May Flies, but June Bugs

It is not that May did not have its challenges.  The German bund extended flash crash had knock-on effects throughout the capital markets. The dollar, which had been trending lower since mid-March, staged an impressive rally in the second half of May that completely unwound the weakness in the first half of the month, and carried it to new multi-year highs against the Japanese yen and New Zealand dollar.   

The polls gave no indication that the UK Conservatives would secure a majority in parliament.  Despite Spain boasting among the strongest growth in the EU, Prime Minister Rajoy's Popular Party was punished in local and regional elections.     Local and regional elections in Italy are being held today (May 31).  Prime Minister Renzi, heading one of the few center-left governments in Europe (parliament was elected even if he was not), is expected to fare better, but still see support for the PD slip.  This is despite the fact that the economy appears to have expanded for two consecutive quarters for the first time in four years.   

Repeated Greek optimism that a deal was at hand only to be shot down by the official creditors also provided for investor anxiety.  It is been nearly a year since Greece received financial assistance and four months since Syriza's election.  Yet, even at this late date, a Greek exit from EMU remains a possibility, according no less than the Managing Director of the IMF.  The German Finance Minister even broached the idea of a parallel currency in Athens.  

Rather the message here is that June will be even more challenging for investors.  May events took the market to a crossroads, and June could very well shape the third quarter, if not the remainder of the year.  

1.  Talk of a US recession is exaggerated.  Not only is the repeated weakness in the first months of the year prompting methodoligical changes, it does not jive with the 1.4% increase in Gross Domestic Income (GNI=GDP).  What the Fed has identified as transitory headwinds are easing and the US economy is expanding.  Key economic data in the week will likely include a small uptick in the core PCE deflator (from 1.3% to 1.4%), the first increase in the manufacturing PMI since last October, and a reduction in the US trade deficit (consensus for $44 bln deficit in April after the $51.4 bln blowout in March). US May auto sales are expected to surpass the 17 mln annualized pace.  The average pace in the first four months was nearly 16.6 mln (compared to 15.7 mln in the year-ago period).   

The highlight of the week is the monthly jobs report.  The Bloomberg consensus calls for a 225k increase, which is in line with the initial estimate of 223k in April.   Many, if not a majority, see scope for a tick up in hourly earnings.  While the Fed's critics complain that the central bank is consistently too optimistic on the economy, the fact is it has been too pessimistic the improvement in the labor market.  Aggregate hours increased by 2.1% in Q1, and nonfarm payrolls rose 2.2% in the quarter.  The various measures of the unemployment rate have fallen, and weekly initial jobless claims made new cyclical lows in May.  

2.  The eurozone's unemployment is more than twice the US level even if it slips to 11.2% in April, as expected from 11.3% in March.  As many already seem to appreciate, the deflationary forces in EMU easing. The preliminary May CPI estimate is expected to show a 0.2% increase year-over-year.  This would be he highest since last November.  The core rate may firm to 0.7% from 0.6%, which would match the highest level since last September.   This is hardly sufficient though for the ECB, and Draghi is likely to say as much at the press conference following the ECB meeting, which means that no early exit from QE is planned.   Still, Draghi is likely to be cautiously optimistic that the cyclical recovery is gaining traction.   Despite the weak labor markets, April retail sales are expected to rise 0.6% after a 0.8% decline in March.  It would be the strongest of the year so far.  

As was the case in 2010, Greece stands out only as an extreme version of what ails the eurozone as a whole.  Integration remains very much an elite project while people chafe under its demands for austerity.  The debt overhang remains significant, and the slow growth is not sufficient to arrest the erosion of bank balance sheets and the continued rise in non-performing loans.  In Europe, the bad loans are greater and provisioning less than in the US.  

Greece has a roughly 300 mln euro payment due to the IMF on June 5, one of four payments due in the month.  The last payment was made only when Greece dipped into its special reserve account at the IMF to pay the very same IMF.  There is a facility by why Greece can bundle its payments due over the course of the month, which would extend the June 5 deadline.  This facility apparently has been used once before for Zambia.  Although the IMF indicated it was Greece's right to make the request, it has reportedly not done so yet.  There seems to have been some progress toward a deal, and if it is not made soon, there will not be enough time to secure the various parliament approvals before the interim agreement expires at the end of June. 

3. Some observers scoff at the reluctance/inability of the Federal Reserve to hike rates despite the economic recovery beginning in mid-2009.  The Bank of England is in a similar position but seems further away from lift-off.  Anything important from this week's MPC meeting will not be known until the minutes are reported later in June.  The UK's manufacturing sector appears sapped. The PMI peaked in August 2013 at 58.4.  It averaged 53.6 in Q1.  Even in May's reading ticks up to 52.5 as the consensus expects, the manufacturing PMI would be averaging 52.3 in Q2.  The service sector is faring better, but after the rise in April to 59.5 (from 58.9) it is expected to pull back to 59.2 in May. 

4.  The Reserve Bank of Australia will meet on August 2.  The central bank has adopted a neutral posture after a mini-easing cycle that brought the cash rate to a record low of 2.0%.  The market is pricing in practically no chance of a cut now, but many investors continue to look for another rate cut in this cycle.  The fact that the Australian dollar has lost 6.75% against the US dollar since the high on May 14 may be one of the factors buying the RBA some time.  The weakness of the New Zealand dollar (-8.5% against the US dollar since late April) and the  4.7% depreciation of the yen (since May 14) has mitigated the impact on the Australian dollar's trade-weighted index, which has fallen only 3%).    

5.  The US dollar finished last week above JPY124, its highest weekly close since the second half of 2002.  Many participants are at a loss to see a proximate cause.  After all, US 10-year yields have fallen almost 30 bp during the dollar surge against the yen and US stocks are practically flat over the same period.  That said,  the Nikkei has rallied non-stop since May 15.  That eleven day advance through May 29 is the longest streak since early 1988.   Speculators in the futures market have expanded the gross short yen position over the past two weeks (through May 26) by the most for nearly three years.  

6.  OPEC holds its semi-annual meeting on June 5.  Given the stabilized and recovery in oil prices, and the continued strong production among non-OPEC producers, like the US and Russia, Saudi Arabia is unlike to bow to pressure from some OPEC members to cut output.   When it did not cut production last November, there was a dramatic response.  This time the market response is likely to be more muted.  Geopolitical developments in the Middle East, with ISIS threatening supplies, poses upside risk to prices.  The US EPA reportedly will cut the corn-ethanol production quota, and this is also seen as a positive development for prices.  

June's other key events beyond this week:  

A.  G7 meeting (June 7-8)--no fresh initiatives are likely.  It is still at 3-6 months away from a preliminary code of conduct for banks.  There is much international pressure on Europe to resolve the Greek crisis.  The US and Japan appear isolated within the G7 in terms of opposition to the AIIB. One aspect that is often overlooked is China is the biggest recipient of infrastructure loans from the Asian Development Bank.  It is also likely to be the biggest recipient of loans from the AIIB, as it builds out the One Belt-One Road regional hegemony strategy.  The potential conflict of interests and the lack of transparency could come to haunt what so many have heralded as an unalloyed good. None of European country's demand, including more representation on the board and permanent on-site directors, were met in the final negotiations before the official launch.  

B.  MSCI to decide whether to include China A shares into its global indices on June 9.  The Hong Kong-Shanghai link and plans to expand it to Shenzhen, as well as other liberalization efforts makes an affirmative decision likely.  The Shanghai Composite is up 126% over the past 12 months, and the Shenzhen Composite is up 165%.   Chinese officials have encouraged a move to the exchanges from the shadow banking sector. Companies have been encouraged to raise equity capital instead of debt.  Stimulative measures, including lower interest rates, may also be encouraging equity gains.  Some domestics may be buying in anticipation a flood of foreign capital if MSCI includes the A shares.

C.  Saudi Arabia is expected to open up its equity market to foreign investors via a Qualified Foreign Institutional Investor (QFII) like China's in the middle of June.  The measure may not be initially enough for to include Saudi shares in frontier indices.  It nevertheless will be seen as an encouraging development, and perhaps the beginning of integrating Saudi Arabia into the global capital markets.  

D. The EU Summit on June 25-26 may see a new initiative from France and Germany to encourage greater political and economic integration within the euro zone.   They want to do so within existing treaties.  France and Germany hold national elections in 2017 when Cameron has promised an "in-out referendum on the UK's EU membership.  While arbitraging welfare benefits by immigrants appears to be a greater source of angst than the regulation and tax arbitrage of businesses, few countries seem to share the UK's focus. Prime Minister Cameron's fall back option appears to be to seek an opt-out the EU's obligation to an "ever closer union".  

E.  Turkey's election is June 7, and Denmark's election is June 18.  In Turkey, the key issue is not if the ruling Justice and Development Party (AKP), led Erdogan (three-times Prime Minister and now President) wins, but if it secures a super-majority (2/3).  Erdogan wants to a super-majority to change the balance of power in Turkey and concentrate it in the executive.  In Denmark, the Social Democrat Prime Minister Thorning-Schmidt seeks a second term.  The polls show a narrow lead by a center-right coalition lead by former Prime Minister Rasmussen.  Thorning-Schmidt is hoping the economic recovery (GDP to grow by 1.6% this year according to her government and 2% in 2016) will offset her pursuit of policies that have antagonized her base (such as selling the utility Dong and toughening the policy for asylum seekers.  She did get high marks for the handling of the shooting in Copenhagen in February.  It will also be a test for the anti-immigration People Party that did well in last year's EU Parliamentary election.  

F.  The Federal Reserve meets June 16-17.  It will include an update of the Fed's forecasts, and is followed by a press conference.  We had previously thought June was a likely timeframe for the Fed's lift off, but this is no longer seems the case.  It was seen as a close call between June and September, and the latter seems more likely, barring a new economic shock.  Given the contraction in Q1, it is hard to see how the Fed's central tendency (forecast after the three high and low forecasts are excluded) of 2.5% (2.3%-2.7%) can be achieved.  Remember the Fed saw this as above trend growth. The forecast is likely to be cut to 2.0% or maybe even a bit lower.   This will be more in line with what economists see as trend growth.  We do not see this in itself to be a barrier to a Fed hike, provided that slack in the labor market continue to be absorbed.  

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