When a Quarter is Two Halves

The year started off poorly, to say the least. Equity markets plunged from the get-go.  The Nikkei, DAX and S&P 500 gapped lower on the first trading day of the year.   Emerging markets and commodities were smashed.  

Many economists blamed the Federal Reserve for hiking rates in mid-December.   Pundits warned that the seven-year bull market and weak economic recovery in the US was ending.  A recession loomed, and worse because monetary policy had lost its effectiveness and fiscal policy was political neutered.  

However, the first quarter is best understood as one of two halves.  The markets turned around the February 11-February 12 though we note that the MSCI Emerging Market equity index bottomed on January 21. The index is up six of the past nine weeks.  The rally was extended to nearly 21% and the pre-weekend high brought it to the highest level since last November. 

Consider that the S&P 500 has advanced seven of the past nine weeks, including the past five. It closed the gap created at the start of the year and is now fractionally higher on the year.  The MSCI World Index (tracks equities of the high income countries) has also rallied for the past five weeks and seven of the last nine. Since February 11 it is up a little more than 13% and posted its highest close of the year before the weekend. 

The price of oil also closed higher for the fifth week and the seventh in the past nine weeks. The May light sweet crude oil futures contract bottomed on January 20. The price has risen by 43% through the pre-weekend high, to reach a four-month high.  

The euro's advancing streak extended for its third week.  It has gained in six of the past nine weeks. The dollar has been performing in sawtooth pattern against the yen, alternating up and down for the past five weeks.   The dollar has risen against the yen in four of the past nine weeks.  On a trade-weighted basis, the dollar has fallen for three consecutive weeks and is off five of the past seven weeks.  

Many investors and pundits express exasperation with officials and the temporal inconsistencies.  Yet the signal from investors has been neither clear nor consistent.  Prices have swung more than changes in economic fundamentals.  One need not claim the onset of new paradigm simply because the currency markets have not responded to changes in monetary policy in a linear mechanical way.    

We helped clients navigate the difficult waters during the US QE operations by recognizing that the dollar was vulnerable on the anticipation of an asset purchase program, but would rally on the announcement.   The BOJ's move to negative rates at the end of January has been the only policy surprise among the major central banks this year.  The yen's seemingly perverse reaction may be explained by the risk-off portfolio adjustments that led to covering of short yen positions used for funding and hedging.  

Many focus on the impact of the yen's rise on exports.  This is true if all else is equal but it is not. Japan exports less than 15% of GDP.  This is about the same as the US.  Several European countries, including Germany, exports around 40% of GDP.  Since the mid-1990s, Minister of Finance data shows that Japanese companies, like American companies, service foreign demand primarily through local production.  Most of the Japanese-brand cars driven in the US were made in the US.  Some Japanese producers exports back to home.   

The more important channel seems financial.  A stronger yen lowers the value of overseas earnings. This squeezes profits and margins.  Toyota is a case in point.  The union asked for a JPY3000 (~$27) increase in the monthly pay, the least in three years.  The company said it is not able to afford even JPY1000 a month.  

Among the reasons Toyota cited, according to press reports, was unfavorable international climate. For the record, reports indicate Toyota is on pace to earn JPY3 trillion this fiscal year, which is more than twice what it earned in 2013.    The division of profits between earnings and wages is not simply a function of economics.  Japan has full employment by nearly any measure.  Wages influenced by a power relationship and the power extends beyond the marketplace.   

Japanese companies seem to recognize that unions are too weak to make strong demands or even enforce its weak demands. The government has neither the will nor value-system that would force business to increase wages.  Japanese officials are facilitating the creation of ETFs that will be bought by the BOJ in its QQE operations that are constructed to favor those businesses that adopt the best practices that is part of Abenomics third arrow.  

The strong yen reduces the current account through the yen value of the investment income earned abroad.   Investment income include dividends, coupons, royalty and licensing fees, for example.  Unappreciated by many, it is the investment income account that drives Japan's current account position.  

Consider that on a balance of payments basis, Japan's trade balance has averaged a monthly deficit of JPY164.5 bln in the three-month period through January, and a JPY16.5 bln deficit in the 12-months through January.  The average monthly current account surplus has been JPY875 bln for the three-month period and JPY1.42 trillion over the 12-month period through January.  

The yen's recovery could also reverse the imported inflation that previously helped lift price pressures in Japan.  Japan reports February consumer price inflation on March 24.  The core rate is expected to be unchanged at zero.  The measure that excludes energy as well may tick up to 0.8% which is what is has averaged since the middle of last year.  Abe and Kuroda cannot be pleased.  

They defined a goal, precise measure of inflation to target, a timeframe, and appear to have carte blanche in terms of tools.   The BOJ is buying a wider array of assets in larger size than any other central bank.   Abe and Kuroda have taken unspecified financial risks to achieve a goal that there is a reasonable and increasing chance that the inflation target has still not been met by the time their terms have ended (2018).  

The markets exaggerated the risk of a US recession. The US reports its third estimate of Q4 GDP.  It is too historical to matter much, and whether it is 1.0% as the first revision indicated or 0.7% at an annualized pace, as the initial estimate had it, is essentially the same thing: poor.   

However, evidence accumulating that the US economy is accelerating in Q1 16, not slowing further. Moreover, the slowdown in the manufacturing sector appears to be ending.  Capital expenditures are improving though it may be hard to see it in durable goods orders report next week.  

The headline will be dragged lower the sharp decline in Boeing orders.  However, stripping out transportation and defense, and looking at durable goods shipments as well, a recovery will likely be evident.  Last week's Philly and Empire State manufacturing surveys that cover March also point to gains.  The PMI, and later the ISM data will be expected to confirm a recovery. 

On the other hand, economic activity in the eurozone does appear to be slowing.  Recall that EMU economy expanded by 0.3% in Q4 15 for a 1.5% year-over-year growth.  This is in line with what economists reckon is trend growth for the eurozone.  Sentiment has weakened.

Although as we have noted the markets have recovered, the refugee crisis and political anxiety warns of downside risks for the flash PMI that will be released on March 22.  However, even if the composite reading is unchanged at 53.0, it puts the quarterly average at 53.2 compared with 54.1 in Q4 15.  It would be the lowest quarterly average since Q4 14.  

Sterling has appreciated by nearly 5% this month. It has recovered the bulk of the losses suffered following the deal with the EU and London Mayor Johnson's formal declaration of supporting efforts for the UK to leave the EU.  However news that Iain Duncan Smith (IDS), the Minister of Work and Pensions in Cameron's cabinet resigned ostensibly to protest the austerity in last week's budget presented by Osborne, could see those gains pared.  The recent jump in speculative purchases of sterling suggests that many longs are in weak hands, and the loss of momentum could spark a reversal.   

However, IDS favors Brexit, and his departure underscores our concern that regardless of the outcome of the June referendum, a political crisis is brewing.  Far from healing the Tory party as Cameron hoped, Osborne's fear tearing the party further apart is materializing.  The referendum provides the issue around which the opposition within the Tory Party can coalesce. 

Osborne, who has often clashed with the backbenchers, may emerge weaker as his budget was singled out as the proximate cause.  Johnson, who will no longer be London's mayor after the May election, is widely touted as Cameron/Osborne challenger. His candidacy is likely helped by a broadening the criticism of the government.   Labour appears to be trying to exploit and widen the rift within the Tory Party.  However, the program put forward by the party's leadership is divisive in their own right.  

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