13 January 2012 at 9:06 GMT
US
The statement released after the last meeting of the Federal Open Market Committee on December 13 reveals a Federal Reserve which is somewhat surprisingly concerned about the economic landscape than might perhaps have been expected, given the moderate upside surprises which can be said to have characterised economic releases in the fourth quarter of 2011.
The statement made reference to only “some improvement” to the labour market, perhaps wisely spurning the euphoria which greeted the fall in the headline unemployment rate to 8.6 percent in November, as the FOMC realised the historically low participation rate of 64.0 percent means the report flatters to deceive and still paints a picture of a discouraged workforce, many of whom have given up even seeking employment - the wider “U-6” measure, which includes the discouraged and the underemployed, remains depressingly high, at 15.6 percent. The statement was also confident that inflation “has moderated”.
Federal measures which are already baked-in, combined with state-level cutbacks, mean fiscal policy will impose a small drag, if anything, in 2012 and it will essentially remain paralysed until 2013, as Presidential and Congressional candidates struggle to devise the stance they believe will please the voters most. With the rating agencies poised with fingers on triggers, the nightmare outcome would probably be an Obama re-election, with Republican control of the House and Senate. All of this will do nothing for consumer confidence - even the big bounce in the Conference Board survey in November still left the headline figure below the lows seen in the decade preceding the Financial Crisis.
Finally, the Elephant in the Room, Europe. Suffice it to say the EU is the US’ no.1 trading partner, with 14 percent of the revenue of the Top 500 US companies coming from Europe. It is also highly likely that European banks’ desperate attempts to meet capital ratio requirements will mean they cut back on lending to US firms - which currently amounts to approximately US$2 trn. We would estimate that US growth will be at least 1 percentage point lower as a result of the recession in Europe that we may well see in 2012.
It is vital to note that, due to the annual rotation of voting members, the uber-dovish permanent voter ruling class on the FOMC will be joined in January by three like-minded Regional Fed Presidents, (and one completely isolated hawk - Lacker), whereas three hawks and only one dove will depart.
It therefore seems probable that the Fed will be predisposed towards further easing; certainly in the event we see one or more of the following - a weak stock market, declining inflation, or a strong dollar. In fact, all of the above seem eminently likely and so we would expect to see further Quantitative Easing, (QE3), in 2012, with the April 25 meeting a highly likely announcement date, given that this meeting will be followed by a Chairman’s press conference.
Eurozone
The 17th EU summit-to-end-all-summits, on December 8/9 marked the start of the long march towards fiscal union - it dare not yet speak its name (we have to call it a ‘fiscal compact’) - but the problem is the march will indeed be long and dangerous, taking two years to complete, as a conservative estimate.
The trouble is that way before then the market will demand blood, if for no other reason than the completely understandable fear that the march will never reach its destination, for the journey to fiscal union will inevitably enjoy unpleasant travelling companions in the form of austerity and soaring unemployment, leading to social unrest and probable regime changes.
The market’s fears will centre upon the re-financing needs of Italy and Spain - Euro 300 bn for Italy alone, (excluding any state support for banks) - with the combined needs of Italy and Spain amounting to Euro 500bn a year between 2012 and 2015.
The probability is we will see yet another crisis summit in Q1 and Germany will cave in - maybe agreeing to the issuance of Eurobonds with joint and several liability - causing bund yields to soar. One way or another we will finally see the European Central Bank satisfied that is has wrung enough fiscal quid pro quo out of politicians and, hiding behind its statutory requirement to ‘ensure monetary stability’, coming to the rescue by explicitly buying distressed sovereign bonds.
In fact one can argue that they have already implemented this policy via the back door; December’s announcement of unlimited, 3-year liquidity enables banks to borrow from the ECB at 1 percent, (or lower in time probably), and invest in the bonds of their mother country at maybe 6 percent or more. Thus we see the classic mechanism by which banks can rebuild capital, (without equity issuance), and the states can apparently stay liquid. Did someone say Ponzi?
In addition to this overt or covert quantitative easing, we’d expect the main Refinance Rate to hit 0.75 percent in Q1, with a further cut to 0.5 percent later in the year.
Japan
Japan continues to represent a casebook study in the dangers of the liquidity trap, with monetary policy apparently emasculated and unable to improve economic conditions. That being the case, the bulk of the heavy lifting falls on the shoulders of fiscal policy and new Prime Minister Noda seems to be displaying an encouraging level of activism in this regard.
In the face of extreme global uncertainty, the Bank of Japan will probably keep its powder dry during Q1, waiting to see whether events in Europe and/or a strengthening of the yen mean they feel the necessity to either increase the amount or duration of JGB purchases or remove the 0.1 percent paid on excess bank reserves.
UK
UK Chancellor George Osborne’s Autumn Budget Statement could hardly have made for more depressing reading - the UK looks set to endure at least another five years of low growth, high unemployment and fiscal austerity.
Whereas the UK economy managed to grow by 1.9 percent in 2010, official projections from the Office of Budget Responsibility, (OBR), now forecast growth of 0.9 percent, and 0.7 percent in 2011 and 2012 respectively, before a ‘blistering’ 2.1 percent recovery in 2013.
In light of the above, the Bank of England will continue to feel that the government is sticking to its side of the ‘bargain’ re. fiscal policy and the Bank will therefore respond with further QE in Q1. The purchase of the additional £75bn of Gilts announced on October 6 will be finished by February 10, and it is therefore possible that additional QE will be announced after the February 8/9 meeting, but we would put our money on March 8. Rates will be held at 0.5 percent throughout 2012.
Switzerland
Despite the introduction of its 1.2 ‘floor’ for EUR/CHF, with its accompanying commitment to print as many Francs as necessary, Switzerland remains in danger of slipping into a deflationary quagmire in 2012. A danger that will only be compounded by the EU’s tribulations. The Swiss National Bank’s, (SNB), latest inflation forecasts, released at its December 15 meeting, nudged its 2013 expectation down to 0.4 percent from 0.5 percent and even at the end of its forecast horizon, in Q3 2014, it sees only 0.8 percent - surely too close to deflation for comfort.
Given what we expect to happen in the EU – austerity cubed and zero growth in 2012 at best - by end-Q1 we would expect the writing to be on the wall and expect the SNB’s EUR/CHF floor to be raised to 1.3.
Fixed income markets
2012 may usher in a new paradigm for fixed income markets with intense competition for capital, meaning we have seen the bottom in yields in most markets. Let’s be clear, this is not the ‘old normal’ world where risk-free sovereign bond yields formed a base for returns, predicated purely upon the classic ingredients, namely expectations for short rates and inflation over the life of the bond, and the yield on lower grade bonds also reflected the price of credit risk.
The new normal means that virtually no sovereign bonds can truly be regarded as risk-free and many factors point to higher yields:
Bank deleveraging to meet new, punitive capital ratio requirements will mean less lending to corporates and therefore more corporate issuance.
One of the world’s prime borrowers, Germany, faces a potentially huge bill to ensure the survival of the Euro - and it is a safe bet that the German people will eventually decide to pay this bill, as they realise how beneficial the Euro has been for Germany and what a cataclysm its demise would bring.
The market can stay irrational longer than governments can stay solvent, if fear dominates greed.
As ever, in an increasingly correlated global economy, the key to success will be the analysis of spreads between issuers, and pure corporate credit analysis will also have to be overlaid with country risk. For instance, the UK has come to be seen as something of a safe haven, due to the coalition government’s extreme commitment to fiscal probity, and so corporate issuance has exploded. (According to Dealogic, Sterling-denominated non-financial corporate bond sales, across all grades, are up 43 percent during the first 11 months of 2012, while euro and dollar markets have collapsed and stagnated, respectively. WM Morrison, the UK supermarket chain, could have sold £1.5bn of its recent 12-year issue, rather than the £400m it looked to raise. QE has probably also helped.
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