This week will be dominated by the Fed interest rate decision and meeting. While there is no expected rate increase at this meeting, the conditions have changed drastically over the last few months. The markets are pricing in a 25% chance of a rate cut by the end of the year and no chance of a rate increase. The importance of this meeting will be the insights of what the Fed plans to do with their balance sheet reduction schedule. Investors will be looking at how the Fed plans to continue, or delay, the balance sheet reduction in the wake of global economic trends. Other central banks have made it clear that they plan to keep their balance sheets as is, or expanding. It will be important to see if the US continues to buck the global trend or not. If so this will keep assets coming into the US Dollar, and dollar denominated assets.
A second factor to watch this week (though still interest rate related) is inflation numbers. The UK in the midst of Brexit is going to release their numbers Wednesday, with the Pound relatively range bound there isn't too much expectation of inflation getting out of control in the near term. The next day the UK will announce its interest rate decision with no expected action. Japan and Canada will also provide inflation numbers with forecasts near the previous levels. Large changes to the upside in these numbers will create a conundrum for central banks as they prepare for lower growth. A shrinking inflation number will provide the central banks with an open field for more monetary expansion in the event of slowing growth.
A second vote in UK parliament is taking center stage today. After the defeat of the new Brexit deal, a vote on whether to go ahead with a no deal Brexit is being voted on. Many are hoping this is going to be defeated and leave the UK with a final vote this week on delaying the March 29th deadline. The likely outcome (given the relatively low volatility) is that the can will be kicked down the road. This will not be good for UK businesses and banks which will most likely hold back on lending and expanding businesses among the uncertainty.
Meanwhile in the rest of the world there is a picture that is being built outside the events of Britain. The global economy is showing signs of slowing, being offset by central banks coming out with more dovish language as the start of the year rolls on. This has many investors wondering if central bankers are coming in preemptively to get ahead of a coming slowdown or adjusting to one that is already starting. With central bank rate changes taking about 18 months to flow into the markets properly, the language and guidance they are giving more important in the near term than actual changes to rates or asset purchases. The reasoning will depend on the data and vary by central bank.
In the US, there is more of an assumption that the Fed is being preemptive. Data (with the exception of the last jobs report) has been supportive of the economy. Inflation expectations have come down, but not in a severe way that will show easing as imminent. Data coming out today (like PPI) will help to build the picture around the Fed's stance on interest rates longer term.
For other banks, like the ECB, there are more tangible steps being taken. While the Fed is looking to be 'patient'
The Pound rallied in early Tuesday trading in Asia as new that the European commission agreed to changes to the Brexit agreement. This is the final chance that the UK will probably have for negotiations with the commission before the end of March deadline. With a vote on the deals coming on Tuesday, there will be another vote Wednesday, should this one be rejected, to determine if they should leave without a Brexit deal. If none of those are passed then a delay in the Brexit will have to be voted on.
One thing to keep in mind, is that the macro picture we are seeing will not improve as a result of the Brexit outcome. So while we might see an increase in volatility in the event of a no deal, the Euro is still likely to suffer in the longer term as slowing global growth will test the central banks and their ability to soften the blow. These monetary policies will only be able to do so much with most central banks (the US being an exception) still near the top of their easing cycle. Fiscal policy and the ability for banks to lend will be the main factors in managing through the next slowdown. The Euro area is suffering in both of these areas because of the 'Doom Loop' where banks hold sovereign bonds, and the lack of political will for the better off countries in Europe to help direct capital where it is needed most.
This is where you could see some resurgence in the UK economy after the Brexit deal (the outcome of the deal will determine the length before growth comes around) where lending starts to open up as less uncertainty causes banks to boost capital. The outcome of this week could provide opportunities to look at buying UK assets over European ones as Brexit winds down and the overall macro economy is taken into account in Europe.
A string of data from the Eurozone is pointing to lower growth in the region. Sentiment was at a 2 year low, German business growth is expected to fall "well below" the 1.5% targets according to the central bank chief, and importantly, corporate lending in the region slowed.
According to the ECB, corporate lending declined in January exacerbating the downturn in the region. This is a start to the confirmation that the slowdown in the Eurozone is continuing and the moves by the ECB will have to be followed to see how they are able to react to these changes. The Fed chair is going into his second day of testimony to Congress, shedding more light on what the Fed is looking for in data and how they will react. The ECB will have to start thinking of what policy tools they can politically use in order to calm the fears of the Eurozone countries in the face of slower growth.
Markets are starting the week on a positive note. Talk of the trade tariffs being delayed has the Chinese stock market entering a bull market and the US futures are pointing to gains of around 50 basis points (half a percent) at the open. Oil prices are hitting highs for the year on supply cuts and optimism. Extending the increase in tariffs that were due to go into effect is a positive sign that normalization in trade can occur. This boosts the prospects for the economy as well as markets in which a normalized trade relationship with China (and other countries), with the help of an accommodative Fed, will produce steady tailwinds for 2019. This week Reality will test some of these assumptions.
Tuesday will start the week with a 2 day testimony by the Fed chairman. This will provide investors with more clarity on the stance of patience and data dependence for 2019. The US will also announce home prices and Crude oil stocks.
On Wednesday the Euro area announce business confidence numbers which will be important to determining if the slowdown in the region is more pronounced going into the final month for Brexit talks.
Thursday has GDP numbers coming out for many countries (including the US) as well as UK consumer confidence and German inflation. This will be a big check on the European Disunity play we are currently looking at. Whether the eurozone slowdown can be slowed, and eventually reversed, in the current political climate of the region. China's bull market will be tested with data, having the manufacturing PMI coming out. The numbers are expected to come in slightly below 50 (signaling a contraction).
Friday will see US numbers on Income and manufacturing which will be compared to the unemployment and inflation numbers of the euro area. Depending on how other regions report, this could show the US bucking a trend of slowing growth or falling in line (confirming the Fed's recent dovishness). Finalized PMI numbers will come out from the Euro Area which was barely in expansion at the last reading.
In Summary the market optimism we are seeing in the week will have the chance to continue should the week show the Fed taking precautionary steps with policy as US numbers still impress, China starting to see signs of strength in manufacturing to piggy back on trade talks, and the Euro area displaying resilient business confidence in the face of Brexit. If these assumptions seem lofty then we could start to see this Monday rally struggle as the start of March begins.
British unemployment stayed at 4% today with claimant counts being revised lower than expected. Construction output in the EU was not as upbeat, coming in lower than estimates. Thursday will see the EU PMI numbers come out which have been slowing down to the 50 range over the past 6 months (a number below 50 denotes a contraction). As Germany is flirting with a technical recession and Brexit looming, it will be important to see how the EU is affected by these trends. Some countries are better prepared for a slowdown (US) or have the ability to take decisive action fiscally and monetarily (UK), the Eurozone could struggle with the sense of unity and political will to counteract a slowdown.
US monetary policy:
As mentioned, the Fed has been raising rates in the past and now stands in a holding pattern to monitor the slowing growth around the globe. On Wednesday the FOMC minutes should shed some light on the recent trend towards monitoring the impact of past rate increases. An important measure is the change (if any) on the balance sheet reduction program. After buying up $4.5 trillion of assets during the financial crisis to boost liquidity, the Fed has been reducing the amount of assets it holds by about $40bln a month. A change in the level that the Fed sets as neutral will be important to the stability of debt levels and the Dollar.
There is a little over 6 weeks before the Brexit date is reached. Without a deal the UK risks falling out of the European Union without trade deals, or a solution on the border of Ireland. This would no doubt cause a lot of volatility in UK assets up to the departure date and beyond depending on the outcome. Since the vote to leave the EU in June of 2016 we have seen the effects of the decision on the currency, markets, and economic numbers. As an investor with a longer horizon, how should you look at these events as they unfold and uncertainty depresses prices.
Looking at the headlines it seems the Eurozone is the obvious winner if the UK suffers a hard exit. Goods from the UK to mainland Europe are small in comparison and many companies have already started to move staff and jobs out of Britain. Looking at the overall economic growth globally the Eurozone might not fare as well as many expect. Aside from the Brexit uncertainty global growth is slowing down and the Eurozone is no immune. In the event of a slowdown the UK is in a better position to provide stimulus to their economy and the depressed Pound will help with exports.
The Eurozone didn't see the economic decline that the UK did after the vote to leave, but since the slowdown started, the Euro countries were hit hard by their intertwined bonds and banking system and the end of massive QE stimulus. One of the major themes we are following is European Disunity, a slowdown in growth and the lack of political will for more monetary accommodation, many of the countries are starting to undertake fiscal stimulus. This is a good sign that the European governments are aware of the problems, but it raises the concerns about which countries can afford to add a lot of stimulus and which cannot. This could create the two speed Europe we have seen in the past, only this time the ECB could have mixed data on their hands.
While Brexit is not great for the UK and will see volatility in the coming months, take into account the larger economic trends and who would be most likely to manage and come out of an economic slowdown quickly, should one occur. In this scenario the UK looks much more nimble and has the ability for more monetary and fiscal stimulus. Now would be the time to sit back and wait to start buying.
US markets have rallied back pretty well at the start of this year, with the S&P500 up over 10% it seems that there is a nice comeback to the market sell-off we had in December. Earnings were not as stellar as in the past so that can't account for the upswing, and trade tensions, Brexit, and a global slowdown are still on the table. The one factor that seems to be putting the market on an upward trend is the change in Fed policy. Since the start of the year the Fed has been pushing a message of patience and concern over the rate of increases that it was set to make in 2019. Since the start of December the probability of an increase in 2019 virtually disappeared, in fact a rate cut of 25 basis points is starting to creep back on the table.
The concern about this current situation is that there is a great emphasis on the actual news of the Fed taking it slower in its tightening policy but the events that are causing the concern are still being priced in as remote. The global slowdown, trade tensions, and Brexit have yet to materialize into real crisis. If you look at the economic data coming out of the US it is still surprising to the upside. This is giving the impression of a strong economy with the Fed easing. These two issues are not going to remain intact for long. The concerns facing the global economy are going to start affecting the US proving the Fed early to react, of the US will in fact weather all of these global concerns somehow at which time the Fed will most likely reverse their tone rather quickly.
Futures in the US are down today after a long weekend at which time the IMF updated its global outlook lower. This was reinforced by China reporting its weakest annual expansion since 1990. A lot of this news from the US side is going to be priced in this week, but overall the news didn't seem to have too much of an effect on global markets. The reason for this could stem from the sell-off in December, when all of the companies started to issue profit warnings about growth in China. Markets sharply sold off (some argue too much) on the expectations that the bad news will come out in the figures this month.
What does this mean longer term? There is more evidence that economies are slowing and this will affect the markets. It will also dampen the market sentiment we have seen since the start of the year where stocks were coming off the December bottom thinking the sell-off was too severe. A January rally of about 10% and data now confirming that there was a slowdown in key markets should pause the bullish sentiment on the markets until data points towards recovery or more contraction.
Concerns about the debt loads in China and the US should be looked at in terms of timing. The ability to manage these large debt payments will become harder as the economy slows down, exacerbating the problem as companies, individuals, and governments try to deleverage. In the deleveraging process there are 3 main ways to manage the debt: Extend maturity, restrict growth and paydown, and default. Extending maturity, especially in the US, will be difficult in a higher rate environment, also the markets are now demanding more premium in spreads over lower quality loans. This leaves the other two options, where the countries will have to muddle through payments and manage those obligations over growth or in the event that is unmanageable, default. These two options are not great in terms of global growth prospects turning around in a short time frame. With rates higher in the US (and the Fed willing to pause and possibly even cut in the future) and the Chinese government starting to add stimulative measures to their economy, mass defaults should not be common. This leaves economies, and their markets muddling through the soft patch, subject to data and bouts of volatility, a great time for income and buying opportunities.
Futures are pointing towards a lower opening today with news of Eurozone industrial production and Chinese exports adding to the declines. These data points coincide with the start of a very busy week that will help shape investment decisions for the coming year.
The Brexit vote is on Tuesday, where UK parliament is going to have a vote on May's proposal for leaving the union. Should they reject the deal, there is little chance that another round could take place before the March deadline, increasing the chances of delaying or having a second vote to avoid a hard Brexit. Companies are adjusting to this new reality as seen in the numbers today. Capital goods such as machinery and white good like stoves and refrigerators were all down in the Ind. production numbers. Retail goods also saw a decline, emphasizing that everyone is holding back investments and purchases as the deadline approaches with no deal in place.
The decline in Chinese exports, specifically with the US, is also a reading of a larger picture concern. The trade wars between the US and China are still ongoing, with tariff increases on Chinese goods pushed to March. There is time for negotiations to take place now, but this extended time frame lowers the urgency. Earnings season in the US is kicking off this week which will show how much the trade wars affected companies last year and give some insight into what impact executives think it will affect overall 2019 earnings.
Overall this week will be important for the sentiments that develop out of the news. Data points are already showing a slowdown as a result of the political uncertainty of these events, so earnings warnings or a vote down of May's Brexit deal will be seen as continued weakness from uncertainty.