MACRO: Twenty-Eighteen

This past
year turned out to be quite a bit better than many had feared.  The populist-nationalist wave did not sweep
across Europe.
  It was a key risk a year
ago, after the UK referendum and the US election, and spurred underperformance
by the eurozone.  The US exited the
multilateral Trans-Pacific Partnership (TPP) that had been years in the making,
and also the Paris Agreement.   The
broadly liberal trade regime, however, and some evidence that a global
community persists, even without the leadership of the world’s largest economy,
speaks to the resiliency of the institutional arrangements.  

Most of the
other parties to the TPP are continuing to pursue an agreement.
  To be sure, America’s presence is missed. 
One of the first components dropped upon the US exit were worker
protections.   There were other efforts on trade,
like the EU and Canada free-trade deal and the EU’s trade agreement with Japan,
struck at the end of the year.  The Paris
Agreement was a voluntary, coordinated effort to address greenhouse emissions. It
appears concern has reached sufficient
levels that a few state governments – including the most populous state,
California – and more than 50 cities committed to adhering to the Paris
Agreement standards despite the federal government’s rejection of the accord. 

 

Many of the
potentially disruptive actions that were previously suggested by then-candidate
Trump have not been implemented.
  China has not been cited as a currency
manipulator, nor has the US put a punitive tariff on Chinese imports.   The Trump administration has not pulled out
of NAFTA, agreeing instead to extend negotiations into next year. 

After the
Great Financial Crisis, global trade slowed, and with the rise of nationalism,
many feared that globalization was unwinding.
 
Global trade accelerated in 2017 as world growth increased.  Indeed, for the first time since the Great
Financial Crisis, trade appears to have
grown faster than world growth.  There is
a synchronized global upswing that appears set to continue well into next
year.  Even the laggards in Europe, such
as Italy and France, let alone Greece, are enjoying
improving growth and falling unemployment.  

This is not to
ignore potential flashpoints, like North
Korea, Venezuela, Afghanistan, and the Middle East.
  Resiliency is not without limit.  The US has an investigation
into steel and aluminum on national security grounds.  Some of the US demands in the NAFTA
negotiations seem almost designed to extend beyond what Canada or Mexico can
agree to.  The migration into Europe has
shifted from eastern routes to more dangerous courses through the Mediterranean,
and immigration remains a divisive issue in Europe and the US.  

Italy’s election,
likely in early March, may rekindle political anxiety in Europe.
  The US
primaries in the first part of next year will set the stage for mid-term
elections in the middle of Q4.  Trump is not the only leader whose
domestic support is weak.  May lost a parliamentary majority, and the
bookmakers have her odds of surviving as UK prime minister at 50/50.   Spain
and Ireland have minority governments.  Macron lost favor shortly
after his election in May, though he has begun recovering as France is fully
participating in the European economic expansion.  Merkel’s CDU/CSU
drew the least amount of public support in modern times, and she is
struggling to cobble together a new coalition, three months after the
election.   Yet there is little evidence that the political
uncertainties are having a negative impact on growth.

Continuity: The Powell Fed

Monetary
policy among the major industrialized countries will continue to diverge in the
year ahead, which is to say that short-term interest rates will likely continue
to widen in the US favor.
 The Federal
Reserve is both raising interest rates and allowing its balance sheet to
shrink.  It continues to anticipate that
three rate hikes will likely be appropriate in 2018, as they were in 2017,
followed by an additional two in 2019 and one in 2020.    In H1
2018, the Fed’s balance sheet will shrink by $150 bln, and in H2 the pace picks up to $270 bln. 

Unwinding
the balance sheet is accomplished by not fully reinvesting the maturing
proceeds.
  It is an unprecedented action.  Some observers had expressed concern that just as the purchases were understood to be the easing of monetary
policy when the zero-bound had been reached,
the reduction of the balance sheet is tantamount to tightening.  

Our
understanding emphasizes the signaling impact of the operations over the material
impact.
  The Fed has clearly indicated that the unwinding of the
balance sheet will be on autopilot and not be
impacted
by high frequency data or interest rate policy.   It did
warn that if rates need to be cut, it will consider stopping the balance sheet
operations if the zero-bound is being approached.  The
expansion of the balance sheet was about monetary policy, but the unwinding
sends no signal about the Fed’s stance.  

We see
parallels with the ease in which the Fed has been able to raise the Fed funds
target.
  Recall that the system is awash
with reserves and liquidity, and many observers had been concerned that it
would require large open market operations to maintain the target.  The surprise is that even as the cycle
matures, the Fed’s open market operations remain modest.  

By the end
of 2018, the Federal Reserve will look quite a bit different.
There will be a
new president of the New York Federal Reserve, the only regional president who
is also a permanent voter on the FOMC.   We expect the Federal Reserve under Powell to
remain on the current path.  Powell’s
leadership will be tested at the end of
the monetary tightening cycle, but that is likely to be some time off.     We have been anticipating the real Fed funds
rate to peak near zero, which we surmise is close to 2.00%-2.25%.   

Still, we expect
greater continuity at the Federal Reserve than the number of personnel changes might
suggest
.  The new chair seems committed
to the course that the Fed is presently on: gradual rate hikes and a pre-set reduction
of the Fed’s balance sheet.  Mr. Powell
revealed in his confirmation hearings that he thought the financial reforms had
strengthened the banking system and resolved the too-big-to-fail
challenge.  He is likely to allow for
deregulation, focusing on the small and medium-size financial firms. Several
large US banks ramped up their trading capacity in 2017, partly on expectations
of some relaxation of the Volcker rule.  

Many cite
the fact that the market has discounted less than half of the 75 bp the Fed
expects to hike as a sign of low confidence in the central bank
. We argue that
the ease in which it has been able to maintain the Fed funds target speaks to
its credibility.   Also, the early
unwinding of the balance sheet has been without incident, and the market has
not rushed to discount the entire operation and tighten
financial conditions, as some investors feared.  

We expect US
inflation to increase in 2018, with the core PCE deflator edging closer to the
Fed’s target.
   The yield curve (2-year
to the 10-year) is likely to continue to flatten into the new year, but we
think there’s a risk that it may steepen later in the year.  Our base case, barring new shocks, is for the
economy to grow around 2.5%.  

ECB: 
Everything Can’t be Bought

The European
Central Bank (ECB) will continue with its extraordinary monetary policy.
  Its balance sheet will expand by another 270
bln euros through the first three quarters. 
We suspect the ECB will taper its 30 bln a month purchases in the fourth
quarter rather than end them in September, though it is a close call.  We expect a tame core rate to take the shine
off any rise in the headline rate, likely driven by higher energy prices.   Despite the broad
and robust growth
, core inflation in November 2017 stood at 0.9%.  It bottomed in 2015 at 0.6%.  

We are
concerned that around the middle of next year, a factor outside the direct
control of the ECB may cause the balance sheet to shrink.
  What we
have in mind is that when the ECB is crafting its guidance for September, the
banks will be able to pay back their
borrowings under the targeted long-term repo operations (TLTROs).  

Given the
negative rates offered by the ECB and the short-end of the curve, ample
liquidity, favorable deposit-to-loan ratios, and lukewarm demand for credit
from households and non-financial businesses, we suspect some will opt to repay
early.
   This
would have the effect of reducing the central bank’s balance sheet.  The return of a modest portion of the more
than 700 bln euros borrowed under the facility could offset months of ECB
purchases.  

The ECB’s
other measures, including the negative 40 bp deposit rate and the full
allotment of refi operations at zero interest rate, will continue into 2019.
 The combination of the double dip cycle with
the regional economy contracting in 2009 and then again in 2012 and 2013, and
the arguably meek response by the ECB at the time, means that the ECB may have
hardly begun to normalize interest rates and policy before the business cycle turns.  

With the
selection of Portugal’s Finance Minister Centeno to succeed Dijsselbloem as the
president of the Eurogroup of EMU finance ministers, a two-year process has
begun that will culminate with a new European Commission, ECB President, and
European Parliamentary
.  The ECB board
will change, beginning with the vice president toward the middle of 2018. 

In
negotiations to form a coalition government in Germany, the pro-business Free
Democratic Party was demanding that countries be allowed to leave the EMU.
  Merkel’s position, like the ECB’s, is that monetary union is inviolable.   The
Social Democratic Party of Germany (SPD) may push in the opposite
direction.  At the SPD conference at the
end of the year, the party leader (Schulz) called for a United States of Europe,
which of course was immediately rejected by Merkel’s CDU.   

    

The SPD will
demand a high price to re-enter another coalition government with Merkel. 
Strategically, they need to be able to
differentiate themselves.  In addition to
domestic social issues, the SPD can demand a ministry that ensures the international
stage.  They may be able to work with France’s
Macron on the future of the European project after the financial crisis and
Brexit.  A shift of the political axis to
the center-left will reinforce our expectation that Draghi’s successor at the
ECB comes from a core creditor country, most likely Germany.  

BOJ: Yield Curve Targeting

The Bank of
Japan’s (BOJ’s) efforts to stimulate inflation shifted from its quantitative and
qualitative easing to targeting the ten-year bond yield (+/- 10 bp).
  It had already set the deposit rate at
negative 10 bp.  This yield curve management requires the
purchase of few government bonds, though it continues to buy other assets
including ETFs and corporate bonds.  

It should
not be surprising if BOJ bond buying under the yield curve management strategy
falls to JPY30-JPY40 trillion rather than the declaratory policy of JPY80
trillion.
  Some observers have called
this tapering, but that is not the signaling impact.  Nor have there been other signs that
investors believe the BOJ is reducing its effort to secure greater price
pressures. 

BOJ Governor
Kuroda’s term is up near mid-year.
  A BOJ
governor has not served two terms in modern history.  We suspect Mr. Kuroda may be offered a second term.  However, even if he is not, we suspect the activist approach to monetary policy will be
shared by his successor
. Prime Minister Abe has influenced the BOJ the
way that President Trump will influence the Federal Reserve: through the power
of appointment.  The BOJ board is now comprised of men with the same general
philosophy as Kuroda (whose name means black) rather than his predecessor
Shirakawa (whose name means white). 

The year-over-year core rate, which excludes
fresh food, rose from -0.2% at the end of 2016 to 0.8% in October 2017
.  While still
well shy of the 2% target, there has been some significant progress, and we
expect more next year.
   We expect the spring wage round to agree with
something on par with this year’s 2% increase. If the global synchronized
recovery continues into 2018, as looks likely, and if global bond yields rise,
there is some risk that the BOJ raises its target on 10-year JGBs.

Prime
Minister Abe is committed to lifting the sales tax in 2019 to 10% from 8%.
  If the previous hike is any guide, the anticipation of the tax increase may boost
consumption late next year. There may be some political pressure to delay it
again, but the economy is performing better than it has in years. 

UK: 
Brexit Drives Investment Climate 

The UK
economy is likely to sustain growth near the 2017 pace of around 1.5% year-over-year.
  Price pressures should ease, and this will bolster the purchasing power of
households, which has been eroded by the
decline in real wages.  More than
macroeconomic variables, however, Brexit may drive the investment climate. 

Nine months
after triggering Article 50, the UK seems woefully unprepared.
  The Chancellor of the Exchequer acknowledged
that there had not been the formal
cabinet discussion of a post-Brexit trade
relationship
that is desired.  The Brexit Secretary admitted that there were no quantitative studies conducted on the cost of Brexit, nor was there industry impact research.  

It took more
than a third of the two-year time limit to address three issues:  its financial obligations, the right of EU
citizens in the UK after Brexit, and the Irish border.
  Even now, the judgment
that sufficient progress has been made
for talks to proceed to the next stage does not mean that they have been resolved. 
One of the most vexing issues is where to locate the hard border for customs
and passport checks when the UK leaves the single market. 

 The EU and Ireland insist that the border
cannot be between the Republic of Ireland and Northern Ireland.
  The Democratic Unionist Party, which gives
May her parliamentary majority, will not accept a hard border between the UK
and Northern Ireland.   The UK’s promise
of “regulatory equivalence” may be sufficient for talks to progress, but they
cannot end there.  

Given the
numerous authorities that must approve the new agreement, the EU is aiming to
complete the second stage of negotiations, which will focus on the new trade
relationship and transition period, by the end of October 2018.
  The hard end date is March 31, 2019, two
years after Article 50 was triggered.  The EU appears
to seek a trade agreement with the UK similar to the one that was struck with
Canada in 2017 after several years of negotiating, which nearly failed to be
approved unanimously as required.  Talks of a new trade agreement between the UK
and EU are unlikely to begin until the March 2018 summit.  The first part of next year will likely be
spent discussing the transition period that the UK seeks.  

Former Prime
Minister Cameron promised the non-binding referendum on EU membership as a way
to heal the fissure within the Tory Party. 

Not only did he make the referendum binding, committing the UK to a
momentous decision on a 52%-48% vote, but the Tory Party remains profoundly
divided.  The divide would be difficult
for even the most adroit leader to navigate. 
The bookmakers put even odds on May remaining at 10 Downing Street a
year out.  May’s Tory Party rivals recognize that the near-impossible must be delivered, and Labour is running ahead in
the polls for the first time in years.  

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