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The Restoration

The focus in the week ahead is squarely on the United States.  The ECB, the BOJ, the Bank of Canada, and Norway’s Norges Bank met last week.  No fresh initiatives were taken, but if there is a takeaway, it is that the vaccine appears to have made policyma

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The focus in the week ahead is squarely on the United States.  The ECB, the BOJ, the Bank of Canada, and Norway's Norges Bank met last week.  No fresh initiatives were taken, but if there is a takeaway, it is that the vaccine appears to have made policymakers, like many of us, more confident about the medium-term outlook, even though more pain and grief are likely first.  Investors see continued open-spigot monetary policy and more fiscal stimulus (e.g., US, EU Recovery Fund).  Coupled with the vaccine's rollout, it will generate a critical mass of more robust economic growth as the year progresses.   The reflation trade has helped lift commodity prices and emerging markets.  The MSCI Emerging Markets Equity Index rose by about 2.5% last week, its fourth consecutive weekly increase.  In fact, going back to the end of September, the benchmark has fallen in only two of the past 17 weeks, during which time it has risen by almost 30% to new record highs.   Since the eve of the election, the CRB Index has risen by nearly a quarter.   

From a high level, it increasingly appears the populist moment has passed. The elites in many high-income countries were challenged beginning with the Great Financial Crisis. We saw it in terms of Karl Polyani's second movement, a popular pushback after a broad liberalization. That broad liberalization we trace to Reagan-Thatcher. 

The AfD in Germany had more nationalist than populist roots, but it is the Green Party that has moved into the vacuum created by the blurring of the Social Democratic Party and the Christian Democratic Union after years of coalition governments.  Ironically, there is speculation about the possibility of a CDU-Green coalition on the federal level, which up to now has been tried only on the state-level, as a possible outcome of the September election.

The Five Star Movement in Italy, for example, is now part of the governing coalition. Its more radical ideas have been tempered by realpolitik.  It appears vulnerable to losing seats in the next parliament, where both chambers will be around a third smaller.   Podemos in Spain serves as the junior partner in the Spanish government. It has lost its earlier momentum and slipped into fourth place.  Co-opting opposition and stealing absorbing their thunder are time-tested techniques.  In Greece, the New Democracy, one of the two main traditional parties, has returned to power and enjoys an outright parliamentary majority.  

In the US, it was not so clear.  Even though Trump was defeated on the national level, his party picked up seats in the House of Representatives and several statehouses and a governorship.  Trump himself drew more than two million more votes last year than in 2016.  However, since the election, particularly the events leading up to and including spectacle in the Capitol on January 6, it seems clearer that the traditional Atlantic bipartisan elite, for want of a better name, has recaptured the mantle of leadership and returned to power. 

This does not mean that stark differences on particular issues no longer exist between the two parties, but rather, the self-immolation of Trumpism appears to have palpably strengthened the traditional American politics do seem particularly fluid.  The Democratic Party since the New Deal has been the party of organized and unorganized workers but, in recent years, has increasingly been dominated by interests and cultural expressions of the professional class. Trump has reportedly threatened to launch a third party, which would ostensibly split off the party's populist-wing that had begun crystallizing with the Tea Party (circa 2009)

The elite is more globalist in outlook and more multilateralist in druthers.  It is a sustained tension between Wilsonian idealism, desiring to recreate the world in its image, and the realpolitik of pragmatic realism.  America will return to its traditional values.  The Chinese relationship is thorny (and seemingly bipartisan), but the relationship with Europe is no walk in the park.  The US has been able to delay it, but the Nordstream 2 pipeline may be completed around the middle of the year.  Europe struck a long-negotiated investment agreement with China a few weeks before Biden took office.  The French oil company Total became the first major to leave the American Petroleum Institute industry lobbyist over disputes about the environment days before President Biden re-joined the Paris Agreement. 

The EC launched a new initiative to bolster the euro's use on President Trump's last day in office. At the same time, the US weaponization of access to the dollar funding market, a key conduit in the circuit of capital, including notably over dealings with Iran, was seen as an infringement on Europe's sovereignty.  Therein lies the real exorbitant privilege of the dollar. It is not about interest rates.  It is how financial power can be levered to influence political outcomes.  Ultimately, that was the sentiment behind d'Estaing's curse, and it is also what chafes American's friends and rivals today.  

The elite has been chastened.  It just had a near-death experience. The pandemic itself strikes the very heart of what it means to be compassionate. There seems to have been a dramatic shift in public sentiment, perhaps illustrated by the redemption of Kaepernick, the football player who took a knee during the National Anthem to protest. If there are no substantial improvements in the conditions that gave rise to the American version of populism, it will return.   Yet, the sympathy expressed by Secretary of State nominee Blinken for the notion that Georgia be granted NATO membership suggests that its dangerous idealism has not been completely exorcised.  Moreover, several countries in Europe, including Germany and France, have been opposed in the past (George Bush had advocated Ukraine and Georgia join NATO in 2008). This could represent another element of divergence if pushed.    

High-frequency US economic data have mostly disappointed, and the pandemic has gotten worse since the FOMC met last in mid-December. The US lost jobs in December (140k) for the first time since April, though the net job gains over the previous two months were revised higher (135k) by almost the same amount.  Weekly initial jobless claims jumped to over 900k in mid-January, the most since August.  But the largest disappointment was in retail sales, which fell for the third consecutive month in December.  The Bloomberg survey's median forecast was for a flat reading, and instead, it fell by 0.7%, and November's decline of 1.1% was revised to -1.4%.  More telling, consider the core measure that excludes food services, auto dealers, gas stations, and building materials, that is used in GDP models, fell by 1.9% (the median forecast was for a 0.1% gain), and the November drop was revised to -1.1% from -0.5%.  

As an aside, along with inflation worries (see here), another common element in many 2021 investment outlooks is the sense that the pandemic has dramatically accelerated e-commerce.  Many declare "e-everything" as consumers purchase a wider range of goods, including groceries and clothing.  Some report an increase in web services, including medical, tax, and legal assistance.  While some earnings reports, like Amazon, may lend credence to such arguments, but the enthusiasm seems to be running ahead of the facts.  In Q2 last year, the peak of the US lockdowns, online sales accounted for not quite a sixth of retail sales, and Q3 20, online sales slipped around a seventh of overall retail sales. Some of the increase in e-commerce may prove temporary in nature.   

The Federal Reserve's two-day meeting concludes on Wednesday, January 27.  The Fed's position is clear.  It will continue to buy $80 bln a month of Treasuries and $40 bln a month in Agency mortgage-backed securities. It will do so until "substantial" progress is made to the policy objectives of full employment and price stability, redefined as an average rate of inflation (headline PCE deflator) of 2%.  

The statement issued after the meeting is formulaic.  The first three paragraphs and the fifth paragraphs of the five-paragraph statement were unchanged in December from November.  The fourth paragraph was adjusted as the FOMC fine-tuned its guidance on its asset purchases.  It could make a couple of adjustments to its economic assessment at the upcoming meeting,  but these will likely be minor.  Its forward guidance and purchase plans can simply be copied.  It appears that the Fed may have downgraded the use of the statement with the now regular press conference as a more important channel.  

Previously, it had appeared more likely that the Federal Reserve would have introduced yield curve control or, at the very least, shifted its buying to the longer-end of the curve.  What has changed?  The Federal Reserve seems to welcome an increase in long-term rates if it is for the right reasons.  In this context, the right reasons have to do with inflation and inflation expectations.  A year ago, the 10-year yield was around 1.75%.  It is now hovering around 1.10%.  The 10-year break-even, the difference between the conventional yield and the one offered by the 10-year inflation-protected security, was near 1.80% a year ago and is now a little above 2.10%.  

A day after the FOMC's decision, the preliminary estimate of Q4 GDP will be reported.  In a Bloomberg survey conducted from January 8th to the 14th, the median forecast was 4.2% down from 4.5% previously.  Three regional Federal Reserve's have GDP-trackers: The NY Fed puts Q4 GDP at 2.6%. The St. Louis Fed sees it at 3.2%, and the Atlanta Fed is at 7.5%. The average is about 4.4%, in line with the median from the private sector. We suspect the risk on the downside. Still, the contrast with Europe will be highlighted the following day when Germany is expected to report its economy, the fourth-largest in the world, stagnated in the final three months of 2020.  The median forecast expects the French economy to contract in Q4 but nearly around as much as the US is projected to expand.  

The NY Fed's model puts the current quarter's growth at what seems to be an optimistic 6.6%. The Bloomberg survey's median forecast puts  Q1 21 growth at 2.3%, down from 2.5% previously. 

The December personal income and household consumption figures will be embedded in the Q4 20 GDP report.  However, given the market's (hyper?) sensitivity to inflation, the PCE deflator, which the Fed targets, will draw attention the following day.  It is expected to have risen by 0.3%, the most since August.  However, since in December 2019, the PCE deflator also rose by 0.3%, the year-over-year rate should not change much from the 1.1% pace seen in November.  Of note, the deflator fell by 0.3% in March 2020 and by 0.5% in April.  These will drop out and be replaced with a higher number, which will lift the year-over-year rate.  The comparisons are more difficult in June and July, and the inflation scare may ease.  It will return, though, in October and November when flat prices in 2020 are dropped. 

The same pattern holds true for the core PCE deflator, which Fed officials talk about but do not target.  As the pandemic struck, the core PCE deflator fell by 0.1% in March and by 0.43% in April. These will drop out and boost the year-over-year pace. The core deflator jumped by a little more than 0.3% on average in the June-August period last year. When these are replaced, the year-over-year pace will likely ease, only to rise again in Q4 21, when low prints (less than 0.1% on average drop out).       


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