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Macro Drivers while Covid Remains Out of Control

Summary:
The new Covid outbreak, social restrictions, business closures, and lockdowns render most of the upcoming data mostly irrelevant.  Given the serious spread of the infection and the seemingly slow rollout of the vaccine, the economic data will be distorted even though the impact may not be as severe as last March and April. Policy settings are also considerably more accommodative, though it does little to address the loss of capacity, especially in services.   Manufacturing is holding up better than services, as one may expect. That is what the PMI reports showed, and what the industrial production data from Europe (November) and the US (December) are likely to show in the days ahead.   Some production will meet current demand, but it also appears to be getting a boost from replenishing

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Macro Drivers while Covid Remains Out of Control
The new Covid outbreak, social restrictions, business closures, and lockdowns render most of the upcoming data mostly irrelevant.  Given the serious spread of the infection and the seemingly slow rollout of the vaccine, the economic data will be distorted even though the impact may not be as severe as last March and April. Policy settings are also considerably more accommodative, though it does little to address the loss of capacity, especially in services.   

Manufacturing is holding up better than services, as one may expect. That is what the PMI reports showed, and what the industrial production data from Europe (November) and the US (December) are likely to show in the days ahead.   Some production will meet current demand, but it also appears to be getting a boost from replenishing inventories.   The importance of the economic data may lie in the broader picture that emerges.  Two elements seem particularly notable: trade and inflation.  

The US reported its November trade balance deficit last week.  The shortfall was the most in 14-years ($68.1 bln), and this is even though the US has become considerably less dependent on foreign sources for energy.   Indeed, oil and autos previously drove the deficit, in general terms.  The 2020 shortfall through November was about 10% larger than in 2019.  In November 2019, the US reported that goods trade adjusted for inflation was in deficit by approximately $77.2 bln.  In November 2020, the real goods deficit stood at $96.5 bln.  China will report its December surplus.  It is expected to remain large around $70 bln, but narrowing a bit as exports may have slowed and imports risen.  Its large surplus offers prima facia evidence that the currency remains competitive, though admittedly, it is too soon to expect the impact from the yuan's 8.2% appreciation in H2 20.    

Japan reports its November trade figures as part of its balance of payments report.  Japanese's trade balance improved in 2020.  Its average monthly surplus has risen from JPY33 bln in the first ten months of 2019 to JPY148.5 bln in the Jan-Oct period this year, which still seems modest.  However, Japan's current account surplus is a magnitude larger (averaging JPY1.46 trillion in the first 10-months of 2020), driven by licensing fees, royalties, dividends, interest, and profits from foreign operations.  Trade warriors often do not make the distinction.  

Investors will also see the eurozone's November trade figures.  The eurozone's trade surplus in the first ten months of 2020 was very much in line with the 2019 performance (18 bln a month euro average in 2020 and 17.8 bln in 2019).  How exports are distributed across the region is a different story, but the sustained and large surplus also speaks to the euro's competitiveness, despite its appreciation (~9% against the dollar in 2020).  Exports in October were around 9% below the year-ago levels, but just shy of 200 bln euros, they were the strongest since then.  

Market measures of US inflation expectations have risen, and the Democratic Party securing the Senate (50/50 but the Vice President breaks ties) has boosted them more.  The ten-year break-even, for example, which is the difference between the 10-year conventional yield and 10-year inflation-protected security, rose to about 2.1% last week, the highest since late 2018. To be sure, the inflation concern is not merely a long-term prospect.  The two-year break-even, which did not get above 1.50% until last month (since February), approached 2.25% last week. It has not been this high since Q1 2013. The 2/10-year yield curve steeped to around 95 bp from about 65 bp before the election and 80 bp at the end of last year.  It is the steepest the curve has been since Q3 17.  

Let's leave aside a discussion of the relationship between deficits and inflation, and reminders of the recent history, since the Great Financial Crisis, and the chronic undershooting of inflation targets, not just in the US, but among most high-income countries, as well.  Instead, our modest point here is that market participants may be susceptible to upside surprises to inflation reports, and the December CPI will be released on January 13.  

The headline may jump by 0.4% after a 0.2% gain in November.  It would be the largest since August when the CPI also rose by 0.4%.  However, the year-over-year rate may only increase to 1.3%-1.4% from 1.2% because last December's 0.2% increase drops out of the comparison.  The base effect will be most pronounced in March and April when the headline CPI fell by 0.4% and 0.8%, respectively, last year.  They will drop out and be replaced by a positive number.  Even a small one will lift the year-over-year rate.  The core rate is expected to rise by about 0.1%, which would keep the year-over-year rate steady at 1.6%.  

Yet, to be fair, investors' inflation fears seem sufficiently engrained that it will require more than some high-frequency data to dissuade them. The jump in prices paid in the manufacturing ISM helped underpin US yields, but news that a decline in prices in the service ISM (which was stronger than expected at 57.2, up from 55.9 in November and defying forecasts for a decrease) failed to arrest the backup in rates. The 10-year yield is approaching 1.10%.  It is the highest since last March and was a little below 1.90% at the end of 2019.  A move into the 1.20%-1.35% in H1 and maybe 1.50% by the end of the year seems reasonable.  The impact on the economy and corporate balance sheets should also be modest.  

The US political theater may be winding down for the season, but European politics could move to center stage after the recent US drama.  Italy's situation is not sustainable and how it is resolved is the immediate focus.  The issue is that Italy's fragmented political system requires a coalition government, and the delicate balance can give an exorbitant amount of power to a small party.  Former Prime Minister Renzi heads up such a party (Italia Vive) and represents about 3% of Italians, but has two ministerial portfolios in the government under the non-politician Conte.  Renzi is threatening to withdraw support for the government over how to spend the roughly 210 bln of EU aid expected under the new budget and Recovery Fund.  

Renzi wants a more significant role for parliament and more funds for health and education, which seems fair.  Prime Minister Conte has revised the spending plans accordingly and reportedly has offered Renzi different ministerial posts in a cabinet reshuffle.  Given the pandemic, the economic crisis,  and the fact that Italy holds the G20 presidency, an election seems like a needless distraction.  Moreover, reform of both chambers of the legislature has been approved, which includes reducing the number of lawmakers by a third. The reconfiguration of the internal functions of a smaller legislative branch has not been worked out.  A new election would initially require parliament to sort this out before facing a myriad of challenges.   Investors are expecting a compromise to be struck.  The 10-year Italian bond yield fell to a new record low near 50 bp ahead of the weekend.  If investors were more concerned, they would likely demand a greater premium for holding Italian bonds over German bunds.  The spread is at its lowest level since March-April 2016 (~105 bp).   

While the average Italian government lasts about 13 months over the past 75 years, the average German government lasts about three-times longer.  Merkel has been Chancellor since 2005 and has seen off many of her domestic and foreign rivals.  Nine Italian governments have come and gone while she has been at the German helm.  Well, those days are numbered.  On January 16, the Christian Democrat Union (CDU) will choose a new party leader.  Ironically, Merkel's attempt to pick a successor has failed miserably.  Annegret Kramp-Karrenbauer is not up to the task and her resignation as party head, seemingly amid the loss of support,  made the party contest inevitable. The three declared candidates do not seem to galvanize the rank and file.  Merz is to Merkel's right and a long-time rival.  Laschet is a moderate, while Rottgen is a modernizer, wanting to feminize, digitize, and transition to the younger generation.  There is an outside chance that someone else emerges as a compromise candidate, but it could weaken the CDU for the fall elections.  

The Social Democratic Party (SPD) has chosen Scholz, the current finance minister, as its candidate for Chancellor.  He is a popular pragmatist and seems, at least from the outside, to represent the most continuity with Merkel.  And therein lies the problem.   The SPD has been cohabiting with the CDU long enough that they have begun to look alike, and the SPD may fall into third place behind the Greens.   There is more talk about a CDU-Green coalition, which has been experimented with in state governments but not on the national stage.  The point, though, is a stable element of European politics is going to change, and the January 16 selection of the head of the CDU begins the process in earnest.  






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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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