Six Weeks that Could Shake the World

The first five months of the year have plenty of unwelcomed surprises for investors.  Volatility throughout the capital markets rose, despite the continued net expansion of central bank balance sheets, as the reduction of the Fed’s balance sheet is offset by continued buying by the Bank of Japan and the European Central Bank.  Existential risk in the eurozone appears on the rise.  Rather than emanate from Greece, as it has previously, Italy, which is considerably larger, is at the epicenter.  The style and substance of the Trump Administration also have kept investors off-balance.  There is a more generalized sense that the multilateral trading order that has evolved over the 40 years or so is being challenged in ways not seen before.  

The next six weeks or a bit more will test the nerves and discipline of investors.  We sketch out the events in the coming weeks, some of which will not be on the commonly used economic calendars. 

June begins off with three important events, not including the US May employment data or China’s Caixin PMI.  First, the tariff exemptions the US granted Canada, Mexico, and the EU expire. This will likely spur retaliation of some kind, challenges at the WTO, and more broadly souring the US relationship with what has traditionally been its allies.   Second, China’s A-shares will be included in the MSCI Emerging Markets Index.  This is another step toward integrating China and is markets into the global financial system, like the inclusion of its mainland bonds into bond benchmarks.  Third, Spain is slated to hold a vote of confidence, which the Rajoy government is unlikely to survive.  The Socialists would likely lead the next government, but if Rajoy resigns and elections are held, the centrist Ciudadanos may emerge as the largest party.    

Trump appeared to have canceled the summit with North Korea, but it now seems that it may take place after all on June 12.  If North Korea were to get rid of their nuclear weapons that would indeed be remarkable.  We are skeptical, to say the least, and see in recent treatment of Syria and Iran unintended incentives to remain a nuclear power.  One of the consequences of the failure to reach an agreement could be a deterioration in the US-China relationship, as the US Administration expected positive results if China used its influence.  On June 15, the US is expected to publish the list of Chinese goods ($50 bln) that will have an extra tariff attached for the intellectual property rights violations. 

In between the North Korean summit and the details of the US tariffs on Chinese goods, both the Federal Reserve and the ECB meet.  There should be little doubt that the Federal Reserve will hike rates by 25 bp, raising the new target range to 1.75%-2.00%.  The Fed has signaled that it will no longer pay interest on reserves at the upper end of the Fed funds range, but five bp below.  This is an attempt to keep other rates within the Fed funds range.  Those observers that emphasize the disruptive effect stemming from the large T-bill issuance do not think the Fed will be successful.  The Fed also updates its forecasts.  We do not expect many significant changes.  We expect the median forecasts anticipate another hike after the June move.  

The ECB staff will update its forecasts.  Near-term growth and inflation forecasts may be tweaked lower, but after the preliminary May CPI figures, inflation seems to be in line with the previous forecasts.  Draghi will likely be peppered with questions about Italy, Note that the way the asset purchases program works, the ECB authorizes the sovereign bond purchases, but the national central bank bears the entire risk.  That is to say that the ECB authorizes the purchase of Italian bonds.  The Bank of Italy buys the bonds holds them.  They do not have to mark to market.  The only risk is if Italy defaults or restructures its debt, but then official holdings may be exempt (as was the case for Greece).    We think the ECB is committed to finishing its asset purchases this year.  Investors adjust to the news stream by shifting the first hike out from mid-2019. 

The Bank of Japan meets on June 15.  With the economy contracting in Q4 17 and inflation moving in the wrong direction, the BOJ cannot think about exiting its extraordinary monetary policy.  There had been some speculation that the BOJ would cut back on its ETF purchases, but this seems unlikely now, but is possible later in the year.   The Bank of England meets on June 21.  It is also too early to anticipate a rate hike form the BOE, though a hike in late Q3 or early Q4 should not be ruled out.  

There is an important OPEC meeting on June 22.  With the excess oil inventories largely been absorbed, Brent reaching the $80 price goal that some officials had suggested, new sanctions on Iran, and loss of output from several other OPEC members, Saudi Arabia and Russia are likely to agree to boost output.  Both the US and China have complained about too high oil prices, but we do not place much weight it for influencing OPEC and Russia’s strategic decisions.   Barring a new supply shock, we suspect the recovery in oil prices is nearly over.  May is the third consecutive monthly advance for oil prices and the ninth monthly advance in the past 11 months.  

At the end of June, the EU Summit may formally approve the transition period for the UK’s departure from the EU.  By the time of the summit, there were be nine months before the transition phase begins, and the UK still seems to be ill-prepared.  Without an internal agreement within the governing Tories or even within the government (parliament and 10 Downing Street), an agreement remains elusive.  The Irish border has not been resolved, and the UK’s relationship with the Common Market may be key.   

Also, at the end of June, the IMF publishes reserve data as of the end of Q1.  The US dollar depreciated against the other major reserve currencies.  This will serve to bolster the dollar amount of reserves held in euros, yen, and sterling.  The Chinese yuan appreciated by 3.7% in Q1 18.  This will also bolster the dollar value of yuan-reserves.  The Australian and Canadian dollars fell against the US dollar (1.65% and 2.55% respectively), and this may dampen the value of reserves kept in those currencies.   

Mexico holds their presidential election on July 1.  NAFTA negotiations will likely stop a few weeks before it.  The political evolution within Mexico coupled with the changes in the US stance has fanned the candidacy of a left-populist in Mexico.  Andres Manuel Lopez Obrador (AMLO), the former Mayor of Mexico is running ahead in the polls, though the contest appears to have tightened a bit in recent weeks.  

US President Trump’s former campaign manager Manafort will stand trial for bank fraud and tax crimes.  He plead not guilty to the charges that were generated from the investigation of how Russia tried to influence the 2016 campaign. The trial begins on July 10, as the November mid-term contests prepare for the homestretch.   

At pixel time, it is not clear yet whether Spain and/or Italy will return to the polls this summer.  Mid-to-late July seems to be the earliest that either could hold elections.  Italian politics are very fluid.  The Five Star Movement, which seems similar in many respects to social democrat parties in Europe, is not the natural partner with the nativist and nationalist League.  Berlusconi can now hold office.  Recent polls confirm that a majority of Italians continue to favor remaining in the monetary union.   Italy may still end up with the first populist-led government in Europe.  The outcome of Spain’s election is likely to be investor friendly.  


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