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Eight Points on the Investment Climate and the Dollar

1.  The swing in the pendulum of expectations back toward a mid-year Fed rate hike is one of the key developments that will shape the investment climate.  The data in the week ahead, including the broader measures of the labor market, like the Fed's new index (Labor Market Activity Index) and JOLTS (Job Opening and Labor Turnover Survey), and core retail sales will strengthen the view.   The rise in US interest rates will lend the dollar support and allow the appreciating trend to continue after a consolidating over the last few weeks.   Equity investors need to adjust to the rise in interest rates.  High dividend payers and utilities are vulnerable.  US companies have expanded overseas more by direct investment than exporting.  That means that while they earn revenues in foreign currencies they also incur local costs.  In addition, many producers price and invoice in dollars.  In any event, in a strong dollar environment, many look for the small caps, which are more domestic, to fare better, even though they may face steeper international competition.   

 

2.  The claim that the US is not an economic oasis is a red herring.  The fact of the matter is that the US expanded in the April-September period while Japan contracted and Europe nearly stagnated.  However, the decline in the euro and yen, and the drop in energy prices and interest rates will help them recover.  The preliminary Q4 US GDP estimate may be revised lower after the surge in December imports was reported.  Note that the US labor dispute is disrupting trade flows.   The eurozone reports its initial estimate of Q4 GDP at the end of the week.  If the consensus is wrong with its 0.2% guesstimate, it is more likely to be surprised on the upside than the downside.  We note too that the EC revised up its forecast for eurozone growth this year (1.3% from 1.1%) and next (1.9% from 1.7%).   Japan does not report its Q4 GDP until early in Tokyo on February 16.  It likely returned to growth after contracting in Q2 (-1.7%) and Q3 (-0.5%). The consensus calls for a 0.9% expansion. 

 

3.  European officials are trying to snip the Greek rebellion in the bud. In a controversial decision, shortly after Draghi met Varoufakis, the ECB voted to rescind the wavier that allowed the sub-investment grade Greek government bonds and state-guaranteed bonds to be used as collateral. The ECB did allow for the Greek central bank to replace its lending with the Emergency Lending Assistance (ELA) program, under which funds cost 155 bp annualized (vs. 5 bp from the ECB).  The ELA loans are reviewed every two weeks.  The general sense is that if the ECB were to refuse access to ELA funds that this would be a casas belli and force Greece to take measures that would push it outside of EMU.  It is also understood that the ECB would not take that eminently political decision itself.   European finance ministers, who meet on February 11, are giving no quarter to Greece.  Eurogroup head Dijsselbloem indicated before the weekend that Greece does not have until the end of the month, when its current aid extension is set to end.  Dijsselbloem said that because some governments will need to seek parliamentary authority, the Greek government has until February 16 to seek an extension of the current program.  Dijesselbloem said a simple extension is possible, but to keep it simple requires an all or nothing approach.  

 

4.  Since the European debt crisis first erupted we have highlighted the potential security issues at stake.  A strong NATO requires that its members are broadly economically stable (given the business and credit cycles).  Greece is an important NATO member.  If it is turned out from EMU, over what appears to be something on the magnitude of 5-10 bln euros, and rather arbitrarily derived rules that do not have a strong track record of success, it risks injecting a new element into geo-strategic considerations, especially vis-à-vis Russia in Ukraine. There can be little doubt, for example, that Russia and/or China would like to have a port/naval base in Greece if it were to be made available.   Those who accept the creditors' narrative may call this blackmail, yet it is simply the logical extension of the pursuit of national self-interest in a post-EMU situation.   Greece is not saying forgive our debt or else.  We are saying this a possibility that should be taken into account when assessing the cost/benefit of Greece's EMU membership, which few, including Alan Greenspan are acknowledging  We are identifying other costs, or externalities if you prefer.   We are saying that there will be unintended consequences of a Greek exit, and they are not all unforeseeable.  This kind of risk cannot be reduced to a value-at-risk model.  Instead, it needs to be understood as credibility times capability.  Even if one says the credibility is low, the capability is great, suggesting the "cheaper option"  for the rational actor.  

 

5.  Italian politics is in transition.  The election of a new President and the end of the Nazarene Pact between Renzi and Berlusconi have begun what appears to be a realignment of political forces.  Securing his left flank, Renzi's PD is gaining support from the center as well.  The risk is that Berlusoni shifts to the right with the Northern League the likely ally.  The key is whether Renzi has enough support to push through his economic and political reform agenda.  At the same time, there are some signs that the economy may be improving, though Q4 GDP (due out February 13) may have still contracted.  The EC recognizes the economy likely contracted by 0.5% in 2014, but its news forecasts have the Italian economy expanding by 0.6% this year. The Bank of Italy now says growth may exceed 0.5% this year and reach 1.5% next year.  In mid-January, prior to the ECB's new bond buying program,  it estimated growth at 0.4% and 1.2% in 2015 and 2016 respectively,  The January composite PMI bounced  to 51.2 from 49.4. Auto registrations, a proxy for sales, jumped 10.9% year-over-year in January from  sub-3% rate in December.  Investors have recognized the Spanish recovery for some time, what is new is the better data from Italy. At the same time, Podemos is challenging the elites the way Syriza did.  These considerations suggest Italian assets (stocks and bonds) may outperform Spanish assets.

 

6.  In this crisis, the shape and size of a central bank's balance sheet have been understood as a tool to implement monetary policy.  Is there a limit to the size of a central bank's balance sheet? After the SNB's balance sheet swell to 80% of GDP, some observers argued that the ownership structure it (public via the canton governments and private via the listing on the stock exchange) imposed a defacto cap.  This forced it; they say, to abandon the franc cap.  Yet the latest reserve data shows the balance sheet continued to grow.  It appears the SNB spent CHF50-CHF60 bln in intervention last month.  The appreciation of the franc conceals the quantity of  euros (and other foreign currencies) that it bought.   There was a suggestion last weekend in a Swiss paper that the SNB had adopted an informal CHF1.05-CHF1.10 range for the euro.  It is thought to have bought euros last week, but the euro still closed the week below CHF1.04.  The point is that the SNB's balance sheet has not peaked, and the end of the franc cap was a tactical rather than a strategic decision.  Although BOJ officials have indicated they will not respond if a decline in inflation can be traced to the decline in oil prices, it is continuing to expand its balance sheet at a 1.4% (of GDP) a month pace.  The new appointment to the BOJ is seen as a dove, keep open the possibility (many think probability) that the BOJ does take more measures.  

 

7.  The size of the SNB's balance sheet has not been a good predictor of the Swiss franc's exchange value.  The SNB has also adopted negative interest rates.  Its 3-month LIBOR target range is -0.25% to -1.25%, and it aims at the midpoint (-0.75%).  As SNB President Jordan confirmed over the weekend, there is room take them more negative. The SNB appears comfortable relying on intervention and interest rates.  Bloomberg reports that when specifically asked about capital controls, he indicated that it was not on the forefront of considerations.  The challenge that is facing Switzerland (and Denmark) is not typical of countries imposing capital controls.  Traditionally capital control are meant to prevent capital leaving one's country.  Their problem is funds entering the countries.   Sufficiently negative interest rates are thought to discourage capital inflows.    Denmark matched the -75 bp of the SNB, but this too does not appear to be the bottom.  

 

8.    Oil prices are correcting higher.  While we are not convinced a significant low is in place, technical considerations suggest the correction is not over either. We envision another 10% rally that would lift the March crude oil futures contract to around $60.   Output has not been cut.  Nor has demand meaningfully increased and inventories are still rising.  Baker-Hughes reports another 83 oil rigs were shutdown, leaving 1140.  The rig count peaked in October at 1609.  Last week was the ninth consecutive week that rigs have been shuttered and 14 of the past 17.  While there are 30% fewer rigs, output remains near its peak at 9.2 mln barrels a day.  Rigs are used to drill the well and are only tangentially related to output.  However, the shale wells have a shorter life span, and the rig count speaks to the exploration and future production.  The decline in rigs appears to be concentrated among the less productive fields and vertical rigs.  That said, through last week, horizontal rigs have fallen for eleven consecutive weeks.  Last week's loss of 80 horizontal rigs is the largest drop since 1991.  It leaves 1088 still operating.    Seasonal forces peak soon.  Meanwhile, the US refinery strike is expanding.  This may boost oil inventories if the refinery shutdowns prevent the production of gasoline and distillates, like heating oil.