Two Known Unknowns

The main risk to investors in the week ahead comes from two
  On the international stage,
the biggest change in the last six months is not China or Russia.  It is
not OPEC or North Korea.  It is the United States
and the seemingly impulsive and transaction-driven affairs of state.
 Defection from the international agreements or regime seems to be a right
claimed in deed, if not word, by both
powerful and weak countries.
The US position at the G7
meeting on trade was along these lines.  
The US, Treasury Secretary Mnuchin
insisted, reserved the right to protectionism if it judged trade not to be free
or fair.  Who is not for free or
fair trade?

The practical problem lies in what these noble concepts mean. Because of the inherent conflict,
multilateral institutions, like the World Trade Organization define those
concepts. Is Trump posturing or is he defecting from the very
international order the US, more than any other nation, envisioned and created?  

Can Trump succeed to make
the US the leading revisionist country, or will its national interests lie with
defending the status quo?  
The actions he authorized in Syria, Afghanistan and escalating rhetoric toward North Korea have
received bipartisan support, though the Trump Administration’s response to the
launch earlier today of two missile tests that may or may not have been
intercontinental ballistic missiles.  Still, up until now, the Trump’s
Administration’s actions have been well within American traditional foreign
policy approach.  
He also recommitted to NATO,
after calling the treaty organization “obsolete,” though Secretary of
State Tillerson gave members two months from the end of March to boost defense
spending or present such plans. 
 Trump has backed away from campaign
pledges to confront China via its currency and exports to the US.
Trump made his early trade moves were very much part
of the mainstream.   
He signaled intentions to renegotiate
NAFTA not leave it. Trump noted when
formally withdrawing from the TPP that
Clinton had also opposed it.  Canadian lumber,  steel, and aluminum were not picked randomly,
but have long been areas of concern.
A new phase is about to
 Lighthizer was confirmed by the Senate and is now the new US Trade
Representative.  Renegotiating NAFTA is thought to be the priority, though
Lighthizer is better known for his criticism of China.   Soon it should be
clearer to investors:   On one hand,
Trump may be like the emperors of old and simply
be demanding greater tribute from everyone else. This seems negotiable and ultimately acceptable.  Several
countries have made concessions, including China and Saudi Arabia.  

On the other hand, the cross-border movement of capital, goods, and
services, has not returned to pre-crisis peak levels. 
 Some suggest that peak globalization is behind us.
 Trump may be both an effect and cause of the de-globalization forces.
 He may purposely seek to re-align US interests with anti-globalization
forces.  Although the border adjustment tax has been rejected in its current form, some disincentives for the
fragmentation of production and extensive supply chains cannot be ruled out.

The US behavior on the world
stage has become somewhat less predictable, and the Trump Administration
continues to make noises as if it were revisionist as an opposed to a status quo power.
 Barely an ally or trade partner has
escaped criticism.  At first, other countries are trying to proceed
without the US, such as TPP or if the US withdraws from the Paris Accord.
 However, the risk is that US nationalism/unilateralism spurs others down
the same path.  In game theory terms, the defection of the US from
cooperation will encourage others to defect as well.   
Some observers have been
crying “currency war” for several years, and therefore do not fully
appreciate the marked departure that is possible under the Trump
 Similarly,  many have been
suggesting a hegemonic stability crisis since at least 2001 and may be slow to recognize the new threats along this line.
The second known unknown is
the outlook for US interest rates, 
 which arguably is among the most
important influences in the capital markets.  The softer than expected
retail sales and inflation report before the weekend spurred a pullback in US
interest rates.  The two-year yield slipped four basis points to finish
the week below 1.30%, snapping a two-week
Expectations for Fed policy
next month did not change substantially. 
 Bloomberg’s calculations suggest the
June contract is pricing in a 97.5% chance of a hike next month, down from
98.8% the previous week.  The CME’s model suggests
the odds were unchanged on the week at
estimate, which assumes that Fed funds would average 116 bp after a hike, which,
relative to the range, is where the effective Fed funds rate has been
averaging, and that on the last day of the quarter the effective rate drops
nine basis points, as it did at the end of Q1, would suggest about a 73% chance
of a hike is discounted.
  At the end of the previous week, our
calculation put the odds at nearly 77%.  Even incorporating the July and
August contracts into our calculations, we don’t see the market discounting
more than a 76% chance.  
There is a risk the April core PCE deflator pulls back
further when it is published at the end
of the month (May 30). 
 Recall it peaked in January near
1.78% and in March stood at 1.56%, which was the lowest since March 2016.
 Any further slippage, which the CPI (and softer rents) hint at, would see
the Fed’s preferred inflation measure ease
to its lowest level since the end of 2015. 
At the same time, inflation
expectations have fallen. 
 Before the weekend, the University
of Michigan’s survey found the 5-10 year inflation expectation fell back to the
2.3%, the cyclical low from the end of last year.  The 10-year breakeven (
the difference between the conventional
yield and the 10-year TIPS has to the lower end of its range since last
November.  The US yield curve (two-year to 10-year yield) has flattened considerably.
 When the Fed hiked rates in mid-March, the spread was about 120 bp.
 Now it is threatening to push below 100 bp.  
The US 10-year yield fell
last week for the first time in three weeks.
  The yield had been gradually rising
in five of the past six weeks.  The setback in response to data is
threatening to continue.   The downside gap created on April 24 in
response to the first round of the French election lies near 2.24% may draw
prices.  Mixed signals are expected from the first round of the Fed’s May
manufacturing, while the April housing starts and industrial output figures
recovery from the March weakness, but might not be sufficient to push US yields
And without higher US
yields, the dollar may not find much traction. 
 News from Asia and Europe will likely confirm what
investors already know.  Japan’s economy likely accelerated from the 1.2%
annualized pace in Q4 16 toward 1.5%-1.8% in Q1 17, bolstered by exports and
industrial output.  Household spending and capex
appear to have disappointed.  Although Chinese credit expansion remained
strong (and stronger than expected), retail
sales and industrial output are expected
to have moderated from Q1’s pace.  

The eurozone is expected to confirm its
earlier estimate of Q1 GDP (0.5%) and
April CPI (1.9% and 1.2% core). 
 Economic strength and a DAX at new
record highs should help underpin the German ZEW survey.  Meanwhile, more
reports seem to prepare the market for a change in the ECB’s risk assessment
and forward guidance. 

In the UK inflation is
likely expected to accelerate, spurred in part by new taxes, including council
taxes, prescription changes, and excise duties on vehicles. 
 Investors will be carefully monitoring the UK’s labor
market developments.  There was a large jump in new claims for
unemployment benefits in March (25.5k, the most in six years).  Weekly
earnings are reported with an extra month
lag, but the concern is that wages will not keep
pace with inflation and that this will
squeeze the purchasing power, and therefore, the consumption of the household
sector.  Still, it may take some time for this emerge, as April retail
sales likely bounced back from the March weakness that overstated the case.  


Share this post

Share on facebook
Share on google
Share on twitter
Share on linkedin
Share on pinterest
Share on print
Share on email