Kiron Sarkar Weekly Report 8.30.14

In spite of the increased geopolitical tensions, oil prices (Brent) have not risen by as much as normally would be the case. Prices are still being impacted by Libya as it increases its production and exports (though internal fighting has increased, which could threaten supplies) and by rising oil production from territory controlled by the Kurds in Iraq. US production is also increasing. A decision by a US district Court stated that they lacked authority under federal laws governing stolen property at sea. This will allow oil supplies from Kurdish held territories in Iraq to be exported to the US, which the government in Baghdad claims belongs to the Iraqi state. Brent (October) closed at US$103.19, up less than US$1 on the week.

The continuing material decline of Eurozone (EZ) bond yields to record lows on expectations of further monetary stimulus (very likely) by the ECB (to counter deflationary trends and a slowing economy) and on geopolitical concerns is having the effect of reducing US bond yields, as investors move to US markets on, inter alia, fears that the EZ is slowing down, increased concerns about escalating tensions in the Ukraine and elsewhere and that the Euro will weaken further. The 10 year German and US bonds closed at yields of +0.89% and +2.34% respectively.

Bloomberg reports that Blackstone have been appointed as advisers to the ECB in respect of their proposed purchases of asset backed securities (ABS). At Jackson Hole, Mr Draghi virtually committed the ECB to implementing such a programme. The big question is whether the ECB will go for a fully blown QE programme and buy EZ government bonds. I suspect that the ECB will wait to see how their TLTRO and (most likely) their ABS purchase programme develops before deciding, which suggests that no decision will be taken until after the New Year.

Inflation in the EZ continues to decline to just +0.3% Y/Y in August. In addition, the EZ economy has stalled, indeed it seems to be declining somewhat. Germany, which had been the driver in the EZ, reported a fall in retail sales in July – to date the domestic economy had held up. On the other hand, US economic data continues to improve, though July consumer spending admittedly was disappointing, as was wage growth. The differential in growth and inflation expectations (hence interest rates) will, I believe, result in the Euro declining to US$1.30 in the short term, with a further fall to US$1.25 (or even lower) thereafter (in Q1 2015?).

Unsurprisingly, the meeting between the Presidents of Russia and the Ukraine yielded little. Furthermore, it appears that Russian troops have entered the Ukraine and have started a new front in the South of the country. As I feared, Mr Putin will not want the pro-Russian separatists to lose, which looked likely as the Ukrainian army was gaining the upper hand. Further sanctions are likely to be imposed on Russia. I continue to believe that this crisis will last for quite a while and, as a result, favour US, rather than EZ equities. German markets are particularly vulnerable. In Europe, I prefer UK over EZ equities. The S&P closed over 2000 and at a record high on Friday.

Markit’s flash August services PMI came in at 58.5, lower than July’s 60.8, though above the forecast of 58.0. The preliminary composite PMI reading came in at 58.8, lower than July’s 60.6.

New home sales declined by -2.4% in July to an annualised rate of 412k, down from an upwardly revised 422k in June and expectations of 430k. However, the previous 3 months data was revised higher. Inventories of new homes rose to a 6.0 month supply, up from 5.6 months in June and the highest since October 2011, though still at historic lows.

July pending home sales rose by +3.3% M/M, above the rise of +0.5% expected and the decline of -1.3% in June.

US durable goods orders surged by +22.6% in July M/M, though the gain was due to a sharp increase in aircraft orders. Non defense and ex aircraft orders, a better indication of future business investment, declined by -0.5%, well below the upwardly revised increase of +5.4% in June (+3.3% previously) and as opposed to the forecast for a rise of +0.2%.

US consumer confidence rose to 92.4, up from a downwardly revised 90.3 in July and at the highest level since October 2007. The present situation component rose by the most, to 94.6, up 87.9 and the highest since February 2008. However the expectations component declined to 90.9, down from a revised 91.9. Consumers assessment of labour markets improved, with the jobs plentiful component rising to 18.2, up from 15.6.

US weekly jobless claims came in at 298k, marginally better than the 299k the previous week and the forecast of 300k. The less volatile 4 week moving average came in at 299.75k, as opposed to 301k previously. Continuing claims rose by 25k to 2.527mn, slightly higher than the rise to 2.51mn expected.

US annualised Q2 GDP (second reading) was revised higher to +4.2% (a decline of -2.1% in Q1), up from an initial reading of +4.0% and better than the +3.9% expected. Business investment rose by +8.1% on an annualised basis, the most since Q1 2012, which is positive for the future. Corporate profits rose by 8.0%, the most in nearly 4 years.

Consumer spending declined by -0.1% in July M/M, below the +0.4% increase in June and the expected rise of +0.2%. It was the 1st decline in 6 months. Personal incomes rose by just +0.2% (the lowest increase this year), below the rise of +0.3% expected and the upwardly revised increase of +0.5% in June. The savings rate increased to +5.7%, the highest rate since December 2012. The core PCE index came in at +0.1% M/M (+1.5% Y/Y), in line with expectations and below the FED’s target of 2.0% Y/Y. The slow increase in wages is impacting domestic consumption, though the decline in energy prices in August should help.

The August Chicago PMI reading came in much stronger at 64.3, well above the 56.5 expected and 52.6 previously. It was the highest reading since May.

President Hollande reshuffled his cabinet and removed a number of left wingers who have been opposing his policies in recent months, in particular Mr Montebourg, the former economy minister. Mr Hollande’s PM, Mr Valls, who is considered a reformist, presented the resignation of the government on Monday and announced the personnel changes last Tuesday. In addition to Mr Montebourg, 2 other ministers were replaced. Mr Hollande may well face a rebellion from the more left wing elements of his party in due course. Political instability is the last thing that France needs at present.

EZ inflation (CPI) increased by just +0.3% Y/Y in August, lower than the +0.4% in July, though in line with expectations. Lower energy prices resulted in the decline. It was a 5 year low and well below the ECB’s target of 2.0%. The core inflation rate rose to +0.9%, up from +0.8% in July. The lower inflation rate strengthens the case for additional monetary accommodation by the ECB, quite possibly as early as next week – an ABS purchase programme? EONIA, the EZ’s overnight lending rate was fixed at -0.004% on Friday, which suggests that the market is pricing a move by the ECB next week.

EZ August economic confidence came in at 100.6, below the reading of 102.1 in July and the 101.5 expected. However, consumer confidence came in unchanged at -10.

German business confidence (the IFO index) declined for the 4th consecutive month. The IFO business climate index declined to 106.3 in August, down from 108.0 in July and below the forecast for a decline to 107.0. The current conditions component fell to 111.1, down from 112.9 in July (112.0 expected), with the future expectations component coming in at 101.7, down from 103.4 in July and below the decline to 102.1 expected. The weaker recent economic data suggests that the Bundesbank’s forecast for 2014 GDP of +1.9% will need to be cut to at best +1.5%, with the risks remaining to the downside.

German September consumer confidence declined to 8.6, down from 8.9 in August and the forecast for an unchanged 8.9. However, the expectations component declined to 10.4, down from 45.9, the largest fall since records began. To date, the domestic economy, together with the construction sector has been the main driver of the German economy. German unemployment unexpectedly rose in August, albeit by a modest -2k, though worse than the improvement of +5k expected. In addition, CPI came in unchanged M/M in August, +0.8% Y/Y, in line with expectations. However, German retail sales were particularly disappointing, declining by -1.4% M/M, the largest fall since January 2012 and well below the rise of +0.1% expected. Furthermore, the June data was revised lower to +1.0%, down from the +1.3% rise announced initially.

French manufacturing confidence declined to a 13 month low in August, slipping to 96, down from 97 the previous month, though in line with expectations. Overall French business confidence declined to 91, down from 93 in July and below expectations of 93. Producer prices declined by -0.3%, below the unchanged level expected.

Italian August consumer confidence declined to 101.9, lower than the 104.4 in July and the forecast of 104.0. Business confidence came in at 95.7, lower than the 99.1 in July and below the forecast of 99.2. The unemployment rate rose to 12.6% in July, higher than the 12.3% previously. Italian flash CPI rose by +0.2% in August M/M, above the +0.1% expected and the decline of -0.1% in July. On the EU’s harmonised basis, prices declined by -0.2% in August M/M, the same % decline Y/Y and the largest fall since July 2002. However, retail sales came in unchanged, as opposed to a decline of -0.6% in the previous month and the drop of -0.5% expected. Q3 GDP is forecast by the Italian statistical agency to be flat, though I suspect the risks are to the downside.

Spanish Q2 GDP rose by +0.6% Q/Q, as reported initially. Domestic demand is improving. However, CPI declined by -0.5% Y/Y, the largest drop since October 2009, though better than the decline of -0.6% expected. The Deputy Prime Minister announced that its economic forecasts would be raised next month.

A CBI survey reported that pay settlements by UK manufacturers were around +2.6% higher in the period February to July. The BoE recently reported that wages would grow by just +1.25% annually. Early days, but this data may suggest that wages are beginning to rise.

At the Jackson Hole conference, the BoJ governor, Mr Kuroda acknowledged that the BoJ may have to increase its stimulus programme if the economy does not meet the BoJ’s forecasts, though believed it was sufficient for the present. He stuck to the BoJ’s economic forecasts, which expects that the domestic economy will grow by +1.0% for the fiscal year ending 31st March 2015, with inflation set to rise to 2.0%. However, most analysts believe that GDP will increase by just +0.4% and that inflation (ex the impact of the sales tax increase) will not reach the 2.0% target. The chances are that the BoJ will have to increase the size of its asset purchase programme later this year. Mr Kuroda also stated that the Yen was still too strong. The Yen weakened following his comments.

Japanese industrial production rose by just +0.2% in July M/M (-0.9% Y/Y), much less than the rise of +1.0% expected, though better than the decline of -3.4% in June. Consumer prices, ex fresh food, rose by 3.3% Y/Y in July, the same rate as in June. Excluding the impact of the sales tax rise and fresh foods, CPI rose by +1.3%, below the BoJ’s target of 2.0%, which suggests that the BoJ is unlikely to meet its target. Household spending declined by -5.9% Y/Y, more than twice the decline expected, as wage increases have been much less than inflation. The data highlights the weakness of the Japanese economy following the sales tax rise on 1st April this year and puts more pressure on the BoJ to increase the size of the Central Bank’s monetary stimulus. Furthermore, the proposed further increase in the sales tax next year must be questionable, which raises the question as to how the government will raise the revenue it needs, in particular as it wants to increase spending, including on defense.

Japanese 10 year bonds are yielding below 0.50%. As the government pension fund, the GPIF increases its allocation to equities and foreign assets, whilst reducing its holdings of Japanese bonds, the yield on Japanese bonds should rise. However, the BoJ may have to increase its bond buying programme later this year, which should stem a sharp rise.

The Chinese finance minister stated that local governments can apply to sell bonds to refinance more expensive debt, though the central authorities will control the overall level of debt.

The Russian economy minister has increased the country’s 2014 inflation forecast to 7.0% – 7.5%, up from 6.0% previously. He left the 2014 GDP forecast at +0.5%, though cut 2015 GDP forecast to +1.0%, down from +2.0% previously. The economy contracted in June and July and Bloomberg reports that GDP is forecast to increase by +0.3% this year. However, I believe that a recession in 2014 is more likely. The Rouble hit an all time low against the US$ on Friday.

GDP in South Africa increased by +0.6% on an annualised basis in Q2 (forecast +0.9%), having contracted by -0.6% in Q1. Strikes in the mining sector in the earlier part of the year impacted growth. The finance minister stated that he would probably reduce 2014 GDP forecast to +1.8%, down from +2.7% previously, though I suspect the risks are too the downside. The rand has been decidedly weak since the start of the year and a further decline looks likely.

Brazilian Q2 GDP declined by -0.9%, with Q1 revised to a decline of -0.2%, from +0.2% reported previously. Brazil is now in a technical recession. Ms Marina Silva’s chances of beating the incumbent Ms Rousseff in the October Presidential election has increased.

Indian calendar Q2 GDP rose by the highest pace in 2 years to +5.7% Y/Y, above the +4.6% rate in Q1. The improvement was broadly based with no sectors posting negative rates of growth on a Y/Y basis. However, inflation remains high at 8.0%.

Australian business investment rose by +1.1% in Q2, the 1st increase since Q3 2014 and inspite of a decline in mining capex and much better than the decline of -0.9% expected. Furthermore Q1’s reported decline of -4.2%, was nearly halved to a decline of -2.5%. A positive surprise which helped the A$. The higher yield on Aussie bonds is attracting investors, which is also helping the currency. However, I remain concerned about the country’s dependence on China, in particular its mining sector.

Iron ore prices continue to decline, in particular due to the slowdown in China and as a result of an oversupply of the commodity. Prices are now at a 2009 low, down some 35% YTD. Whilst the Chinese authorities are likely to increase the size of their stimulus programme this year, the increase is unlikely to be of a size that will materially increase prices. The risks of further price declines remains.

Kiron Sarkar
30th August 2014

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