A Few Things on Our Mind

A few weeks ago investors were bemoaning a new bear market for equities, and there was much ink spilled drawing parallels between now and 2008-2009.   Falling commodities, weakening growth, and prospects of Fed tightening saw the MSCI Emerging Market equity index fall 21.5% from early-November through the third week in January.  Since then it has rallied more than 16%, and both yesterday and earlier today traded above where it finished 2015.

The rebound in emerging market shares appears to have been driven by the recovery in commodity prices.  Copper, steel, nickel, oil and iron ore prices have moved higher.   The Journal of Commerce Industrial Commodity Price Index has rallied since the third week in January, and yesterday reached its best level since mid-November.

Brazil's Ibovespa exemplifies the rise in emerging market equities and commodities.  It rallied by more than a third between January 20 and March 4 to its highest level since last August.    Hopes of an imminent resolution of the political crisis may have added some froth at the end of last week, but the market has thus far held on to the lion's share of its gains.

The MSCI Emerging Market Equity Index stopped yesterday just shy of the 800-806.  This is important from a technical perspective.  It corresponds to a 61.8% retracement of the decline from early-November and highs from last December.  Watch the 780 area.  A break below there would be the first sign that the upside correction may have run its course.

China has indicated it will shutter some of its excess capacity, and although officials have said it before. Each time they do, many want to believe them.  The general thrust of the National People's Congress meeting is that supporting growth will take priority over reform.  Addressing the excess capacity that plagues many industries runs contrary improving near-term growth prospects.

It is a mistake, however, to think that excess capacity is simply a Chinese problem.  Look at what Fonterra, New Zealand's milk co-op said yesterday.  It cut is price forecast and noted the global slump in milk prices would extend into the third year.  The increase in European supplies, while (effective) demand in China and Russia eased means that there is greater supply than demand.  What this means is that four of five dairy farmers in New Zealand are operating at a loss.

Isn't this same process at work with money itself?  Too much milk relative to supply weighs on the price.  Too much oil relative to demand weighs on oil prices.  Too many workers relative to jobs restrains wages.  Too much money depresses interest rates.

Among the policies the ECB may be considering is a new long-term repo facility.  However, as we have seen with the prior attempt (Targeted Long-Term Repo Operation), the participation was relatively modest.  The most pressing problem is not that banks do not have access to cheap funding or do not have the resources to lend.  Instead, European banks are wrestling with nonperforming loans, regulatory capital requirements, and a new resolution rules that place even senior creditors in a riskier position (bail in before taxpayers).

Look at what the Bank of Japan reported earlier today.  Under the regime of negative deposit rates and a further decline in market rates, there was still not enough to stimulate bank lending. Excluding Japanese trust banks, bank lending slowed in February to a 2.2% year-over-year pace from 2.4%.  It matches the slowest pace since the start of Q3 12.

The same assessment applies to corporate investment as well.  The reasons capex continues to disappoint is not that business lacks capital or that rates are too high.  There is little evidence from the history of corporate tax cuts that a reduction in the tax schedule boost investment.

While many neoliberal economists reject the idea of surplus capacity or surplus capital, they do seem to recognize surplus people.   Europe and some Middle East countries, like Jordan, are overwhelmed with refugees.  To allow for visa-free travel within the EU (Schengen), greater efforts must be taken to protect the external frontiers.  This has put Turkey at the center of the issue.  Turkey wants three things, funds, easier travel for Turkish passport holders into the EU, and expedited talk for EU ascension.

Even if Europe could reach an agreement, the proposed agreement is controversial. The agreement calls for the return to Turkey of all migrants that went from there to Greece, and for every Syrian returned to Turkey, a Syrian would be relocated from Turkey to the EU.   There has been some suggestion that such a rule contravenes international law and the UN-recognized right of asylum.

Turkey has shown what it can do.  Weekly arrivals into Greece peaked in mid-December near 27k.  In early-February it fell to 8k, but by the end of the month had more than doubled off the low.  On top of the dramatic economic shock, Greece has experienced, it now is being hit with a refugee shock.  This combination would likely overwhelm even stronger countries than Greece.

The official creditors are returning to Greece.  In addition to maturing T-bills this month, Greece owes the IMF about one billion euros this month.  Although there is still not an agreement between the IMF and the EU on the sustainability of Greek's debt, there does seem to be a consensus among the creditors that more work needs to be done on pensions and the closing of a couple budget holes.  Yet even when debt servicing obligations increase toward the middle of the year, European officials want to avoid a repeat of last summer.

The refugee problem is a different class of existential challenges for the EU that Grexit ever was.  There are many considerations that the EU must balance, and with conflicting priorities, no solution is ideal.   While the deal with Turkey could conflict with the human right to asylum, the attempt by Brussels to devise a new system to deal with refugees may antagonize the Brexit debate in the UK.

Presently the responsibility for refugee claims is addressed on the country-level. There were 1.3 mln such claims last year.  The so-called Dublin rules make the EU country of initial entry responsible.  This is obviously unfair to the frontline states like Greece and Italy.  Brussels is debating about centralizing the process, which would supersede the Dublin approach.  However, it could be fodder for those in the UK who argue too much sovereignty has been ceded to Brussels.  That said, the UK already has a veto on matters of justice and home affairs, and the new rules would not necessarily apply.  However, the ability of the UK to send back refugees to the initial country of entry may be diminished.

Three EMU members have had elections in the past three months, Spain, Ireland and Slovakia.  The voters in each country have not only failed to elect a majority government, but the votes have been sufficiently split to make a coalition, and even a minority government difficult to forge.   It is possible that all three are forced to the polls to try again.

Germany holds three state elections this weekend.   For investors, the important point may not be any one of these contests, but the general pattern.  How does the CDU perform given the erosion of support for Merkel?  How does the anti-EU AfD party do in the races?  The events market has seen the odds that Merkel steps down before the end of the year slip below 20% from nearly 30% a week ago.

The more immediate focus in on the ECB.  It meets Thursday.  The OIS market suggests a 10 bp deposit cut has been discounted  Further out; the derivatives market expects the bottom to be near minus 50 bp.  The rally in peripheral bonds is consistent with extending the asset purchases, modifying the capital key restrictions and/or increasing the size of the program.   Although BBK Weidmann will not vote at this month's council meetings, it is unlikely to change the outcome.

The euro has been sold from $1.1375 on February l1 to $1.0825 on March 2.   Remembering the disappointment coupled with the sell the rumor buy the fact type of activity at the December ECB meeting, it appears that many have cut exposures, which reinforces the technical significance of the $1.08 area.  The euro has not traded above its 20-day moving average since February 22.  It comes in today near $1.1060.  Above there, the next retracement objective is near $1.1100 and then $1.1160.

Two other central banks meet this week, the Reserve Bank of New Zealand and the Bank of Canada.  Although a Bloomberg survey found 15 of 17 economists do not expect a change in policy, the OIS market is discounting almost a 30% chance of a cut.  The OIS market is consistent with about a 10% chance the Bank of Canada cut rates this week, but this does not necessarily mean that its mini-easing cycle is over.  The derivatives market appears to be discounting a 50% chance of a cut over the next year.

Meanwhile, the market anticipates the Federal Reserve will soften its outlook for four hikes this year.  While the market still does not have a single hike completely discounted for this year, it has increased the likelihood of a move.  For example, between February 11 and yesterday, the implied yield of the June Fed funds futures contract rose nearly 14 bp.  The yield of the December contract rose almost 30 bp.     Over time, we expect the divergence of monetary policy to support the US dollar.