March Madness

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Despite Donald Trump having been inaugurated as the 45th President of the United States only 28 days ago, saying that it has been an event-packed month is the under-statement of the decade.

However, as Randy Bachman sang in his number-one hit in 1974 – incidentally the year President Richard Nixon resigned following the Watergate scandal – “You Ain’t Seen Nothing Yet”.

Indeed while President Trump has already provided markets, the media and policy-makers a lifetime’s worth of material to digest, many of the issues which have pre-occupied financial markets in the past twelve months have somewhat lost some of their bite. Only recently, following Chairperson Yellen’s testimonies to the Senate and Congress (on 14th and 15th February), has the Fed’s likely path of rate hikes re-focussed financial markets’ attention.

Moreover, the frenzy surrounding the British vote to leave the European Union (EU) has lost its fizz since Members of the Lower House of Parliament in early February overwhelmingly voted through, with no notable amendments, draft legislation granting the government the right to trigger Article 50 – the formal notification for the UK to start the process by which it exits the EU. The draft bill is now with the Upper House of Parliament (House of Lords) where the ruling Conservative Party only has 252 peers out of 805.

However, the broad-based expectation is that the House of Lords, which will debate the draft bill on 20-21 February (see Figure 1), will approve the draft bill albeit perhaps in exchange for a few amendments. This final step in the long-winded road towards Prime Minister Theresa May triggering Article 50 by her self-imposed deadline of end-March has seemingly failed to capture the imagination of a public and media perhaps starting to feel the effects of “Brexit fatigue” (see Figure 3 in Market fatigue in the face of catastrophic success, 20 January 2017).

olivier desbarres march madness fig1

Finally, the April-May French presidential elections are attracting much attention given the size of France’s economy, its influence with the EU and possibility – albeit still remote in my view – of the National Front candidate climbing to the highest echelon of French politics (see EM currencies, Fed, French elections and UK reflation “lite”, 25 November 2016). The added twist is that the Republican candidate, François Fillon, is facing possible prosecution over alleged allegations that he paid his wife, Penelope Fillon, for official work she did not do (“Penelopegate”).

Yet, there are still too many “ifs” and “buts” to confidently predict the winner of the first round of the elections (on 23rd April), let alone who will win the likely second round (on 7th May) to become France’s president. For starters, the final list of presidential candidates has yet to be confirmed (see Figure 2). Fillon could conceivably pull out of the race and François Bayrou – the leader of the centrist Democratic Movement and a veteran of three previous presidential elections – has yet to confirm his candidacy.

While Bayrou will in all likelihood not finish in the top two to make it through to the second round, current opinion polls and his past record suggests that he could easily win 5% or more of the popular vote in the first round. While this may be insufficient to have a material impact on which two candidates come first and second, Bayrou could at the margin split the centrist vote which would work against Emmanuel Macron, an independent running on a centrist platform.

olivier desbarres march madness fig2

Needle to push into the red on “intensity dial” in March, starting with March Fed meeting

While markets have arguably had a lot to digest in the past few weeks, it will likely pale in comparison to the torrent of macro data, central bank policy meetings, political events and possible policy announcements which they will face in March (see Figure 1). The needle on the “intensity dial” could be pushed well into the red.

For starters, in the US the Federal Reserve will hold its first truly meaningful policy meeting of the year. While a February rate hike was never really in play, markets are now attributing a 25% probability of a 25bp hike on 15 March. Pricing for a hike could conceivably edge higher if US data out on 1 March show a further rise in ISM manufacturing (in February) – it rose for a fifth consecutive month in January – and personal income, spending and CPE inflation tick higher. Non-farm payrolls are out on 10 March. A continued fall in the pool of available labour (the unemployed, part-time workers and inactive workers who want to work) from just over 40.7 million in January would, in my view, further nail down the probability of a March Fed hike.

US data have on the whole been robust in the past month and I would flag the surge in the Philadelphia Fed Manufacturing Business Outlook Survey to a 33-year high of 43.3 in February (see Figure 3).

olivier desbarres march madness fig3

Since 1980, on only five occasions has the average quarterly Philly Fed index been above 32 (between Q2 1983 and Q2 1984) and GDP growth averaged 8.3% quarter-on-quarter annualised during that period.  Based on the admittedly basic trendline from Figure 3, GDP growth in Q1 2017 could be as high 6% qoq saar – the fastest growth rate since Q3 2003. Of course other variables will colour Q1 GDP data and the consensus forecast is currently for far more modest GDP growth of 2.5%. The first estimate of Q1 2017 GDP data will not be released until 28 April (i.e. well after the March Fed meeting) but the Fed’s own models will give it a pretty good idea of what actual GDP growth was in Q1.

Moreover, President Trump has promised to flesh out in the first 100 days of his presidency his administration’s plans to cut US income and corporate taxes – by end-March it will be 70 days since his 20th January inauguration.

Whether or not Trump is true to his word, my view is that the burden of proof is and will likely remain on the doves to show that a rate hike is not warranted and my core scenario is that the Fed will hike its policy rate 25bp on 15th March for the second time in three months.

 

The political calendar in Europe has the potential to be as disruptive to markets, with key dates in the UK, Netherlands and France

 

UK – Triggering of Article 50 and weak real wages and retail sales

The House of Lords will likely have approved by mid-March the draft bill allowing the government to trigger Article 50. So barring any surprises, Theresa May will be in a position to formally notify the EU of the UK’s intention to withdraw from the EU and she will want to do this before her self-imposed deadline of end-March (note that Clause 2 of Article 50 does not specify the format of the notification but presumably it will be in writing). From that point on, the two-year clock starts ticking. Whatever deal the British government reaches on the terms and conditions of its exit from the EU and its new agreement with the EU, the UK will in all likelihood officially cease to be a member of the EU by end-March 2019.

This timeline should come as no surprise to anyone but the actual notification is likely to be a watershed moment in British politics and financial markets are unlikely to be totally immune, in my view. I would expect Sterling to weaken, even if temporarily, as ultimately a formal notification of the UK’s decision to leave the EU would reduce to almost zero the probability of the UK not leaving the EU (theoretically the British government could change its mind and ask to annul the triggering of Article 50 but this would be an almost inconceivable loss of face and would in any case most likely require unanimous consent from all EU member states).

While any such Sterling sell-off could prove temporary, there are more fundamental reasons – which may not be solely linked to Brexit – why Sterling will remain under pressure. I have since last summer flagged the risk of Sterling’s weakness feeding through to rising UK inflation while the still sizeable pool of available labour dampens workers’ wage-negotiation powers. The corollary was that corporate profits would be squeezed and nominal wage growth fall behind inflation, ultimately weighing on household consumption growth – the UK’s main engine of economic growth (see UK economy post-referendum – for richer but mostly for poorer, 26 August 2016). This risk has clearly become reality in recent months (see Market Fatigue in the face of catastrophic success, 20 January 2017).

UK inflation jumped to 1.8% year-on-year in January 2017 from 1.2% yoy in November while nominal weekly earnings rose only 1.9% yoy in December, far slower than the pace of growth in the previous 6 months (2.6% yoy), as seen in Figure 4. Despite positive employment growth (see Figure 4), the pool of potential workers – the unemployed, part-time workers and inactive workers who want to work – still stood at about12.3 million in December (see Figure 5). That is down from a high of 13.2 million in August 2012 but still 1.5 million more than back in the early 2000s.

olivier desbarres march madness fig4 and 5

So in real terms, weekly earnings rose only 0.2% yoy in December – the slowest pace of growth since August 2014 (see Figure 6). They fell 0.6% month-on-month in December and were down 0.2% since May. Put differently, real wages contracted in the second half of 2016 (see The common theme of low-wage growth, 10 February 2017).

olivier desbarres march madness fig5 and 6

Perhaps unsurprisingly the volume of retail sales has been on a downtrend, falling in January for the third consecutive month (see Figure 7). Since October, retail sales have contracted 2.7% and the year-on-year rate of growth fell to 1.5% in January 2017 – the low since November 2013. This trend in real wage growth and retail sales along with the only modest narrowing of the UK trade deficit guides my view that the Bank of England (BoE) is for now likely to look through the current rise in inflation and keep its policy rate unchanged at its all-time low of 0.25%.

If my scenario of a Fed rate hike in March alongside a dovish outlook for the UK economy and BoE prove correct, this would advocate being short GBP/USD in the run-up to mid-March.

 

Netherlands – Nationalists will not win parliamentary majority but they will be key player

Parliamentary elections for the 150 members of the House of Representatives are scheduled to be held on 15th March. While the Netherlands is a modest-sized economy – the sixth largest in the EU with a GDP of about $770bn – it is a major trading partner for the EU’s largest economies (including Germany and the UK). Moreover, the result of these elections will likely be viewed as a barometer of public support for nationalist parties across Europe, including in France.

The Party for Freedom (PVV) – the nationalist and right-wing populist political party led by Geert Wilders – currently holds only 12 seats (8%) but is currently ahead in admittedly volatile opinion polls. While support for PVV has fallen in the past week, it remains around 25% which would give the party 37 seats. Other main parties have said they would not enter into a ruling coalition with PVV, which would in turn make it almost impossible for Geert Wilders to become Prime Minister. Nevertheless, in such a scenario the Netherlands would join the ranks of Austria, Denmark, Finland, Greece, Italy and Sweden in having a populist/nationalist party with more than 10% of parliamentary seats (see Black swans and white doves, 8 December 2016).

 

France – Political outlook may start coming into focus mid-March

Potential candidates for the presidential elections need to confirm their candidacies by 17th March, which the Conseil Constitutionnel will then have to approve and confirm by no later than 24th March. This will remove the current uncertainty about the presidential bids of François Fillon and François Bayrou. Moreover, by then the first round of the elections will only be a month away.

Opinion polls in the month and in particular ten days preceding the 2012 and 2007 presidential elections were good barometers of public opinion and the odds of a candidate making thought to the second round and ultimately being elected president (see Figure 8). Markets will thus likely pay growing attention to even incremental changes in opinion polls as we get closer to the 23rd April.

However, prior elections have thrown up a number of surprises. In 1974, 1981 and 1995 the winners of the first round lost in the second round, highlighting the importance of “tactical” voting. Moreover, in the 2002 elections opinion polls under-estimated support for Jean-Marie Le Pen, who came a close second in the first round, and the prevalence of “protest” votes. If anything, predicting this year’s winner will be more, not less, difficult, as President Hollande has opted not to run for a second term (the first time for an incumbent President since the 1974 elections).

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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