Fed rate hikes, the European economy and the Brazilian slowdown
Finally, Greece is off the table as the big topic. So I have a few topics I want to cover and am going to put them altogether below. Let’s start with the U.S.
The U.S. has been growing faster than most of the rest of the G-7. And this has put the U.S. central bank in a tightening mode while other major central banks are easing. I don’t see the strong dollar that has resulted as an impediment to growth because the U.S. domestic economy is so large. While it would take a major external shock to throw the U.S. off kilter, there are a few events domestically that could lead to or be signs of slowing. My biggest concern is profits growth and business investment.
Here’s the picture as I see it. Consumer spending in the U.S. economy right now supports 3%+ growth and that is because real wages are perking up and the decline in oil price has further bolstered disposable income. Q4 2014 consumption rose at a 4.2% annualized pace. At the same time, the jobs picture has been spectacular, with large gains in non-farm payrolls and massive upward revisions in Q4 2014. All of this speaks to a healthy economic outlook.
As a result, the Fed, having ended its last quantitative easing program months ago, feels ready to pull the trigger on rate hikes. Nothing Janet Yellen said to Congress this week eliminates June as a date when the first interest rate increase could occur. Moreover, just in the past 24 hours two other Fed Presidents have come out talking about rate hikes in June to September. St. Louis’ Bullard sees little reason to delay hikes. And Atlanta’s Dennis Lockhart says outright “I continue to believe that all meetings from June onward should be on the table.” So nothing has changed in terms of the Fed’s tightening bias. June is the first month when rate hikes can occur, and those hikes will be data dependent.
Moreover, Janet Yellen was sanguine about the drop in consumer prices, because she sees the drop as mostly related to the drop in oil and commodity prices, with the core inflation rate still humming along at 1.6% y-o-y. That means the focus for the Fed will be on jobs. And the jobs numbers have been good.
This brings me to my concern: profits and business investment. Macro data have ben weak of late, with a number of data points missing expectations to the downside. We have seen Q4 GDP downgraded to 2.2% from a 2.6% annualized rate just today and the horrible weather in the Northeast over the past several weeks is bound to take a toll on retail sales and consumption. Moreover, earnings growth has dropped at the same time. Estimated consensus EPS growth in 2015 is only 3%.
So from the capital investment side of things, the outlook is much less benign than it is from the employment side of things. The data are saying that business profits are under threat, not just in the energy sector, and that businesses may have to cut back on capital investment and hiring as a result. The recent uptick in jobless claims is not yet worrying. However, if jobless claims were to move into the 300,000s and push up from there, it would be a sign of weakness that may or may not translate into headline unemployment or non-farm payrolls numbers.
This is the environment that the Fed is tightening into. Average EPS growth in the 12 months after a first rate hike is 18%, whereas we are seeing just an anticipated 3% EPS growth rate for 2015. That tells me that hiking rates and potentially inverting the yield curve is reactive rather than forward looking irrespective of how the Fed tries to sell it. The Fed’s stealth third mandate of financial stability has meant that it is increasingly uneasy about the elevated level of asset prices and wants to normalize rates in order to moderate this trend. Ironically, the Fed could be doing so just at the point when the market internals are already putting pressure on shares, creating a negative backdrop as we enter 2016. For me, the data points to watch are EPS growth for business investment, the trend in jobless claims for jobs, and the non-farm payrolls number to track the Fed reaction function.
Over in Europe, I anticipate a modest pickup from today’s anemic levels. Lower oil prices and interest rates are bolstering consumer spending power and mood. According to Bloomberg, an index of business and consumer confidence rose to 102.1 in February, beating estimates.
At the same time yields are falling to record lows everywhere for sovereign bond debt in anticipation of quantitative easing. A great example here is that the spread between Italy and Germany’s 10-year bond yields is the lowest since 2010. At the peak of the sovereign debt crisis, the spread was over 500 basis points. Now it is below 100 basis points. And Italy is the economy in the periphery that has had the weakest growth rates and the highest government debt to GDP levels outside of Greece. It is emblematic of what is occurring regarding yields. Even Portugal is seeing a 145 basis point spread to bunds now, versus 211 basis points when the year began. That is a massive convergence, one I believe can continue as lon as the economy heads up and the ECB backstop remains in place via QE.
The risk for Europe remains Greece because, despite the agreement and Bundestag approval, it is not clear to me that the Greek interpretation of the loan extension is in accordance with the Troika’s understanding. German finance minister Wolfgang Schäuble is selling the deal to his German compatriots by saying things like, “Greece will not get a single penny until it complies with its obligations.” At the same time, the Greek finance minister Yanis Varoufakis is telling the press that “the Memorandum is finished! Because you know what the Memorandum is? It is a series of conditionalities and criteria that needed to be fulfilled. These criteria are now over!” These two statements are mutually exclusive in my view. Someone is going to see their interpretation of events not being fulfilled. And that is going to set up another roadblock.
My view: The German interpretation of the extension is untenable politically for Syriza. And if it comes to implementing on those lines – as the IMF and the EC voiced concerns too, we won’t even get to the end of April before this agreement collapses. The Greeks need to be preparing their economy and financial system for capital controls and default right now. This is very important because, even if we get past April, there are going to be no writedowns in June. That’s clear from the German side. And that’s not going to fly in Greece politically. A longer-term agreement has a high likelihood of failure. And so default is a good probability then. Greece should be working on parallel currency options as well as ways to prevent deposit flight and bolstering bank capital including the prospect of turning to the Russians as Cyprus seems to have just done. This could be explosive politically.
And then the question becomes redenomination for Greece and whether that same risk lies elsewhere, with the Spanish elections looming large in this debate later in the year. Europe is not out of the woods by a long shot.
Then, there is Brazil, which is emblematic of what is occurring in the emerging markets. Here’s the Wall Street Journal’s take:
or all the debt crises, hyperinflation and boom-and-bust cycles Brazil’s economy has suffered in recent decades, the country hasn’t posted two consecutive years of contraction since the Great Depression.
But if 2014’s fourth quarter was as bad as many economists think and their expectations for this year hold true, Brazil will repeat that feat for the first time since 1930-31.
On Monday, economists polled weekly by Brazil’s central bank downgraded their consensus 2015 forecast to a 0.5% fall in gross domestic product.
And the central bank’s preliminary indicator this month revealed a 0.12% drop in economic activity in 2014, though the Brazilian Institute of Geography and Statistics won’t release official GDP figures for the year until next month.
The Wall Street Journal points to slowing growth in China as well as the drop in prices for agricultural and industrial commodities as well as oil. Basically, Brazil’s boom was predicated on the oil and commodities boom and now that this boom has unravelled, the Brazilian economy has been thrown into a soft depression. Petrobras, Brazil’s most well-known company, has been downgraded to junk and has been forced to slash capital expenditure and shelve a slew of deepwater exploration projects. At the same time, companies like Petrobras are laden with debt, much of it denominated it US dollars, meaning their balance sheet is seeing a double whanmmy due to the strong dollar. Assets are falling in value and liabilities are increasing in value at the same time.
If the Fed does raise rates this year, this will have a negative impact on emerging markets and I fear it could produce more volatility than the Fed expects. For now, both the US and European markets are headed up, based on positive outlooks. Risks do remain, however.