Just then they came in sight of thirty or forty windmills that rise from that plain. And no sooner did Don Quixote see them that he said to his squire, "Fortune is guiding our affairs better than we ourselves could have wished. Do you see over yonder, friend Sancho, thirty or forty hulking giants? I intend to do battle with them and slay them. With their spoils we shall begin to be rich for this is a righteous war and the removal of so foul a brood from off the face of the earth is a service God will bless." Chapter VIII – Don Quixote 1605 by Miguel de Cervantes

We maybe tilting at windmills as the relentless rally up in risk in the last week for US equities begets ever more analysis as to why markets react to policy and economic data as bulls beat bears. The cause and effect of why shares are bid in the US and Europe, less so in Asia and emerging markets matters. Knowing what caused the rally matters more than the rally itself, as it will be the underpinnings for the next cycle of selling. The abnormality of the last week stands alone - Stocks up, Dollar up, Oil up, Bonds up, Emerging Markets down. The cracks are in the logical inconsistency of it all, bonds and stocks can’t rally together forever, nor can the USD rally with commodities. Emerging markets depend on growth and easy money and yet the weakness last week seems to suggest more a zero-sum game in play for value. The bulls will list out better 4Q earnings, less fears about US/China trade, less fears about China growth, less US political troubles – ie. no new government shutdown – and further easy money promises from numerous central bankers. Bears continue to point to the growth disappointments of Europe, the troubles in China and doubting of its data, ongoing political issues in Europe from Brexit to Spain to Italy and Germany, along with the usual geopolitical problems from Russia, to India/Pakistan to Mexico and Venezuela. The four stories that play out next week will matter significantly to how markets see the windmills of cause and effect – they might be giants or they may be more grist for the millstone. 

China bank lending exploded last month will it continue?

1)  China. Is this optimism that the US/China trade talks lead to a March 1 deal or if not an extension in the deadline? According to a Reuters report, China offered to boost its purchases of U.S. semiconductors in exchange for lower U.S. tariffs even as the talks seem inconclusive on intellectual property or state subsidies. The underlying status of talks will become more obvious with the Trump tweets on this next week along with the China auto sales and home price data. 

2)  Fed. Or is this hope that the FOMC is next going to ease – driving another risk parity rally - with the 1.2% drop in US December retail sales – worst drop since Sep 2009 – along with a higher weekly jobless claims shifting the Fed policy games on balance sheet reduction and rate normalization. The FOMC minutes will be critical in assessing the reaction function to the present data. 

3)  ECB. Similarly, is the EUR weakness due to German near recession and Italian confirmed recession or because the ECB is more likely to reverse from its QE end and talk for rate normalization? The numerous ECB speeches from Praet next week along with the ECB meeting account will be seen as critical in judging this point. 

4)  Brexit. Finally, we see the confusion of Brexit still bleeding over the UK economy and yet the GBP holding stable, perhaps because of the inevitability that without a deal yet acceptable both Europe and the UK will delay any divorce. 

There are many undercurrents to cause and effects in markets, as every cause produces more than one effect. We will found this out next week in the readings of the FOMC minutes as they compare to those of the ECB. Present policy expectations are like windmills – they might be giants blocking the next advance up in risk as not hiking isn’t the same as easing, nor is freezing the size of your balance sheet the same as continuing to expand it. What matters is what the US, Europe, PBOC, BOJ, and others do with their policy more than one action alone. 

Question for the Week Ahead: Is this more than a short-squeeze for stocks? There is a growing view among analysts that the present 8-week rally up in the S&P500 is more than just a short-squeeze from the 4Q correction. Some argue that the FOMC and other central banks are now going to continue the easy money liquidity, others claim that the efforts for China stimulus and the likely Trump/Xi deal on trade mean 2019 growth will beat present reduced expectations. The flip-flop of bearish to bullish price action in US shares from December 24thto the present has become legendary. The rise in shares despite weaker expectations for 1Q stands out for the S&P500.  

According to FactSet, the fourth quarter, companies are reporting earnings growth of 13.1% and revenue growth of 7.0%. For CY 2018, companies are reporting earnings growth of 20.1% and revenue growth of 8.9%. However, analysts expect a decline in earnings in Q1 2019 and low, single-digit growth in earnings in Q2 2019 and Q3 2019. 

• For Q1 2019, analysts are projecting a decline in earnings (-2.2%) and revenue growth of 5.3%. 
• For Q2 2019, analysts are projecting earnings growth of 1.0% and revenue growth of 4.7%. 
• For Q3 2019, analysts are projecting earnings growth of 2.4% and revenue growth of 4.5%. 
• For Q4 2019, analysts are projecting earnings growth of 9.1% and revenue growth of 5.0%. 
• For CY 2019, analysts are projecting earnings growth of 4.8% and revenue growth of 4.9%.

The other issue for the bullish argument about equities is one about the real economy and its risks for 1Q and beyond.  The ECRI Is flashing red about US growth. Its track record in capturing recessions is worth studying. There are other worrying signals at play as well. The hits of retail sales and weekly jobless claims also stand out in the last week as they drove the Atlanta GDPnow to 1.5% from 2.7% Feb 6. 

Bottom Line: In order to argue that US equities have more upside, you will need new drivers. The cause and effect of the rally from Christmas Eve is changing from short-squeeze to something else. Just exactly what this is matters – whether its FOMC dovishness or Trump trade deals or better news from the rest of the world – particularly China – all that matters in how to trade the S&P500 and other risk markets going forward.  

Market Recap: Between weaker US retail sales and jobless claims there was ongoing US earnings reports and more US/China trade talk headlines mixed with a deal to keep the US government funded clouded by Trump’s emergency powers call to build a wall on the Mexico border. The German GDP was 0% in 4Q while the industrial production fell 0.4% in December. Factory orders fell 1.6% m/m. The EU as a whole rose 0.2% in 4Q while its industrial production fell 0.9% m/m in December. The UK parliament again rejected UK PM May’s Brexit strategy which sought changes to the Irish backstop to avoid a hard border.  Spain’s PM Sanchez called a snap election for April 28 after his parliament rejected the budget. Japan 4Q GDP was up 1.4% y/y bouncing back from -2.6% y/y in 3Q after natural disasters. In emerging markets, India suffered as a deadly attack in the Kashmir added to political uncertainty into the election and upped the geopolitical concerns with China and Pakistan. India PM Modi said that the perpetrators behind the attack “will now have to pay a very heavy price,” raising the prospect of military action against Pakistan. Brazil found some relief as the new President Bolsonaro released the first details for pension overhaul with the raising of the minimum age vote set for Feb 20 next. Russia suffered after a bi-partisan Senate group introduced a bill to increase sanctions on Russia over the Ukraine and US election meddling. 

Equities: The MSCI all-country World index rose 1.91% to 498.24 on the week. The MSCI EM index fell 0.52% to 1030.64 on the week. US 4Q earnings are winding down with 79% of the S&P 500 reported and 70% beating EPS and 62% beating revenues. The blended earnings rate now 13.1% for 4Q that is up from 12.1% Dec 31 estimates – this 1% spread is below the 5-year average beat of 3.8% for earnings. 

• The S&P500 rose 2.50% to 2,775.60 on the week – 8th weekly gain. By sector, energy and industrials led while financials and utilities dragged. The DJIA rose 3.09% to 25,883.25 on the week. The NASDAQ rose 2.05% to 7,055.18 on the week. The Cboe VIX fell 5.15% to 14.91% on the week. 
• The Stoxx Europe 600 rose 3.04% to 368.94 on the week. The German DAX rose 3.60% to 11,299.80 on the week. The French CAC40 rose 3.86% to 5,153.19 on the week. The UK FTSE rose 2.34% to 7,236.68 on the week. The Italian FTSE MIB rose 4.45% to 20,212.34 on the week. The Spanish IBEX rose 3.01% to 9,123.20 on the week. 
• The MSCI Asia Pacific rose 0.47% to 155.60 on the week. The Japan Nikkei 225 rose 2.79% to 20,900.63 on the week. The Hong Kong Hang Seng fell 0.16% to 27,900.84 on the week. The China Shanghai Composite rose 2.45% to 2,682.39 on the week. The India CNX Nifty fell 2% to 10,724.40 on the week. The Korea Kospi rose 0.87% to 2,196.09 on the week. The Australian ASX rose 0.2% to 6,148.60 on the week. 

Fixed Income: Last week brought weaker US data for CPI and retail sales and that alone could justify the bond moves seen last week but for the rally up in shares and for the ongoing rally back in oil prices. Hope for a US/China trade deal continues to weigh more heavily than almost anything else. Markets abroad were mixed with the biggest move in New Zealand as the RBNZ surprised by sounding less dovish than the RBA two weeks ago. The rally up in NZD and selling of bonds there stands out in contrast to Japan and Europe. German Bunds continued to languish with the data as there was scant comfort in the 0% 4Q GDP. The Japanification of Bunds is fast approaching with many calling for German rates to mimic Japan in the near future. Brexit debates continue to hang over UK Gilts while Spain and Italy suffer growth doubts and ugly politics. The emerging markets last week were watching Brazil vs. Mexico, India vs. China for contrasts in politics and flows.  Whether the next week plays to safe-haven stability rests on the FOMC and ECB minutes.

• US bonds see curve flattening flip-flop on trade and weaker data– For the week: 2Y up 3bps to 2.51%, 3Y up 4bps to 2.47%, 5Y up 5bps to 2.49%, 10Y up 4bps to 2.67%, 30Y up 1bps to 3.01%. 
• Canadian 10-year bond yields rise 2bps to 1.90% on the week– with jobs and US moving with oil and growth hopes returning. 
• Japan JGB yields up 1bps to -0.02% on the week– with equities insufficient to matter – focus is on data and risks for trade. 
• Australian 10-year bond yields rose 5bps to 2.13% on the week– modest payback from the big RBA rally thanks to RBNZ and China trade 
• UK Gilt yields rose 1bps to 1.16% on the week – holding pattern with focus on politics and Brexit continuing.
• German Bund yields rose 1bps to 0.10% on the week– with focus on 0.05%-0.15% for trading and risk for ECB dovish tilt rising. 
• French OAT yields flat at 0.54% on the week. Macron and yellow vests still key worry, data ahead matters
• Italian BTP yields fell 15bps to 2.82% on the week– with market locked into banks/growth with 2.70-3.00% key trading band
• Spanish Bono yields rose 14bps to 2.37% on the week– snap election call, mixed data driving. 
• Portugal 10-year bond yields fell 8bps to 1.57% on the week– more Italy, less Spain with focus on growth/budget
• Greek 10-year bond yields fell 18bps to 3.83% on the week– with focus on growth and better politics. 

Foreign Exchange: The US dollar index 96.90 up 0.3% on the week. In emerging markets the USD was mixed with ZAR, RUB, ARS and MXN notable losers for the week - ASIA: CNY 6.77 up 0.2%, INR 71.32 off 0.2%, KRW 1125.4 off 0.15%; EMEA: RUB 66.252 off 1.2%, ZAR 14.075 off 3.3%, TRY 5.27 off 0.45%; LATAM: BRL 3.701 up 0.75%, MXN 19.235 off 0.85%, ARS 38.58 off 2%. 

• EUR: 1.1295 off 0.3% on the week with focus on 1.1215 and 1.1180 next as 1.13 support breaks and ECB policy questioned against weaker data.
• JPY 110.50 up 0.7% on the week with equities, risk-on mood, lower rates driving but 111.20-50 held. EUR/JPY 124.70 up 0.3% with 125.50 key pivot. 
• GBP 1.2890 off 0.45% on the week with Brexit still the only story and 1.28-1.30 range holding. EUR/GBP .8760 up 0.15% on the week reflecting politics. 
• CHF: 1.0050 up 0.5% on the week with risk-on helping hold 1.00 but not enough for 1.02 yet. EUR/CHF 1.1350 up 0.2% with 1.13-1.15 key
• CAD: 1.3245 off 0.25% on the week with oil and jobs helping along with rates – BOC key 1.3050-1.3350 broad range holding
• AUD: .7140 up 0.7% on the week with focus on China and NZD .6865 up 1.75% on RBNZ Orr sounding less dovish than expected with .6920 key there and A$ stuck .7050-.7250. 

Commodities: The S&P/GSCI total return index rose 3.3% to 2,473.72 on the week. Gasoline and Oil led the winners for the week while Orange Juice and Coffee lagged. 

• Oil: $55.59 up 5.4% on the week. Brent $66.25 up 6.7% on the week. OPEC and IEA reports coupled with Venezuela sanctions, risk-on offsetting US inventory draws with a technical break of $55 key for $57.30 next. 
• Gold: $1321 up 0.5% on the week. USD stronger and gold up – with safe-haven demand in EM driving.  Other precious metals mixed - Silver $15.775 off 0.3%. Platinum $802 up 0.5%. Palladium $1432 up 2.1%. 
• Corn: $374.75 up 0.15% on the week. Better trade hopes less important than weather, rates. Soybeans $907.50 off 0.75% on the week. Wheat $504.25 off 2.5% on the week.
• Copper: $2.8025 off 0.3% on the week.Futures (Mar) off 0.45% to $2.7985. Despite better shares and China trade story. Iron Mar $84.54 off 8.8% on the week. 

Calendar for the Week Ahead: The week ahead starts slowly with a US holiday but will culminate in a data overload Thursday. The focus is likely to remain on US/China trade talks and other geopolitical stories like Brexit, EU politics and US sanction. As for economic stories the key focus is on US FOMC, durable goods orders, flash PMI, Philadelphia Fed manufacturing index and home sales. The global flash PMIs for Australia, Japan, Europe are also key along with German IFO and ZEW, UK jobs and Swedish inflation. Australia employment, RBA minutes and Japan CPI round out Asia with China auto sales and home prices. The ECB minutes also matter but the speeches from the ECB and Fed this week maybe more powerful given policy reaction function doubts to present economic data. 

Monday, February 18: US Presidents Day Holiday, China vehicle sales.

• 0650 pm Japan Dec machinery orders (m/m) 0%p -1.1%e (y/y) -.8%p +4.8%.
• 0400 am China Jan vehicle sales  (y/y) -13%p 
• 0600 am Bundesbank monthly
• 1115 am ECB Enria speech

Tuesday, February 19: Swedish CPI, UK jobs, German ZEW, US NAHB

• 0600 pm Japan Feb Reuters Tankan 18p
• 0730 pm RBA meeting minutes
• 0330 am Sweden Jan CPIF (m/m) 0.4%p -0.7%e (y/y) 2.2%p 2.3%e / CPI 2%p 2.2%e
• 0400 am Eurozone Dec current account surplus E23.2bn E36.2bn
• 0400 am Italy Dec industrial sales (m/m) 0.1%p -0.3%e / orders -0.2%p +0.5%e
• 0430 am UK Jan claimant count jobless 20.8k p 2.4k e / ILO Oct-Dec unemployment rate 4%p 4%e / average earnings 3.4%p 3.5%e / ex bonus 3.3%p 3.4%e / 4Q labor productivity -0.4%p +0.5%e
• 0500 am German Feb ZEW economic sentiment -15p -13.5e / current conditions 27.6p 20e / EU sentiment -20.9p -20e
• 0500 am Eurozone Dec construction output (y/y) 0.9%p 1.1%e
• 0515 am ECB Guindos speech
• 0850 am Cleveland Fed Mester speech
• 1000 am ECB Praet speech
• 1000 am US Feb NAHB housing market index 58p 59e

Wednesday, February 20: Japan trade, German PPI, US FOMC minutes, Brazil vote on minimum age for pension. 

• 0650 am Japan Jan trade deficit Y55bn p Y1.1trn e / exports -3.8%p -5.5%e
• 0730 pm Australia Jan Westpac LEI -0.2%p +0.1%e
• 0730 pm Australia 4Q wage price index (q/q) 0.6%p 0.6%e (y/y) 2.3%p 2.3%e
• 0200 am ECB Praet speech
• 0200 am German Jan PPI (m/m) -0.4%p -0.1%e (y/y) 2.7%p 2.2%e
• 0540 am German 5Y Bobl auction
• 1000 am Eurozone Feb flash confidence -7.9p -8e
• 0200 pm FOMC Minutes
• 0430 pm API weekly oil inventory -0.998mb p +1mb e

Thursday, February 21: Flash global PMI, Australia jobs, Indonesia rate decision, ECB minutes, US durable goods, Philly Fed, existing home sales

• 0500 pm Australia Feb flash CBA PMI manufacturing 53.9 p 53.4e / services 51p 50.7e / composite 51.3p 51.1e
• 0730 pm Australia Jan employment change +21.6k p +15k e / unemployment rate 5%p 5%e / participation 65.6%p 65.6%e
• 0730 pm Japan Feb flash Nikkei PMI manufacturing 50.3p 50.4e
• 0200 am German Jan final HICP (m/m) 0.3%p -0.1%e (y/y) 1.7%p 1.7%e / CPI 1.7%p 1.4%e
• 0200 am Indonesia central bank rate decision – 6% unchanged expected
• 0245 am French Feb business confidence 103p 103e
• 0245 am French Jan final HICP (m/m) 0.1%p -0.6%e (y/y) 1.9%p 1.4%e / CPI 1.6%p 1.2%e
• 0300 am ECB Praet speech
• 0300 am Spanish Dec industrial orders (y/y) 22.3%p 12%e
• 0315 am French Feb flash PMI manufacturing 51.2p 50.9e / services 47.8p 48.9e / composite 48.2p 48.9e
• 0330 am German Feb flash PMI manufacturing 49.7p 49.8e / services 53p 52.8e / composite 52.1p 52.0e
• 0400 am Eurozone Feb flash PMI manufacturing 50.5p 50.3e / services 51.2p 51.2e / composite 51.0p 50.8e
• 0400 am Italy Jan final HICP (m/m) -0.1%p -1.7%e (y/y) 1.2%p 0.9%e / CPI 1.1%p 0.9%e
• 0430 am UK Jan Public Sector net borrowing (PSNB) -GBP2.11bn p +GBP10.5bn e
• 0440 am Spain 3-5-10Y Bonos auctions
• 0500 am France 3-5Y BTAN auctions
• 0730 am ECB policy meeting accounts
• 0750 am Atlanta Fed Bostic speech
• 0830 am ECB Praet speech
• 0830 am Canada Jan ADP employment change -13k p -3k e
• 0830 am Canada Dec wholesale sales (m/m) -1%p +0.1%e
• 0830 am US weekly jobless claims 239k p 228k e
• 0830 am US Dec durable goods orders (m/m) 0.8%p 1.8%e / ex trans -0.3%p +0.3%e
• 0830 am US Feb Philadelphia Fed manufacturing index 17p 14e
• 0945 am US Feb flash PMI manufacturing 54.9p 54.7e / services 54.2p 54.3e / composite 54.4p 55.1e
• 1000 am US Jan existing home sales (m/m) -6.4%p +2.2%e / 4.99mn p 5m e
• 1000 am US Jan conference board LEI -0.1%p +0.1%e
• 1100 am US weekly EIA oil inventory 3.633mb p -1mb e
• 1250 pm BOC Poloz speech

Friday, February 22: Japan CPI, German IFO, FOMC policy forum, French finance summit

• 0530 pm RBA Lowe speech
• 0630 pm Japan Jan core CPI (y/y) 0.7%p 0.8%e / headline 0.3%p 0.2%e
• 0830 pm China Jan house price inflation (y/y) 9.7%p 9.4%e
• 0200 am German 4Q final GDP (q/q) -0.2%p 0%e (y/y) 1.1%p 0.6%e
• 0400 am German Feb IFO business climate 99.1p 98.9e / current conditions 104.3p 103.7e / expectations 94.2p 94.2e
• 0500 am Eurozone Jan final HICP (m/m) 0%p -1.1%e (y/y) 1.6%p 1.4%e / core 1%p 1%e
• 0600 am UK Feb CBI distributive trade orders 0%p +6%e
• 0830 am Canada Dec retail sales (m/m) -0.9%p +0.3%e / ex autos -0.6%p -0.3%e
• 1015 am NY Fed Williams speech
• 1030 am ECB Draghi speech
• 1100 am Canada Dec budget deficit C$2.2bn p C$0.3bn e
• 1200 pm FOMC Vice Chair Clarida speech
• 0130 pm FOMC Quarles speech

Conclusions: Are we about to see more volatility? The markets have been set up for ignoring bad news and exaggerating good ones. The price action for risk rests on the results of the next week from the ECB and FOMC minutes, from US/China trade talks and more economic data globally starting with flash PMI reports and, of course, the brewing geopolitical stories from UK Brexit to India and its Kashmir response. The role of central bankers in capping volatility has been absolute since 2009. But since 2014 and the first FOMC taper tantrum, shifting real policy has been difficult except for the US. Over the weekend, the French BdF head highlights the data dependency ahead. “The key question will be if the slowdown is temporary — with a bounce-back during this year — or more durable,” said Villeroy, who is head of the French central bank and seen as a frontrunner to succeed Mario Draghi as ECB President this year.  A more dovish ECB and a collared FOMC maybe the risk into the week ahead to consider. This would put the EUR back into the focus as a key barometer for equities and bonds everywhere. Watching 1.1180 for a breakdown with 1.08 risks for the rest of 1Q. A stronger USD won’t help global growth and will likely increase uncertainty and volatility. 

The role of politics as a risk to the EUR isn’t new and the May EU Parliamentary election are increasingly in play as a problem should more nationalist parties control the group as it sets up leadership roles for EU diplomats over the next 5 years. The risk for politics plays into the distrust of voters to governments as a whole. When you mix weaker economic growth with low trust in government you get surprising outcomes. Just as the UK and Brexit. The Spanish vote on April 28 and the May EU vote will be viewed with some doubts accordingly.