Week Ahead: Shutdown, SPD, BOJ, ECB, BNM, Brazil Lula Court

North America: At the time of writing, the US government is in partial shutdown. Assuming no breakthrough comes from highly unusual Saturday sessions of both the House and Senate, markets will absorb the implications of the shutdown, which was only realized well after market close when a Senate floor vote failed (50-49) to meet the 60 votes needed for a continuing resolution; five senators from each side crossed party lines. This week, sixth round Nafta talks begin Tuesday in Montreal (23-28 Jan). After a relatively quiet start for economic data, the US sees Markit PMI (Wed), wholesale inventories (Thu) and Q4 GDP, durable goods, and two price measures – core PCE and GDP price index – on Friday. The regional Fed branches have GDP proxy estimates that range from 3.1–3.9% (consensus 3.0% qoq ann, prior 3.2%). Also on Friday, Canada releases CPI, where consensus forecasts are in a wide range from 1.7% to 2.5% yoy (standard deviation 0.19ppts, prior 2.1%).

• Trade idea – Tactical long S&P 500 volatility: Risk appetite is likely to stall and potentially wane the longer that the US government shutdown persists. The last government shutdown (1-17 October 2013) is estimated to have shaved 0.5ppts to US 4Q13 GDP growth. During the two-week government shutdown in 2013, VIX rose - peaking at +25% after seven days - while SPX fell 2.5% before rebounding strongly (see chart). Reaction in DXY and UST 10s was relatively muted. Last week, we hedged our cautiously bullish view on US equities and positioned for underappreciated risks of a shutdown via long VIXY in anticipation that Senate Democrats would stand their ground on the Deferred Action for Childhood Arrivals. The Democrats’ political calculus favored using the stopgap bill as leverage to protect DACA given its widespread American voter support. This shutdown may resolve itself in days or weeks, though another shutdown cannot be ruled out. The stopgap bill is only anticipated to provide funding through 16 February, possibly sooner (if the Senate bill expires before the House version). The risk to this trade is a quick resolution to the shutdown showdown (eg DACA adoption by the GOP and the White House, which has insisted on reopening the government first before tackling immigration).

• Monitor – US Treasurys: This week, we are agnostic US Treasurys and see the 10-year yield ending the week above and around Jeff Gundlach’s 2.63% bear-market threshold (last 2.66%). Marginal safe haven demand from risks of a protracted government shutdown may be offset later in the week by a strong Q4 core PCE deflator (consensus 1.9% qoq, prior 1.3%) given the market’s current sensitivity to inflation trends. However, we stay bearish UST 10s on a strategic basis – seeing 2.85% by April 2018, in large part due to cases of higher wage pressure (e.g. Walmart nationwide salary hike) and evidence of rising core price pressure ( points to Cleveland Fed's core price gauge - see  , 19 Jan-18).

Market reaction during the last government shutdown (1-17 October 2013)

Asia-Pac: The BOJ’s press conference and outlook report will dominate headlines early in the week (Tue), in particular, given speculation over ‘taper talk’. Japan also reports all-industry activity and machine tool orders (Tue), trade and PMI (Wed) and nationwide CPI (Fri). Elsewhere in Asia are Philippines GDP and Singapore CPI (Mon), Malaysia CPI (Wed) as well as Korea GDP and Bank Negara Malaysia meeting (Thu). Also on Thursday, New Zealand will release its important quarterly CPI figure for Q4 where we think risks are skewed to the upside (consensus 0.4% qoq/1.9% yoy, prior 0.5%/1.9%).

• Trade idea (conditional) – Tactical short EUR-JPY at 136+ around BOJ MPC (target 134 by end-of-week, last 135.4): Whilst we are neutral JPY vs the USD (109-113 forecast range in 1Q18, last 110.8), we prefer it to EUR in the very near-term (last 1.222). This bias is supported by both divergent extended positioning (long EUR, short JPY – see chart) as well as recent central bank headlines – specifically, 1/ Reports that a minority within the BOJ are discussing policy normalization and 2/ ECB Governing Council members' recently-expressed discomfort over the pace of EUR strength. Japanese growth is steadily broadening (see  , 14 Jan-18). In our view, additional data consistent with gradual Japanese economic and price recovery in the coming week – machine orders (Tue) and inflation (Fri) – would make it more challenging for the BOJ to talk down the yen than it is for the ECB to talk down the euro. We see upside risk to Japan's national CPI ex-fresh food print this Friday (consensus 0.9% yoy, prior 0.9%). The risk to this view is that the BOJ on Tuesday somehow reverses the momentum that is building around eventual – though by no means imminent – policy normalization. For instance, it could signal a willingness to double-down on additional QQE if necessary (eg by expanding yield curve control to other tenors on the JGB curve). Externally, a moderate risk-off mood – possibly stemming from an extended US government shutdown – would add a tailwind to this trade. A euro-positive outcome from Germany’s SPD delegate convention on Sunday would provide an attractive entry-level and timing to tactically short EUR against JPY. 

Until last week, CFTC leveraged fund positioning was the most net long EUR since 1H14 (top chart). Leveraged funds are still more short JPY than its 5yr average (bottom chart). USD positioning is more neutral (middle chart)

• Trade idea – Strategic long MYR/MSCI Malaysia (via EWM, through at least 16 Feb-18): We stay long  on sustained improving confidence around the Ringgit -  - which has rebounded over the past year (MYR was the best-performing Asia FX over the past 1-, 6- and 12-month periods). A prospective BNM rate hike this week – as seen by 7 of 10 economists in Bloomberg’s survey – would further support MYR outperformance. If the central bank opts to stand pat (we assign 50-60% probability), a ‘hawkish hold’ may be sufficient to maintain positive sentiment around the currency. Portfolio inflows have risen in November and December and this may continue further given little evidence of overweight foreign positioning, particularly in fixed income (global investors have net sold $620m in bonds in 2017). In equities, current month-to-date net equity inflows ($569m) are the highest since April 2017 (see chart). Domestic politics remains a risk ahead of elections that must take place by August 2018. However, if PM Najib dissolves the parliament shortly after Lunar New Year (16 February) - as recently speculated (15 Jan-18, ), this not only implies an earlier election date between March and early May (before Ramadan, from 15 May-14 Jun). More importantly, it could indicate some degree of confidence within the ruling BN coalition that it stands a better chance of preserving its 60% parliamentary majority by calling elections sooner rather than later. Policy continuity and - above all - a clear election outcome would be positive for Malaysian assets. It bears emphasizing, however, that an early election date by no means guarantees the outcome that the BN coalition is seeking, which is a reason to re-evaluate this trade in 2H-February (see 's three scenarios: , 17 Jan-18). Elsewhere this week, Malaysian CPI (expected Wednesday) is expected to inch higher from 3.4% to 3.5% yoy, supporting the case for a less dovish stance from the BNM.

Portfolio inflows – into bonds (in red, net monthly) and especially equities (in blue, net monthly/cumulative daily) – have risen in November and December, buoying the MYR

Europe: The main event this week is the ECB meeting (Thu). The press conference provides President Draghi the opportunity to reiterate the bank's views on a fast-rising euro - echoing three ECB officials (Costancio, Nowotny and Villeroy) who spoke out on euro strength over the past week. Economists estimate that a 10%-rise in the trade-weighted EUR would cut inflation by 0.5ppts (in 2017, the euro rose 5% according to the BIS REER measure – see chart). Formal ECB guidance is unlikely to change until updated economic forecasts are available by the 8 Mar meeting. Also on Thursday is Norges Bank’s rate-setting meeting, where no change is expected. Wednesday brings Eurozone PMIs as well as important UK labor data. German confidence surveys are released on Tuesday (ZEW) and Thursday (IFO, GfK). Sweden’s Riksbank governor Ingves speaks (Tue) ahead of economic data later in the week: unemployment and PPI (Thu) and retail sales and household spending (Fri). The annual World Economic Forum in Davos begins Tuesday and ends Friday.

The euro's 5% appreciation in trade-weighted BIS REER terms is a challenge to the ECB's inflation objectives

• Trade idea – Strategic long DAX (target 14,000 before 8 March ECB MPC): As we went to press, SPD delegates have yet to approve formal coalition talks with Merkel’s CDU-CSU bloc. Presuming that the SPD party leadership will have overcome internal divisions (ex-SPD chair Kurt Beck last Thursday predicted 60% of delegates to vote in favor), this should provide a boost to German equities, which have underperformed EU peers. The DAX – even after last week’s significant 1.4% rally – continues to trail the CAC, UKX, FTSEMIB and Ibex indices since ‘Jamaica coalition’ talks broke down on 20 November. Once a coalition pact is formalized (a process that may take ~2 weeks), the agreement would still need to be approved by 400k SPD party rank-and-file members - a task that SPD leaders believe will be easier compared to the delegate convention. As details of the coalition pact are finalized, we would monitor the reaction from the SPD's youth wing, 'Jusos', as well as any departures from the 'grand coalition' blueprint that led to Sunday's vote (, 21 Jan-18). On the economic front, strong results from this week’s PMI, IFO and ZEW business surveys (and GfK consumer confidence – see chart) would add to positive sentiment. In addition to DAX futures, we also own a strategic long position on  given our benign medium-term view on the Euro (1.20-1.25 forecast range through 1H18).

Germany IFO, ZEW, PMI and GfK consumer confidence data this week could provide additional evidence of underlying economic strength

EM ex-Asia: In LatAm economic releases, we await Mexican economic activity and Brazilian mid-month inflation (Tue), Argentina economic activity and Mexico bi-weekly inflation (Wed) and Mexico retail sales (Thu). Argentina’s BCRA meets Tuesday. Brazilian political risk will feature on Wednesday when an appeals court is expected to rule on whether to uphold the corruption and money-laundering conviction of ex-president Lula da Silva. For his part, Lula still intends to declare his presidential bid ‘in defiance’ the next day regardless of the outcome. In EMEA, South African CPI is reported Wednesday, while the two-day Czech presidential run-off election begins Friday. 

• Trade idea – Strategic short Brazil Bovespa (via EWM, through at least mid-February's tentatively scheduled pension reform vote): We initiate a short position on . Brazil has recently outperformed MSCI Latin America and broken out of its technical range, as  noted (see , 19 Jan-18). This rally has largely ignored the recent S&P downgrade (to BB-, stable) and growing risks that the Temer administration – lacking the necessary votes – may be forced to delay next month’s crucial pension reform vote until after the October presidential elections. If the pension reform vote is delayed - or worse yet, fails - it would reflect the political reality that the window of opportunity for structural reform has closed despite best efforts by the Temer administration. Such a delay would presage additional sovereign downgrades from either Fitch and Moody's (both are one notch above S&P at BB, with negative outlooks). This week, we especially see poor risk-reward on Brazil assets ahead of Wednesday’s appeals court decision, where it is difficult to imagine any positive outcome. Whether or not the appellate court upholds Lula’s sentence, his Workers’ Party (PT) is expected to launch his candidacy and lodge an appeal. Lula is unlikely to back down as long as opinion polls continue to show him as the front-runner. The question of Lula’s eligibility to run in the October elections may not be clear until just a month before. Heightening political risk is also coinciding with the probable end of the BCB's easing cycle (current Selic: 7.00%), a trough in inflation (set to rise from 2.95% yoy in Dec-17 to 4% by mid-2018) and a plateau in economist upgrades for growth (consensus 2018f GDP growth of 2.5% yoy). Elsewhere in LatAm, we also hold a negative bias towards Mexico where economic trends point to modest 'stagflation' dynamics that are aggravated by uncertain Nafta negotiations and a contentious election in June. In contrast, we are relatively more positive on Andean markets (Chile, Peru, Colombia) and Argentina.