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Challenges and Opportunities in the Week Ahead

Summary:
Liquidity will return to the foreign exchange market, and volatility may increase. The three-month implied volatility of the euro and yen fell to record lows last week (~4.35% and 5.06%, respectively), extending a multi-year trend. The dollar is threatening to break out of recent ranges that have been historically narrow.  A breakout could underpin volatility.  However, low volatility is not just about the foreign exchange market.  The volatility of the S&P 500 (VIX) is below 12% and near the year's low set in April.  A similar metric in the bond market (MOVE) is below its 200-day moving average.  The risks of an escalation in the US-China trade conflict and an inconclusive UK election appear to have diminished.   President Trump signed the Hong Kong bills in part on the

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Challenges and Opportunities in the Week Ahead
Liquidity will return to the foreign exchange market, and volatility may increase. The three-month implied volatility of the euro and yen fell to record lows last week (~4.35% and 5.06%, respectively), extending a multi-year trend. The dollar is threatening to break out of recent ranges that have been historically narrow.  A breakout could underpin volatility.  However, low volatility is not just about the foreign exchange market.  The volatility of the S&P 500 (VIX) is below 12% and near the year's low set in April.  A similar metric in the bond market (MOVE) is below its 200-day moving average. 

The risks of an escalation in the US-China trade conflict and an inconclusive UK election appear to have diminished.   President Trump signed the Hong Kong bills in part on the assumption that it will not derail the trade talks.  If Trump did not sign the bills, they would have become law, but this ploy was not needed.  China made the same unspecified threats before (advanced weapons sales to Taiwan, sanctioning companies involved with human rights violations, and blacklisting Huawei).  Bejing could bar the bill sponsors from entering Great China (mainland, Hong Kong, and Macau), but it is largely symbolic. It would become a badge of honor for those subject to it.  Moreover, China knows as well as anyone that a law on the books means little without enforcement.  

The market expected the 15% tariff on around $160 bln of Chinese goods that the US threatened for the middle of December will be waived, and a scaled-back version of "phase one" will be struck.  It is quite clear from the recent industrial profits report that the sectors that have been subject to US tariffs have been walloped, while the seconds that are more domestic, like infrastructure, for example, have fared considerably better.  

The polls suggest the Tories can secure a parliamentarian majority at the December 12 election.  Labour's strategy of being nearly agnostic on Brexit and promising a referendum the deal seems to be failing to inspire.  The escalation of antisemitic accusations does the party no good. The Lib-Dems "remain" message has not been able to break the hold of the duopoly.  The Scottish Nationalists will do well, and this will begin to lay the groundwork for another referendum for independence. 

The economic data in the days ahead will set the tone for the remainder of the month.  Last week's data prompted the NY Fed GDP tracker to tick up to 0.8% fro 0.7% form Q4 GDP.  The Atlanta Fed's model jumped to 1.7% from 0.3%.  The optimism could be challenged by the week's ahead reports which are headlined by the November jobs data.  The return of striking GM workers will lift the nonfarm payrolls by around 45k, and most economists look for an increase of a little less than 200k.  Year-to-date, the US is averaging 167k net new jobs, a 25% decline from the same period last year.  In the first ten months of 2018, the US created an average of 226k jobs a month.  

Average hourly earnings growth is expected to be steady at 3.0%.  A robust job market creates the fuel of consumption that drives the economy.  Yet the relationship is more complicated and anything but straightforward.  Consumption appears to be slowing.  It grew by 4.6% in Q2 and 2.9% in Q3.  It is off to a soft start in Q4.  Real personal consumption expenditures rose 0.1% in October, the weakest since February.    At the time, the strong, durable goods orders and shipments suggest the composition of GDP growth may be shifting: less consumption, more investment.

Jobs growth is cyclical.  The 12-month moving average peaked in February 2015, near 260k.  Some consumption is cyclical.  Auto sales in the US have held up well this year.  In comparison, Japan will report November auto sales on December 2 and in October were off 26.4% year-over-year.  The UK will report new car registrations, a proxy for sales, were off 6.7% year-over-year in October. In the US year-to-date average is about 16.9 mln vehicles at an annualized pace.  This is a little slower than the 17.03 mln vehicle average in the first 10 months of 2018.  November sales figures are expected to have ticked up from October's 16.55 mln, which was weakest in six months. 

China reported an unexpected jump in its official November PMI.  The manufacturing index rose to 50.2 from 49.3, and the non-manufacturing PMI rose to 54.4 from 52.8.  This lifted the composite reading to 53.7, the highest since March, from 52.0.  The national report focuses on large state-owned businesses, while the Caixin measure puts more weight on smaller firms.  The Caixin PMI will be reported around the time Shanghai markets open on Monday. Investors appear more skeptical of strong than weak data from China, given their preconceived notions.  

The eurozone sees the final November PMI and October retail sales.  The flash composite PMI fell to 50.3 from 50.6.  However, both the German and French composite PMI edged higher.  Germany's composite rose to 49.2 from 48.9, and the French composite firmed to 52.7 from 52.6.  This means that there was deterioration outside of Germany and France.  It most likely points to dramatic weakness in Spain and/or Italy.  The economic strain can only exacerbate political pressures. 

The UK's final PMI will most likely confirm the weakness of the flash report. Declines in both manufacturing and services sectors saw the composite tumble to 48.5 from 50.0, a new cyclical low.  The Bank of England meets December 19.  Two members dissented at the November 7 meeting for an immediate cut. About a one-in-nine chance of a rate cut has been discounted, but a cut next year seems increasingly likely.  That said, Carney is due to step down on January 31.

The UK will announce the change in the value of its reserve holdings on December 4.  This is not a market-moving report, but the UK has accelerated the pace of reserve accumulation, likely in anticipation of Brexit.  Reserves have risen an average of $1.53 bln a month this year compared with a $720 mln average last year. 

The sales tax in Japan and typhoon saw the October composite PMI fall to 49.1 from 51.5.  The flash report suggested the situation stabilized in November with a bounce to 49.9.  The impact is likely to linger because labor earnings have been weak.  Labor cash earnings rose 0.5% year-over-year in September, and the October pace is expected to have slowed to around 0.3%.  Real cash earnings were up 0.2% year-over-year in September.  

Household spending surged 9.5% year-over-year in September as activity was brought forward to beat the tax increase.  When it is reported at the end of next week, the October pace is expected to have fallen 2.5% from a year ago.  The risk is on the downside after Japan reported that retail sales plummeted 14.4% in the month of October as the tax hike and typhoon spurred a greater than expected contraction.  

The Reserve Bank of Australia and the Bank of Canada meet next week.  A cut by the RBA is unlikely, but it would be less of a surprise than a move by the Bank of Canada.   The RBA cut rates in October and saw the justification for a rate cut in November but did not move.  The bank's statement may be more important to the short-term price action barring a surprise.  The Bank of Canada softened the language around its neutral stance but is in no hurry to ease policy where officials argue the benefits do not outweigh the potential costs.  As parliament returns, the government will push middle-class tax cuts, which may also take some pressure off monetary policy. 

The Trump Administration assault on the World Trade Organization and NATO will be in the spotlight next week.  NATO meets next week.  The US has insisted, and the allies have agreed to a new funding formula that will result in a smaller contribution from the Americans.  Previously, the US provided for 22% of the alliance's direct funding of around $2.5 bln.  The US will scale back its contribution to 16%, in line, according to reports, of Germany's contribution (14.8%).  

Since 2014, when Russia invaded Crimea, defense spending in Europe has risen by around $100 bln, according to reports.  The increased spending, which has long been sought by US administrations, is partly a functioning of the increased risk threat, previous commitments to boost spending, and, arguably, the hectoring by the Trump Administration.   Meanwhile, NATO has also become a bone of contention in Europe.  Macron said it was suffering from "brain death" as he advocates a stronger European military presence that German, as the biggest economy, would be expected to fund, while France would likely provide important parts of the command structure.  Merkel, on the other hand, who has yet to present a pathway fulfilling its 2% of budget commitment to NATO, gave a spirited defense of the alliance.  

Many are aware of the US attack on the World Trade Organization's conflict resolution mechanism, which is one way it differed from its predecessor GATT (General Agreement on Tariffs and Trade).  The US has been blocking the appointment of new appellate judges for nearly two years.  Around 70% of the initial judgments are appealed.  When fully staffed, there are seven appellate judges, and three are needed to make a decision.  There are three members now, and the term of two ends on December 10.  As of December 11, there will no longer be sufficient judges to issue binding decisions.  The US argues that the appellate body oversteps its mandates, and judges stretch out a case to earn more money.  

Few seem aware of the US threat to block the WTO's 2020 budget (~CHF200 mln), where unanimity is necessary.  It made two dramatic proposals, without promising to allow new appellate appointments.  It proposed that the operating fund be limited to CHF100k, which represents a 95% reduction.  The US also proposed that now more than CHF100k be earmarked for the appellate body, which represents about an 87% reduction from the full budget allotment.   

The US also seeks to stop the end-run by the EU, Norway, and Canada who have created a parallel dispute settlement system to work around the American's obstructionism.  The Trump administration insists that going forward, only the WTO Secretariat can approve of funding for such efforts, not the appellate body itself.  There appear to be some ways that if the US proposals are not accepted, the WTO can limp into next year.   The sums are not particularly large.  The US share in 2018 was about 11.5% of the general budget or around CHF23 mln, and the WTO enjoys a small surplus (~CHF40 mln).  The budget will be discussed next week, and it seems that in any case, the WTO will be further weakened.  

There is are two other meetings next week that could have far-reaching implications.  First, the EU finance ministers meet on December 5.  Among the issues to be discussed will be updating the rules on biofuel taxation and related matters.  In particular, there seems to be a push afoot to phase out the preferential treatment for aviation fuel under a new set of regulations.  This could have far-reaching implications.  Carbon pollution from international aviation has doubled since 1990, according to reports, while total carbon emissions have fallen by a little more than a fifth.  Recall rules that forced ocean tankers to generate less pollution saw shipping costs soar earlier this year as shipping capacity fell while operators were having their ships retrofitted.  

The other meeting is the German Social Democrat Party conference on December 6-8.  As we have discussed previously, the SPD is fighting for its survival.  It has in coalition with Merkel's CDU for 10 of the past 14 years.  It appears to have lost its identity and has seen its public support dwindle.  Regardless of who wins its leadership contest, the rank and file will vote at the conference whether to stay in the coalition.  If it chooses not to, it would likely force a national election early next year.  

Disclaimer



Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.

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