron’s departure to launch his own party removed a key obstacle to the fundos-wing taking control of the Socialist brand that had been driven into disrepute by the unpopular Hollande.

French national interests do not change from election to election. It is a debtor nation that often expresses the interests of debtor countries. It is a check on Germany and the interests of the creditors. Macron, like Merkel, Renzi (and Gentiloni), and Rajoy, are pro-Europe but attach somewhat different meanings to Europe.

France follows Finland, Austria, and the Netherlands in turning back a populist-nationalist challenge. In recent council elections in the UK, the populist-nationalist UKIP was nearly wiped out. Its single issue agenda has been co-opted by the Tories. The French results reaffirm our belief that populists will win only when supported by a center right party. On their own, they fare poorly.

It is still not clear how Trump will govern. He plays to the populist-nationalists, even when he does not have to, such as endorsing Le Pen. Yet in many ways, he is governing like what the FT’s Martin Wolf dubbed a post-Reagan Republican.

Some observers may be exaggerating the importance of a change in the ECB’s forward guidance. The ECB has famously kept an easing bias by suggesting that rates could be cut further. However, while true in theory, after all the zero thresholds have been breached, no one believes it is within the realm of possibilities barring a paradigm shifting shock.

In effect, the ECB may drop a phrase of little real value to investors in the first place. The most likely scenario is still that the Fed hikes and begins to reduce its balance sheet before the ECB stops expanding its balance sheet or brings the deposit rate back to zero from minus 40 bp. The BOJ’s balance sheet is expanding a bit slower than JPY80 trillion a year, but what is a few trillion yen at this juncture than a rounding error?

While the Fed funds futures strip implies a strong chance of a Fed hike in June (Bloomberg says almost 99% chance, the CME says 78.5%) to 1.00%-1.25%, the US two-year note is yielding 1.31%. In January and February, when many expected the next hike to be in June, the two-year hovered around 1.20%. The yield rose to 1.40% in response to the Fed’s full course press to prepare investors for a March move. At 2.35%, the US 10-year yield is below where it was the Fed hiked at the end of 2016 and again a couple of months ago.

After the poor Q1 GDP, the onus is on the US economy to demonstrate that the headwinds were transitory. That is what we expect to be delivered in the main two economic reports this week: retail sales and CPI. Consumption was particularly weak in Q1. The foundation for better consumption is income, and that means wages/salaries and transfer payments remain intact.

If consumption is going to increase, then the first place to look is retail sales. A 0.5%-0.6% is expected after a 0.2% decline in March. In part, this will reflect the increase in gasoline prices. The components that are used in GDP calculations are expected to be rise by 0.4%. That said, the average core retail sales rose an average of 0.23% in Q16, while they averaged 0.27% in Q1 17. Personal consumption expenditures rose 3.5% an annualized rate in Q4 16 but only a miserly 0.3% in Q1 17.

Consumer prices appeared to have increased in April after softening in March. The headline may increase 0.2% after a 0.3% fall in March. The year-over-year rate could edge lower to 2.3% from 2.4%. The core rate is expected to increase 0.2% after easing 0.1%. This would keep the year-over-year rate steady at 2.0%.

The markets did not react much to the passage of health care reform by the House of Representatives. It was to free up funds that could ostensibly be used to fund tax reform. The S&P 500 edged to new record highs before the weekend, but this seems to be part of a global move and not a US-specific driver. In fact, the only G7 market to do worse than the S&P 500 0.6% gain was Canada’s where the TSX was off 0.3%, after a 1.2% rally before the weekend.

Trade tensions with the US, the decline in oil prices, and diverging interest rate differentials undermined the Canadian dollar. It is the worst performing major currency so far this year, off 1.6% against the US dollar. The two-year US premium jumped from 45 bp on April 20 to 63 bp at the end of last week. This is the widest premium in a decade.

However, the positioning and price action in the Canadian dollar is warning the bears to be careful. The gross short Canadian dollar futures at the CME appear to be at a record high as of May 2. The price action before the weekend, whereby the US dollar made new highs and then sold off and closed below the previous session’s low, is a negative technical sign.

Not coincidentally, oil prices snapped back to close 1.5% higher after initially plunging 4% to levels not seen since April 2016. Copper prices stabilized after briefly trading to new lows for the year. Iron ore future prices in China fell more than 5% before the weekend to end the sixth weekly decline in the past seven. Steel futures have also fallen.

China’s capital controls appear to have effectively slowed capital outflows, while under-performance of the equity market and bearish sentiment toward the yuan has discouraged capital inflows. Reserves rose ($20.45 bln to $3.03 trillion) for a third consecutive month in April as capital controls bit and the dollar’s decline flattered the valuation of other currencies in reserves. Even if capital flows have slowed, trade linkages remain significant. Its supply and demand for industrial metal may not be the only consideration, but it is a major driver most of the time. It is expected to report a moderation of both imports and exports (in dollar terms).

Slower growth in imports and exports is not inconsistent with a larger trade surplus. Indeed, that’s what happened as the April surplus rose to $38 bln vs. $35 bln expected and $24 bln in March. There is also a large seasonal component. China’s trade surplus has widened in April over March for the last seven years and in nine of the past 10. Tame consumer prices will create scope for stimulus if economic slowing becomes too pronounced, and in the meantime, officials can focus on curbing some of the excesses, including lending and leverage.

The Bank of England meets and issues its quarterly inflation report. Just like the FOMC looked past the soft Q1 GDP, the MPC seems inclined to look through firm real sector and price data. Each of the three April PMIs released last week were better than expected. Prices pressures do not appear to have peaked. However, it is still arguably reasonable to expect the economy to slow and the base effect points to a peak in CPI, perhaps by the end of Q3. Since the last quarterly inflation report, growth has been a bit slower than expected, and inflation a bit firmer.

Forbes disagrees. She dissented last month for an immediate hike and is likely to dissent again. However, her term ends shortly, and she probably was unable to convince any of her colleagues to join her. That said, if perchance there is more than one dissent, it could catch the market leaning the wrong way.

Consider that the implied yield of the December short sterling futures contract finished last week at 42 bp. In the middle of last December, before year-end pressures emerged, the yield was near 55 bp. We note that in the future market, speculators have retained a large short gross sterling position (135k contracts, 62.5k GBP per contract), the largest among the currency futures.

The Reserve Bank of New Zealand meets this week and policy is on hold. There is no urgency to move. Australia’s fiscal policy eclipses monetary policy. Infrastructure spending (rails, roads, and a new airport). Over the past month, the Australian dollar has been the weakest of the majors losing about 2% against the US dollar. It staged a sharp recovery before the weekend, not as technically robust as the Canadian dollar, but promising.

Industrial production figures are featured from Europe, but the data does not matter. Investors focus is not on Q1 data as we approach the midpoint of Q2. Also, the challenge for the ECB is not current growth, but prices. The combination of euro’s gains (three of four months this year) and weaker commodity prices are not usually associated with an acceleration of inflation.

Overshadowed by the French election, the small German state of Schleswig-Holstein went to the polls. The SPD-led ruling coalition lost to Merkel’s resurgent CDU, which boosted its vote total to 32%, up 1.2 percentage points from 2011. The Free Democratic Party picked up 11.5% of the vote, up 3.3 percentage points from 2011. This came largely at the expense of the SPD, which saw its share drop over 3 percentage points to 27.2%.

The new SPD leader Schulz had a brief honeymoon that bolstered the party’s standing in the polls, but it has faded. Next week, his home state North Rhine Westphalia (the most populous German state) holds local elections. It is currently led by a minority SPD-Green coalition. This election will most likely give markets a better read on this fall’s national election than this past weekend’s results.

There has been a perverse counter-intuitive reaction to Brexit and Trump’s unexpected electoral success in the US. In Europe, pro-EU sentiment has grown since the slim majority voted for the UK to leave in nearly every country, except Italy. In the US, traditional media has found new subscribers and Democrats are talking about the benefits of trade agreements.

The populist-nationalist rhetoric in Washington is spurring populism-nationalism in Mexico. Trump’s bellicose rhetoric and his reference to Korea once being part of China may have helped bolster the candidacy of Moon Jae-in as the next president of South Korea. More than the other candidate, he is more likely to delay the establishment of the US anti-missile capacity, which has antagonized China and would be a possible basis for a rapprochement with North Korea.

EM FX got some limited traction as the week closed, helped by stabilizing commodity prices. However, oil, copper, and iron ore have all broken important technical levels that suggest further weakness ahead. Indeed, EM FX and commodities are starting the week off on a largely softer note. We also think the FOMC statement and US jobs data from last week support our view that the next Fed hike will be in June. This backdrop should keep EM on the defensive this week.