One of the most important forces shaping the investment climate is that the US is closer to beginning to normalize monetary policy than other major countries and regions. That gap may be measured in years, not months or quarters, and has not reached the apogee. The Federal Reserve will likely hike rates in the next six months, while other major central banks, from Beijing and Tokyo and Sydney, to Frankfurt and Stockholm, that are providing monetary policy for nearly 2/3 of the world economy are still committed to easing policy.

Since the middle of March, doubts have grown about the how close the Federal Reserve really is to raising rates. Stronger data from the euro zone and flows into the European equities also served to stem the dramatic dollar rise in Q1. A recovery in commodity prices and doubts about the Fed enticed flows back into emerging markets since late in Q1.  

The investment climate will become more treacherous in the coming months. Several key issues are going to come to a head. Chief among these is whether the US economy strengthens sufficiently to provide the Federal Reserve with the opportunity that it is looking for to begin to normalize monetary policy. The Federal Reserve regards the headwinds that slowed the US economy to be temporary. This needs to be born out in the data. Continued improvement of the labor market is a clear prerequisite.  

June is the first opportunity for the Fed’s lift-off. The weakness in Q1, which follows a now familiar pattern, has spurred a shift in expectations further out.  Since the recovery began in 2009, US growth in Q1 has singularly been disappointing, averaging 0.6% at an annualized pace. The average growth of the other quarters is 2.8%. September is understood to be the next such opportunity. 

The US handled China’s initiative for the Asian Infrastructure Investment Bank poorly. It served to strengthen the sense in some quarters that US global leadership is waning. There are two issues that will be decided in the coming months that will be seen in that light. Will the US trade initiative, the Trans-Pacific Partnership, come to fruition? If Congress does not grant the President trade-promotion authority, without conditions that antagonize the potential partners, the probability of a successful conclusion diminishes considerably. 

The other issue involves the future of the US Export-Import Bank. Will its life be extended beyond the end of June when the current authorization expires? Many Democrat constituencies have long been opposed to this socialism for businesses, where the government helps provide loans to foreign investors to purchase goods from US companies. What is new is that many Republicans are opposed. A compromise was forged last year, but now the supporters seem weaker and attention diluted by competition from other priorities. Ironically, China has recently indicated it will boost the funding of its Ex-Imp Bank by roughly $25 bln. 

The existential challenge to the irreversible European Monetary Union posed by Greece led by the Syriza government will be brought to a head. Negotiations for the first half of the four-month extension have results in recriminations on both sides. The end of June appears to be a hard deadline, and it is not clear that Greece has the money, or it banks the solvency, to last until then. 

There is no easy solution, but the failure to do so with Greece remaining within a monetary union, would be both economically and politically costly. Where Greece went in 2010, others followed. The debt overhang in Greece is but an extreme mutation of the virus that ails nearly every member of the euro zone (not mention among the major industrialized countries and many leading emerging markets, including China and Brazil). 

In the confrontation with Greece, European officials have an opportunity to gain experiential insight into dealing with two challenges that will likely recur. First is the election of a government that rejects the main thrust of collective policy, or at least, some basic elements of fiscal consolidation. This occurs simultaneously with overwhelming public support for remaining in the monetary union. It is entirely possible that political parties who resist austerity may come to power in other countries over the next couple of years.  Indeed, nearly every country has either on the right or left political parties that are critical of the entire European integration project. 

Second, under the guidance of regulators, banks are repairing their balance sheets, but governments are woefully behind. Whatever monetary union means it must be elastic enough to allow for the restructuring of government debt. It has so far in the sense that private sector investors in Greece and Cyprus have already experienced losses as the debt was restructured. 

We did not think Greece would leave the monetary union in 2011-2012. We argued that many investors had not given sufficient due to political considerations.This assessment still seems valid. The political will determined that monetary union is irreversible has consistently been under-estimated. At the same time, a cost-benefit analysis would suggest that a 50% reduction in Greece’s outstanding debt that is in official hands is still less than the full costs of what  would likely be incurred were Greece to leave. 

II

The UK election is a known unknown. Although the Scottish referendum on independence was defeated, it triggered political reverberations that are shaping the UK’s political landscape. The strength of the Scottish Nationalist Party will give it a significant bloc in parliament. Both the Conservatives and Labour are statistically in a dead heat with just less than a third of the electorate each, according to the polls. 

It is one thing to have a coalition government, for which the British are not particularly comfortable. If one thinks this is a good definition of a hung parliament, imagine a minority government. While there are numerous permutations that are theoretically possible, the one that remains the most compelling is a Labour-Lib Dem minority government, supported on votes of confidence by the Scottish Nationalists. The polls suggest the Lib-Dems will likely loose seats in the new parliament, and enough seats at that to make a repeat of the configuration unlikely. The SNP would not support a minority Conservative-led government. 

A Labor-led minority government would likely be seen as sterling negative by investors. It is like Woody Allen’s complaint about a restaurant where the food was bad and portions small. Such a government would be perceived as fragile and in pursuit of policies that are more difficult for business. 

At the end of last October, the Bank of Japan surprised investors by increasing the size of its already large asset purchase program and did so on the basis of a 5-4 vote. Since then the composition of the BOJ board has since slanted more dovishly, and the economic recovery from the contraction in April-September 2014 has been weak and uneven. Price pressures have evaporated. 

However, the BOJ does not seem to be in a particular hurry to respond with additional easing. It continues look past the recent inflation trends and anticipate a renewed pick-up later this year. Political pressure from the Abe government also seems at a low ebb. Perhaps there is a greater appreciation for the lack of export sensitivity to yen depreciation. The economic performance in the coming months will determine whether more stimulus is needed and the form it would take. 

China will impact the investment climate on two channels. First, the economy appears to be slowing down faster than desired, and policy makers have begun easing monetary policy more broadly and forcefully than before. In addition, some of the PBOC’s reserves have been earmarked for the so-called policy banks that are used to support public investment. There are reports suggest the PBOC is also considering either a form of quantitative easing and/or a new loan facility, like the ECB’s Long-Term Repo Operation and some features of the Bank of England’s Funding for Lending program. 

Second, Chinese officials are taking more steps toward opening up the financial system. Officials have been adept at taking advantage of market conditions to sequentially time its reforms. They recently took advantage of the rising stock market, which they had encouraged, to deepen the securities lending market and the ability to short stocks. This facilitates portfolio insurance.  
China is experiencing capital outflows. There are reports officials are looking at revamping or abolishing completely the QFII quota system that regulated capital inflows, for example. Before significant banking reform can be implemented, depositors have to be protected. China is expected to launch a preliminary deposit insurance program by the end of May. 

There is another impetus as well. China has been campaigning to have the yuan included in the IMF’s SDR basket.  In order to make the most compelling case, additional liberalization steps will likely be delivered. A preliminary discussion is expected in May to be followed by a formal decision later this year. The SDR composition is reviewed every five years. 

OPEC holds a semi-annual meeting in June. Recall, that oil prices had fallen for a few months before OPEC’s meeting last November when it decided not to cut back on output. Perhaps the decline was initially more function of weakening demand. However, it appears to have transformed it into supply story. 

Oil prices stabilized and traded higher.  With ideas that US output cuts will follow with a lag the decline in drilling acts as a modest floor, but it may discourage OPEC from cutting production in H2 15. Even the modest firming of prices is reportedly reviving some US production in parts of Eagle Ford and Permian shale deposits in Texas and New Mexico. Moreover, there has been a marked increase in the amount of oil wells that have been drilled, but capped pending better market conditions. Under such conditions, keeping it in the ground is like cheap storage. 

Saudi Arabia is expected to take some economic liberalization steps itself over the coming months. It has indicated it will launch a program loosely based on China’s QFII that will permit large institutional investors access to the Saudi stock market. There will be caps on foreign ownership of the entire market (10%) and individual stocks (20%). Such a program is a first tentative step and is unlikely to lead by themselves to Saudi Arabia’s inclusion in the MSCI frontier index. Nevertheless, it may prove to be turning point. 

III

The US dollar’s rally in the first part of the year was among the strongest of the floating rate era. The news stream has cooperated with the technical need for some consolidation and adjustment. The shift in US rate expectation coupled with a significant portfolio shift into European stocks and, starting in March into emerging market equities, has taken the wind from the dollar’s sails.  It is clear that speculators have reduced short currency exposure in the futures market. 

Our bullish dollar view was based on the divergence of the trajectory of monetary policy that puts the US ahead of Europe, Japan, and China. While we recognize this is a well-known story now, we do not believe that this can be full discounted. The interest rate curves provide financial incentives to the marginal new unit of savings, the fund manager assessing the cost of currency hedging, and a corporate Treasurer’s decision how to finance a project. 

The peak divergence in monetary policy still lies several quarters at least ahead. The inability to find a floor for European interest rates, while the ECB’s asset purchase program is hardly a couple months old, portends greater distortions going forward. The use of the central bank’s balance sheet and that zero is not the lower bound of interest rates are the two innovations from this crisis, and Europe is utilizing both. 

In a larger sense, this is the third dollar bull market since the end of Bretton Woods. To put this bull market in perspective, we use the euro (and its equivalent prior to 1999), which corresponds closely to the US broad trade-weighted index as a proxy. During what can be calling the Reagan dollar rally, the euro’s equivalent depreciated by almost 60%. During what can be dubbed, the Clinton dollar rally, the euro depreciated by 45%. The Obama dollar rally has seen the euro depreciate 35% from its 2008 peak near $1.60. 

If the Obama dollar rally were to match the Clinton rally, the euro would trade toward $0.8800.  If the Obama dollar rally were to match the Reagan rally, it would fall to $0.6400. We have tended to discount a repeat of the Reagan dollar rally because the policy mix will not be as supportive as it was under Reagan and Volcker and US leadership seems weaker. Even if the dollar still dominates the global economy, there are a greater number of alternatives. At the same time, the prolonged divergence and the negative interest rates in Europe and unprecedented pace of monetary easing in Japan warns that the overshoot might be larger than what was experienced under Clinton.  

Both the Reagan and Clinton dollar rallies ended with coordinated central bank intervention, which is to show that the trends take a life of their own and can be sustained for years. There are different phases of the dollar bull market. The next leg up likely requires a stronger sense that the Fed will get the opportunity it is looking for, and European rates continue to go where no rates have gone before