Global Tensions Lessened, but Bound to Increase Ahead of June FOMC Meeting

We expect the FOMC statement this week to recognize the improvement in the global conditions that have been an increasing worry for officials over Q1.  At the same, time the soft patch of the US economy is undeniable.   

We suspect the Fed will look past the weakness of the US economy. The strength of the labor market, with weekly initial jobless claims at their lowest level since 1973 and continuing claims at their lowest level since 2000, it is difficult to get too negative the US economy.  

Still, the calm in the global climate is unlikely to be sustained.   More than that, around the June 15 FOMC meeting, global tensions will be on the rise.  There are several events that are pushing in that direction. 

On the top of many concerns will be the UK referendum week after the Fed meets.  Although polls and the events markets show a mild move away from Brexit, the risk is still palpable.  The risk, we argue, needs to be understood as a function of the probability multiplied by the potential impact.   It remains a modest probability and a potentially high impact event.  Many investors are concerned not simply about the implications for the UK, but also the EU itself.  

It is not only the UK referendum that may lift global tensions around the time of the June FOMC meeting.  Spain had elections at the end of last year and has still not been able to form a government.  A do-over election is likely to be scheduled for late June.   

Turkey is raising the stakes over its negotiations with the EU.  Turkey insists that if the EU does not grant visa-free travel for the 78 mln people with Turkish passports, the refugee agreement will stall.  The refugee flow into Greece has slowed to a trickle in recent weeks.  In exchange for in essence agreeing to respect its previous agreements, Turkey demanded more funds (6 bln euros over four years) and two other concessions.  

First by the end of July, the EU must restart Turkey's ascension negotiations.  Second, and more pressing,  is the visa-free travel to the EU.  For its part, the EU had identified 72 areas that the Turkish passports needed to be addressed by the end of this month.  Last week, a member of the European Parliament who is involved in such matters noted that only 35 of the conditions have been met.   Next week, the EU will make issue a formal report of the progress.  Turkish officials seem to think that sufficient progress to bring the passports security features up to EU standards. 

Another potential risk comes from Greece.  Greece wants to pass the review its progress so that debt relief can be discussed.  Germany, for one, still seems reluctant to even put it on the agenda.  The IMF is insisting on it.  One of the reasons, Greece has been off the front pages is that it does not have debt payments due to the IMF or ECB, until June.  

There are three key issues: pension reform, tax increases, nonperforming loans.   The creditors have insisted that in addition to the implementation of 5 bln euros in new savings (tax increases and spending cuts), Greece needs to agree to a 3 bln euro contingency plan that kicks in if the Greece falls short of the 5 bln euro in savings. 

The IMF talks about debt relief, but it seems to exclude itself.  On the other hand, it takes a more realistic view of Greece's primary budget surplus target.  The current target is 3.5% of GDP from 2018 on indefinitely.  The IMF says the current agreement only gets it to 1.5%.  It seems more skeptical that the 3.5% primary budget surplus can be sustain even if reached.  It does no appear that any country, including Germany, have been able to achieve this for any meaningful period.   Before the weekend, Eurostat reported that Greece's primary surplus was 0.7% of GDP, which was a little more than anticipated. 

The IMF is opposed to new taxes in Greece.  It wants the tax base broadened by eliminating exemptions.  According to one estimate, exemptions reduce the households' tax burden by 55% compared with an average of 18% for the eurozone as a whole.  The IMF insists on cutting the exemptions to 1800 euros per household.  Over the weekend, Greece apparently conceded to 1900 euros per household.  This difference is 0.1% or about 200 mln euros in a 5.4 bln euro package.  

OPEC meets in early June.  We suspect that this is still too soon to reach an agreement on freezing output.  Iranian oil production is coming back online more slowly than the government had projected.  It is being stymied on some different fronts, some of which stem from the fact that no all sanctions have been lifted, many are wary of engaging the country when there is still low hanging fruit elsewhere, and there appears to be a shortage of oil tankers for it.  Some of the shortage of oil tankers and financing may also be stemming from obstructionist tactics from its rival(s).  

Finally, there is a sense among many investors that the reprieve for emerging markets and commodity prices are a short-term phenomenon.  They worry that it is not sustainable. From January 21 through last week the MSCI Emerging Market equities rallied nearly 25%.   The price of WTI rebounded 70%, as has iron ore prices.    The rally in some major equity markets, like the US S&P 500 and the UK's FTSE have completely retraced the sharp losses seen in the first several weeks of the year.  The MSCI World Index (major markets) rebounded 16% from the lows seen in on February 11 through last week's highs. 

The risk is that as the FOMC meets this week, the condition of the global capital markets may be as good as it gets.  By the time the June meeting comes into view, the risks mount of greater instability.   While appreciating the global context that the Fed operates in is important, a strategy that puts too much weight on global developments may take control of US monetary policy away from the Federal Reserve and give it to the UK, Greece, Turkey, the IMF, and countless other places. 

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