weakness in H1 followed by a stronger, even if moderate, H2 is continuing
Summary of Big Picture Views
Posted Friday, August 17, 2012 at 11:45 AM
In golf, it is said "drive for show and putt for dough". In learning to drive an auto, one is often advised the exact opposite. "Aim high in steering", one is told, which means that rather than look a few feet in front of the car, look further down the road.
Given current market conditions, summer vacations and the numerous key events in September, investors are better served by the auto advice than the golf advice. To facilitate this, we summarize our main G10 views here:
1. The FOMC rate decision is Sept 13. Ahead of it, participants will look at Bernanke's Jackson Hole speech at end of August for insight. In 2010 he tipped his hand. We do not expect him to do so this year as the key to the FOMC action is the jobs market and the monthly non-farm payroll report due Sept 7. We suspect the economy created roughly the same number of net private sector jobs as it did in July (172k). Other data (like retail sales and industrial production) also suggest that the pattern seen over the last couple of years of weakness in H1 followed by a stronger, even if moderate, H2 is continuing.
Our base case was that the Fed would not opt for QE3 this year, but recognized that the third quarter was the most likely window of opportunity. There are other measures the Fed can take instead of Treasury or MBS purchases. If job growth does pick up for the second consecutive month, given the trade-offs with QE and the near record low interest rates, we suspect the Fed will likely rely on these other measures, including future guidance.
2. We are concerned that the approaching fiscal cliff will weigh on business investment and hiring decisions. However, mitigating this to some extent, is the belief that some compromise will be worked out to extend the temporary tax cuts. Previously, it seemed that after September's key European events, the market's attention would shift to the US elections and fiscal cliff. However, it seems that this might not take place until mid-October, after (another) European summit. Given the polls in the half dozen or so swing states, we expect President Obama to be re-elected. Our best information suggests a spilt in Congress is the most likely outcome.
3. Since the end of last year, we suggested the investment climate in Europe would be characterized by three no's: No ECB backstop for sovereigns. No common European bond. No euro zone break up. This remains our base case. Of course, we recognize that the ECB may buy sovereign bonds, but in a different way than Trichet did. Draghi outlined conditions, which include a country formally requesting EFSF support for its bonds and signing a memorandum of understanding. This seems to be less backstop and more a different form of aid. We also recognize that no common European bond also means no collectivization of debt.
Although there are some officials in some of the creditor countries that seem to want to evict Greece, among the European elite there does not appear to be a consensus for this. We expect Greece to agree to the additional savings measures for 2013-2014 and that the Troika will authorize the next tranche, but this seems unlikely before October.
4. There is some speculation that Spain will formally request assistance within days, but we are skeptical. It does not make much sense to do so ahead of the auditors report on the banks' capital needs. Moody's is expected to finish its review of Spain's credit rating in the Sept-Oct period. It currently has the lowest investment grade rating. A cut in the rating would likely be a market factor, even if one accepts that rating agencies sovereign ratings are compromised by i) a poor track record for timeliness, and ii) unlike its corporate ratings, the sovereign ratings rely exclusively on publicly available information.
5. We expect EU officials to recognize, perhaps in Oct, that Portugal needs some extension of its program as it is most unlikely to be able to return to the capital markets as soon as had been assumed in its aid package. Cyprus' package may also be arranged by the Oct EU summit. Slovenia may also need assistance, but it is not clear yet whether this is a 2012 or a 2013 event.
6. By the start of Q4, we look for Italian politics to heat up as political parties jockey to replace Monti's technocrat government next spring. There is concern that some of the reform initiated will be diluted if not reversed. Although Spanish and Italian bonds have been highly correlated, we suspect if Spain does formally request EFSF assistance to push yields lower that the two are decoupled and Italy comes under more pressure.
7. We argue the creditor-debtor axis is the main division in Europe. France's interests are more aligned with the debtors. We suspect that before the crisis in Europe is over, France will be challenged. However, this is not taking place now. French bonds have been trading more like German bunds than Spanish bonos.
8. While accepting that the 0.7% contraction in Q2 UK GDP overstates the contraction, we do not see where the impetus from growth will arise. The poor economic performance will cause greater strains in the coalition. While a break up is not the most likely scenario, the risks of such will likely increase in the coming months. An extension of QE may be announced before the current gilt purchase plan is completed in November.
9. We expect the ECB to cut the refi rate to 50 bp and to unveil a new collateral framework. We do not expect it to cut the deposit rate below zero. If it does buy sovereign bonds, we expect it to continue to sterilize the operation, but will probably have to offer longer than 7-day repo operations, given the zero deposit rate.
10. The Bank of Japan is under pressure to step up its asset purchases to achieve its inflation target. While it is possible, the BOJ still seems reluctant. However, as the reconstruction efforts ease, the economy is poised to weaken and that would seem to be a more likely opportunity. That said, the BOJ is encountering some technical difficulties in implementing its QE and some adjustment can be seen earlier. Prime Minister Noda spent a great deal of his limited political capital on the passage of the controversial retail sales tax hike. He may face a leadership challenge within the DPJ.
11. Our Q3 forecasts, published at the end of June called for the euro to finish Sept near $1.19, and sterling to finish near $1.52 and the dollar to finish near JPY78. With the caveat of the path dependency of forecasts, our year end targets were $1.24 and $1.56 for the euro and sterling respectively and JPY79 for the dollar-yen.