Macroeconomics and Psychology

There is a broad consensus around the macroeconomic picture.  The headwinds slowing the US economy in H1 16 have eased, and above trend growth in H2 16 appears
to be carrying into 2017.  Q4 16 GDP is expected to be revised to 2.1% up
from 1.8%.  Many economists appear to accept that a good part, though not
all, of the decline in the estimated trend growth in the US, is a function of demographic
Price pressures
are gradually increasing, though the Fed’s preferred and targeted measure of
inflation, the core PCE deflator is likely to have remained at 1.7% in January,
the base effect warns of topside risk in the coming months. 
  Meanwhile, the labor market continues to improve.
 The four-week moving average of weekly jobless claims fell to a new
cyclical low the same week the BLS
conducted the survey for non-farm payrolls, which will be released on March 10.  
The Federal
Reserve raised rates once in 2015 and once in 2016.  
This year will be different.  The
shift in opinion is not so much in the increase of the likelihood of a March
increase or June increase, but in a move in May.  As we have noted, the
advantage May is that it would be part of the normalization process when every
meeting must be live.  Up until now,  there was a general recognition
that Fed action would take place at the quarterly meeting that had the economic
forecast updates and was followed by a press conference.  
That was good
and arguably necessary.  
However, this may no longer be the case.  As the pace of
removing accommodation increases, the Fed needs greater flexibility.  Just as the minutes of the January FOMC meeting showed
that the Fed would tweak the dot plot communication tool by including fan lines
of confidence,  as we have argued before, the Fed ought to consider a
press conference after every meeting, like many others, including the BOE, ECB,
and BOJ, and that would kill two birds with one stone, so to speak.
 Communication would be enhanced,
and the Fed would double the number of actionable meetings.
 Alternatively, the Fed could scramble and put together an ad hoc press
conference, but there are risks of leaks and fails
to take advantage of the opportunity to evolve the Fed’s communication
and transparency.  
Eurozone growth
is solid and stable, and above trend, which is
estimated near 1.25%.
is likely to be confirmed with the final January PMIs due in the second
half of the week ahead.  Individual countries will update Q4 16 GDP
estimates, and most likely will not have much market impact, but will be
revealing nonetheless.  The Spanish economy motored ahead by 3.0%
year-over-year in Q4 16.   France and Italy both appear to have grown
1.1%.  Among other European countries reporting GDP, Sweden’s 1.9% puts it
a little ahead of Germany’s 1.7%, while Switzerland’s 1.2% places it nearer
France and Italy.  
The risks of
deflation have evaporated in Europe thanks to the rise in oil prices.
  Indeed, the preliminary estimate for
February CPI, which is to be reported on
March 2, is expected to tick up to 1.9%-2.0%.  The higher oil prices have
knock-on effects on transports, heating, and energy prices.  It was also
unseasonably cold in southern Europe, which may have underpinned unprocessed
food prices as well.  In any event, core prices are expected to be flat at
0.9% for the third month and have seen a steady pace of 0.8%-0.9% since last
May.   It bottomed at 0.6% in January 2015.  
Many observers
do not appreciate the importance of the faster increase in Germany inflation
than elsewhere in the monetary union. 
 Germany’s headline harmonized
measure may push above 2.0% in February and will be reported ahead of the aggregate figures.  There are a number of ways that countries can boost their
competitiveness against Germany.  Draghi pushes for structural reforms in
both Germany and elsewhere, but it is proving a difficult to achieve.  
Another way is
through the inflation differential. 
 Several years ago, it was thought desirable that the periphery has lower inflation than Germany.  However,
Germany was experiencing disinflation and sometimes outright deflation.
 This forced deflationary condition on others.  However, Germany now
has higher inflation, even above target, and this is a net positive for the
periphery, though the real impact requires this to be sustained.  

Japan has a
full slate of economic reports but the consensus view is unlikely to change. 
 Japanese growth may be improving, but it is not firing on all cylinders. Industrial
productions, exports, and government spending are largely offsetting the drag
of consumption and domestic demand.  A small increase in Q4 capex appears to be mostly in the export sector, and industrial output is accelerating.
The median expectation is that capex rose
0.6% in the last three months of 2016, recouping less than half the decline in Q3.  

consumption in January is not expected to improve from the 0.3% year-over-year
contraction reported in December. 
 The poor consumption is not a
function of the high level of
unemployment as is the case in parts of Europe.  The Japanese unemployment
rate is expected to slip to 3.0% in January, matching the cyclical low, from 3.1% at the end of last year. 
Also, Japan is
the last of the large high income countries that continue to wrestle with
 The core measure, which excludes
fresh food finished 2016 at minus 0.2% year-over-year. It is
expected to be at zero in January when it is
reported at the end of next week.   The core measure more
comparable to the US measure, which excludes food and energy fell to 0.1% in
December, the lowest year-over-year pace in three years. The recent peak was
1.3% at the end of 2015.  It may have risen to 0.2% in January.  
The UK reports
the January PMIs starting in the middle of the week. 
 The economy remained firm in H2 16 despite the wobble
and fears around the referendum.  While the low rates and sterling’s
depreciation have been important shock absorbers, the risk seems to be on the
downside.  Most of the benefits will likely dissipate by Q3.  The
PMIs are likely to be largely steady with a slight softer bias. 
China’s official and Caixin version of the PMI also be a touch lower than at
the end of last year.  
The February times series are likely to be skewed by the Lunar New
Year celebration and will most likely not elicit an important market response.
 Capital outflows appear to have slowed, and the February reserve figures
are expected to be reported March 6-7.
 Recall that the $12.3 bln draw down of reserves in January was the
smallest since last July.  The yuan has edged higher against the US dollar
this month, but the 0.2% gain is more a
sign of stability than an appreciating trend.  
The implied
volatility of the yuan has fallen sharply. 
is consistent with less bearish outlooks. The implied 12-month
volatility is near 6%, the lowest since late 2015. It had finished last
year above 8%.  The implied 3-month vol is near 4.7%, which is a
four-month low.  It was near 7.3% at the end of last year.  Also
since early January, the offshore yuan (CNH) has traded at a premium to the onshore
yuan (CNY).  
The Bank of
Canada is the only major central bank that meets
in the week ahead. 
 There is practically no chance of a
change in policy, and there is little need to adjust the economic projections.
The slow recovery continues, but there is still plenty of slack in the economy.
 There has been an improvement in the terms
of trade, and the risk of a trade disruption given the new US
administration appears to have slackened.  However, non-energy exports
have disappointed (-4.1% in December).   
Canada reports
GDP figures the day after the BoC meeting. 
 The economy is expected to have
expanded 0.3% in December after 0.4% in November.  Growth appears to have
accelerated to 2.0% at an annualized pace in Q4 after a 3.5% pace in Q3, which
was the strongest in a couple of years.   
Australia also
reports Q4 GDP.  It is expected to have bounced
back after contracting 0.5% in Q3. 
 A 0.7% expansion in Q4 would put
year-over-year growth just below 2.0%.  The risk is on the downside after
last week’s disappointing capital expenditure figures.  
The most
important event next week for investors may be US President Trump’s speech to
the joint session of Congress.  
Those hoping for detailed plans regarding tax reform and
infrastructure spending are likely to be disappointed.  He may offer some
hint about the controversial border adjustment.  Although he seems to want
to punish importers and dismantle the global supply chains, there are legal and
practical constraints.  News that he will not support the currently
construed board adjustment in the GOP plan helped spark a late rally in retail
shares before the weekend.  
Many investors
continue to grapple with Trump’s concrete policies, and the priorities are becoming clearer. 
  His infrastructure initiative does not appear to be
a 2017 priority.  Treasury Secretary Mnuchin suggested that he was hopeful
of an agreement on taxes by the congressional recess in August.  This may prove optimistic, especially if the
repeal and replacement of the national healthcare take long.  The end of taxes associated with it was expected
to help fund the other tax cuts.  
The threat to
cite China as a currency manipulator on day one proved to be bluster.  
Mnuchin suggested that no judgment will be made until the April review as part of the
Treasury’s Congressional mandated report
on the international economy and the foreign exchange market.   Under the
current criteria, China is not guilty of currency manipulation.  Both Bush
and Obama had indicated, when they were on the campaign trail, that they would
cite China too.  However, as they became aware of the facts and the
framework, they too refrained from citing China.  If the Trump Administration
moves toward a valuation metric, it would also be difficult to cite the yuan as
many models suggest it is near fair value.   The BIS measure of China’s
real equilibrium exchange rate pulled back early last year but has been trending higher since last August.  
As the
macroeconomic developments seem fairly stable, the focus is on politics.  
The premium France offers over Germany
narrowed last week in both the short- and long-end of the yield curve.
 The German two-year yield fell to new record lows and is approached minus 100 basis points.  This has widened the spread between the US and
Germany, for which the euro is particularly sensitive.  As we noted
previously, the 0.65 correlation (60-day on percent change basis) between the two-year
spread and the euro is relatively strong.
 Similarly, the yen’s correlation with the 10-year differential between
the US and Japan  (60-day percent change basis) is 0.77, the strongest in
more than a decade. 
Lastly, we note that
the correlation between the S&P 500 and the VIX futures contract has been
inversed since at least 2004 when our time series began.
However, now the inversion (~-0.44) is the least in two years.  It has
rarely gone above -0.40.  We understand this to be partly an indication
that there is some sort of floor the VIX.  It may reflect the demand for insurance
through the options market.  It means that the equity market could
continue to rise (the S&P 500 is on a five-week advancing streak), but
without the VIX falling.  Over the five-week streak, the VIX has been in a
saw-tooth pattern, alternating on a weekly basis between gains and losses, and is
net-net flat.  


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