Pieces of Eight: Drivers in the Week Ahead
The fourth quarter begins with a bang. The US government risks closure due to an inane argument over authorizing continued government spending and issuing debt to cover the past spending that was authorized. Provided the US government is open, the important monthly jobs report is due out at the end of the week. The Italian government appears to have collapsed over the weekend. Three central banks from high income countries meet (RBA, ECB and BOJ). A free trade zone was launched in Shanghai as the country begins a holiday week, closing Chinese and Hong Kong markets. The latest purchasing managers surveys from around the world will also be reported.
Below we provide a thumbnail sketch of these eight drivers.
1. US fiscal brinkmanship: It remains unclear at this juncture how the events in the US Congress will play out. There are two separate issues. The first is the continuing resolution that allows the government to continue to spend money in lieu of a proper budget. The second issue is the debt ceiling, which allows the government to borrow funds to pay the spending that had already been authorized. The former has a potential for a greater direct impact on GDP. The drag is a function of the number of workers actually furloughed and for the length of time. The three-week shutdown in 1995-1996 is thought to have cost about 0.25% of GDP.
The second may have a greater indirect impact on the economy. The ramifications of a default on US debt is hard to estimate a priori. Although we recognize the risks and the fact that the cost of insuring US debt has risen by about 50% since the start of the month (5-year credit default swaps), the risk of default seems minor. In fact, even now at this late date, the cost of insuring US debt is less than Japan and France (remember the US insurance is in terms of euros, while others are denominated in dollars). The historical experience and surveys warn that voters will more likely hold it more against the Republicans than the Democrats.
2. The fragile government in Italy faces its biggest challenge to date. Before the weekend the cabinet failed to approve key measures that could have averted the VAT hike and continued to fund the temporary lay-off program (CIG). Apparently, the beleaguered prime minister threatened to resign and was talked off the edge by President Napolitino. Instead, it was Berlusconi's allies center-right ministers who resigned early Saturday. Early elections may suit them, as the center-right is ahead in the polls, and it may forestall a Senate vote to enforce Berlusconi's ban from public office. The center-left remains divided between Letta and Renzi, with a leadership contest not scheduled until early December. One of the failures of the Letta government has been the inability to proceed with electoral reform. It is not yet clear if a new coalition can be cobbled together to prevent a new round of elections under the old arcane rules. Italy's 10-year bond was the worst performer in the EU last week with a 15 bp increase in yields and the cost of insuring Italy debt rose to its highest level in two months. Although Italy's most acute challenges may be country-specific, knock-on effects, especially in other periphery countries cannot be ruled out.
3. Of the central banks from the high income countries that meet next week, the Reserve Bank of Australia may be most interesting. The statement following the September meeting encouraged many market participants to think that with the cash rate at a record low of 2.5%, the RBA's easing cycle was complete. However, economy continues to appear fragile and even with last week's slippage, the Aussie is still about 4.5% stronger than it began the month. We expect the RBA to signal to investors that there is indeed scope for lower rates, provided inflation remains anchored. Barring a significant surprise when Q3 inflation data is made available (Oct 22), we think the odds favor a November rate cut.
4. The ECB meeting will be held Wednesday (Oct 2) instead of Thursday due to the German reunification holiday. The ECB is not going to change policies. President Draghi is likely to reiterate the forward guidance that rates will remain here or lower for an extended period. He will also promise the ECB stands ready to do more if needed. Although the excess liquidity in the system is drained through the LTRO payments, Draghi is likely to argue that this will not necessarily force up EONIA. Some quarter-end pressures appear evident. A new LTRO offering is not imminent, though we think the risk rise at the end of the year and into Q1 14. There may also be some more details about the release of minutes, or some record of the discussions, but is unlikely to be a market mover.
5. The BOJ meeting on Thursday is unlikely to decide to change its policy. BOJ Governor Kuroda is likely to reiterate that if the retail sales tax hike threatens to derail the economy, it is prepared to take additional measures. BOJ officials cannot be content with last week's news that core CPI, which is what the central bank targets (excludes fresh food), even though it rose to a 5-year high of 0.8%. The weakness of the yen has contributed to a sharp increase in energy prices and once this is excluded from the measure, deflation is still evident. Separately, though related, we note that the Japanese government is doubly punishing households. Inflation is rising faster than wages and the government seem intent on raising the retail sales tax. Individually and together, this double-whammy threatens to undermine consumption and a tax break for businesses cannot really offset this.
6. We have been impressed by the number of measures the new Chinese government has taken toward liberalization of its capital markets. The free-trade zone in the outskirts of Shanghai that was launched over the weekend is another important step in this direction. It is an experiment and will give investors a sense of what the near-future may look like. Without providing a time frame, or much in the way of specifics, the government says that in the free-trade zone, the yuan will be convertible under the capital account and greater interest rate liberalization. Chinese banks will be able to conduct business offshore and Qualified Foreign Institutional Investors (QFII) will be allowed to set up banks in the free-trade zone. Reports indicate 25 companies and 11 financial institutions have already received permission to set-up operations. Chinese officials had tried what appears to be a similar attempt last year in Qianhai (near Shenzhen) last year, but the results have fallen well shy of expectations. That this did not deter officials from trying it again in Shanghai speaks volumes.
7. Provided the US government is open, investors expect to see the September jobs reports at the end of the week. It is among the most important economic reports in the monthly cycle and often sets the tone for other data, such as personal income, industrial production, and construction spending. There are few inputs for economists, but we do know that weekly initial jobless claims have continued to trend lower. This year the US has averaged about 180k net new jobs a month. In 2012, the average was about 183k--statistically the same. Such a stable average makes it a relatively easy forecast. Regardless of what the actual report shows, we attribute a near-zero probability of an October tapering move by the Fed.
There are other economic reports due over the course of the week. The purchasing managers surveys and Japan's Tankan are scrutinized by investors and policy makers. We note that the euro area PMIs will be released after the ECB meeting because of the German holiday, so this may reduce their market impact.
The preliminary September CPI report for the euro area will be released Monday. The risk is to the downside of the consensus 1.2% headline rate (after 1.3% in August). Soft German and Spanish figures before the weekend highlight this risk. The Fed's concern about the persistence of below target-inflation is unlikely to be echoed by the ECB, but if not checked, the disinflationary forces can morph into deflation.
Japan starts the week with August industrial production and retail sales figures. The former may slip after the out-sized 3.4% rise in July, while retail sales may bounce back after the 0.3% decline in July. The US reports auto sales figures. These are particularly important now because of the sector's traditional sensitivity to interest rates. Industry data warns of the potential for a decline in September, which would be the second decline in three months.
8. The portfolio flows since the Fed's decision not to taper are interesting. From various industry reports, we see a modest rotation of sorts from equities to fixed income. Bond funds snapped a nearly two-month streak of outflows. The $4.5 bln inflow reported by one industry tracker is the most in five months. Equities saw a net outflow of $1.5 bln, but this masks a clear divergence. US equity funds experienced an outflow of about $7.5 bln, while European equity funds saw a $2.3 bln inflow. That was the thirteenth consecutive week of inflows, the longest streak in eight years. Emerging market debt reported experienced inflows (albeit minor ~$0.5 bln), but the first inflow in 18 weeks. The longest streak though still belongs to floating rate debt funds, where net inflows have been experienced for over a year.
Separately, we note that Japanese investors bought foreign bonds for the second consecutive week. The Federal Reserve custody holdings for foreign central banks rose by $5 bln, which is the most in about a month. Among emerging Asian equities, South Korea and Taiwan remain favorites, with $1.08 bln and $0.89 bln net inflows in the past week. This is really continuing the pattern seen for several weeks. Through September 27, foreign investors have bought $7 bln of South Korean equities and $4.3 bln worth of Taiwanese shares. India, for which data is only available through September 26, saw about $136 mln inflow into its equities last week, but $2.1 bln here in September.
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