Kiron Sarkar’s Weekly Report 9.13.14

At the meeting on the 17th September, the key issue
will be whether the FED retains the phrase that rates will remain low “for a considerable period of time”. I believe that there is a better than 50/50 chance that the phrase will be removed either this month or (more likely) next. If that is the case, short
term rates should rise by more than long term rates, with the yield curve flattening further. The FED will also release updated forecasts this month. US bond yields have finally started to rise in anticipation of higher rates earlier than previously expected,
with the 10 year yield closing at 2.61%. Eurozone (EZ) bond yields also rose, as the prospect of QE looks unlikely and as yields had fallen to ludicrously low levels.

There has been much talk about the Scots voting
for independence.The latest polls suggest that the Scots will vote to remain in the UK, though it remains tight. However, I continue to believe that they will not, though the turnout is expected to be exceedingly high which, admittedly, makes it more difficult
to assess. Importantly, the supporters of independence have had to concede that revenues from North Sea oil would not necessarily belong to Scotland, as the islands nearer the oilfields could opt to remain within the UK. Furthermore, a number of businesses, including 2 major banks (Lloyds and RBS) have threatened to relocate to the UK in the event of independence. Sterling has bounced from its recent lows as a result.

The EU confirmed that additional sanctions will be imposed on Russia, a position Germany has been pressing. The impact will be particularly severe on Russia (a recession, indeed stagflation is likely), though the EU will also be affected. The Ruble declined to a record low against the US$, though the Central Bank kept interest rates unchanged. Russia has threatened to retaliate, including possibly banning flights over its territory. However, Russia/Mr Putin will not be swayed by the additional sanctions – they see it as a political issue, irrespective of the economic effects and one which they will not back off. GDP, already anemic in the EU (in particular the EZ) will decline, with the Euro weakening even further. Major countries such as Germany will be impacted, in particular.

There appears to be momentum behind the sales of Japanese government bonds (JGB’s) by Japanese institutions, with the proceeds being reinvested in foreign bonds and equities, a process which I expect will continue, indeed accelerate. The sell off, if it continues, (which looks likely) is yet another reason I believe that the BoJ will be forced to increase the size of its monetary accommodation programme. The impact will be particularly negative on the Yen, subject to geopolitical issues.

The US$ strengthened materially against the major currencies during the week, though I believe that it has further to go. As is the case in the UK, US interest rates are set to increase, whereas rates in every other major country will remain low for a considerable period of time.

Geopolitical risks (Ukraine, ISIS etc) have increased and are impacting equity markets. With the FED, I believe, set to signal that rates will start to rise (in late Q1/early Q2 in my opinion) this month or next, markets are likely to pause for a while. The ECB could well provide a positive catalyst next month as it announces details of its ABS/covered bond purchase programme. Furthermore, European corporate earnings are being upgraded. Remember Greece, well it was upgraded to B from B- by S&P, with a stable outlook. However, at present, it looks as if markets have turned cautious. Recent fund flow data indicates that investors have been selling US high yield and US equities, whilst increasing their cash positions and equity investments in the EU, with some money going into emerging markets.

US consumer credit rose by +9.7% (US$26bn) in July, the largest increase since 2011. Auto and student loans rose by +10.6%, with credit card debt up by +7.4%. Clearly consumers are increasing spending, which is positive for the US economy. It also suggests that the FED will have to raise rates sooner than the market expects. Indeed, a paper by the San Francisco FED indicated that investors are underestimating the likelihood of the FED raising interest rates earlier than the market believes.

US retail sales rose by +0.6% in August M/M (+5.0% Y/Y), the fastest rate in 4 months and in line with forecasts. July’s data was revised higher to +0.3%, from an unchanged level previously. Auto’s and building materials contributed the most, with petrol lower, reflecting the decline in prices. Retail sales, ex autos, petrol and building materials (which feeds into the calculation of GDP) rose by +0.4%, in line with forecasts and the same as that for July, which was revised higher from the initial estimate. The data supports the view that consumer spending is much better than previously thought. Furthermore, recent data suggests that income growth may just be starting to pick up, which should help consumption. Finally, US consumer sentiment rose to the highest level in 14 months, coming in at 84.6, above the forecast of 83.3 and Augusts 82.5, which further argues for increased spending.

Import prices declined by a significant -0.9% in August, reducing the Y/Y rate to -0.4%, from +0.8% in July. The stronger US$, combined with, primarily, lower energy costs contributed to the decline. In addition, lower commodity prices generally and slower growth internationally resulted in the sharp fall in August. The decline suggests that inflation should not be a problem for the US at present.

The US August NFIB small business confidence index increased to 96.1 M/M, slightly higher than the forecast of 96.0 and above July’s reading of 95.7. It was the 2nd highest reading since October 2007. The capex and the future economic outlook components contributed the most to the higher reading, which certainly is positive, though hiring plans dipped.

The FED intends to impose a capital surcharge on the large banks such as JP Morgan, Wells Fargo, Citi and BoA and those which rely heavily on short term funding, such as the Goldmans and Morgan Stanley. The amount of the capital surcharge has not yet been decided. However, analysts believe that the surcharge will amount to 2.0% above the highest range of +2.5% agreed by international regulators.

US jobless claims rose by 11k to 315k, above the forecast of 300k and the highest for 2 months. The data is somewhat erratic during the holiday period, though admittedly, recent employment data has been weaker than expected.

Mr Draghi once again stressed the need for additional spending on investment in the EZ, though added that structural reforms were also necessary. He added that business investment has improved only slightly since 2008, though is still well below the pre crisis levels.

EZ investor confidence declined to -9.8 in September, much worse that the rise to +1.4 expected and August’s +2.7.

German exports increased by +4.7% (+0.6% expected) to over E100bn for the 1st time in July, with the trade surplus rising to E23.4bn, an all-time high.  Imports on the other hand declined by -1.8% (+0.2% expected), most likely due to lower oil prices. However, the Bundesbank has warned that the German economy was likely to weaken in H2 as a result of the crisis in the Ukraine.

Germany and France will jointly submit proposals for a E300bn investment plan for the EU, which will involve financing by the European Investment bank.

German wholesale prices declined by -0.6% Y/Y, the largest fall since November 2009.
Spain continued in deflation, with August final CPI falling by -0.5% Y/Y, the largest fall since September 2009.

Italy is also suffering from deflation, with August’s final CPI at -0.1%, in line with expectations.

The French finance minister admitted that the budget deficit will widen to 4.4% of GDP this year, up from 4.3% last year. In addition, he cut the 2014 and 2015 GDP forecasts to +0.4% and +1.0%, down from the previous estimate of +1.0% and +1.7% respectively. Furthermore, he forecast that the budget deficit would decline to the 3.0% target only in 2017. However, I believe that the downside risks to the revised forecasts remain.

Italy’s woes continue. Italian July industrial production declined by -1.0% M/M, well below the decline of -0.2% expected and the downwardly revised +0.8% in June.
However, EZ July industrial production, seasonally adjusted, rose by +1.0% M/M, higher than the +0.7% expected and a rise of just +0.3% last month.

Whilst a poll last weekend reported that the % of people in favour of Scottish independence (from the UK) rose above 50%, the 1st time that polls indicated that more Scots would vote for independence, subsequent polls suggest otherwise. I continue to believe that the majority of Scots will vote in favour of remaining within the UK, though it certainly looks as if it is going to be a closer call than expected previously. The referendum will take place on the 18th September.  Sterling clearly declined sharply following the release of last weekends poll results, though has recovered subsequently.

UK industrial production rose by +0.5% M/M in July (+1.7% Y/Y, as opposed to a forecast for a rise of +1.3%), higher than the forecast for an increase of +0.2% and the rise of +0.3% in June.

The governor of the BoE suggested that a rate rise in the UK by spring next year (in line with market expectations) would be consistent with the Central Banks goals of meeting its inflation target, as the improvement of the economy had “exceeded all expectations” and “has momentum” . Wages remained weak due the slack in the market, with the BoE forecasting that wage growth will start to rise in coming Q’s. Unit labour costs were below the level which was needed to meet the BoE’s CPI target, with inflation remaining benign. Finally, he reiterated that rate increases would be gradual and limited.

Japanese calendar Q2 GDP declined by -7.1%, the largest fall since calendar Q1 2009 and greater than both the previous estimate of a decline of -6.8% and the forecast of -7.0%. Capital expenditure was lower than previously estimated and consumption was marginally weaker. The weaker than expected data suggests that the government will increase its fiscal stimulus programme. The governor of the BoJ denied that it would increase the size of its monetary accommodation “for now”, though I suspect he will have no choice but to do so later this year or early next. GDP should increase in calendar Q3, with the Bloomberg estimate at +2.7%.

Japanese core machinery orders (a key indicator of future capex) rose by +3.5% in July (+1.1% Y/Y), below the rise of +4.0% expected and the +8.8% gain in June.

Japanese PPI unexpectedly declined to -0.2% in August M/M (3.9% Y/Y, lower than the +4.1% expected and July’s +4.3%), below the flat reading expected and the +0.4% increase in July. The lower reading suggests that the BoJ will have to increase the size of its monetary accommodation policy if it is to meet its inflation targets.

Japanese regulators approved a safety report for 2 nuclear reactors, though 2 further approvals will be required before they can be restarted, which analysts expect will be in Q1 2015. However, there remains significant domestic opposition, given the Fukushima disaster.

In August, Japanese institutions increased their sales of JGB’s and bought nearly US$12bn of foreign bonds (mainly US and French) and equities. No great surprise, given the declining currency and negative real returns on JGB’s. Furthermore, the Japanese pension fund (GIPF), the world’s largest, is set to reduce its holdings of JGB’s and invest more into Japanese equities, together with foreign bonds and equities. An announcement is expected this month. The Yen looks likely to weaken further, in my view much further, subject to geopolitical issues. I would also expect the Central Bank, the BoJ, to increase its purchases of JGBs, in particular as it is likely to have to increase monetary accommodation. However, I remain deeply sceptical of Abenomics and the BoJ’s policy.

China’s trade surplus rose to a record of US$49.8bn
in August. Exports rose by +9.4%, higher than the estimated increase of +9.0%, whilst imports unexpectedly declined by -2.4%, well below the rise of +3.0% expected. The continued decline in imports indicates the weakness of the domestic economy, through exports
are increasing as the US economy, in particular, continues to improve.  The government is likely to have to increase the size of its fiscal stimulus, with the Central Bank, the PBoC easing monetary policy further, in particular, in an attempt to bolster the
housing sector. Home prices have declined by -10.5% in the 1st 7 months of the year Y/Y, with no sign of stabilising. However, additional stimulus is producing lower and lower returns. Nevertheless, the prospect of additional stimulus, with an accommodative
Central Bank has been positive for Chinese equity markets. This week, the Chinese leadership were much more circumspect on comments in respect of the economy

Chinese August CPI rose by +2.0% Y/Y, a 4 month
low and below the forecast for a decline to +2.2% from July’s +2.3%. The lower than expected inflation rate confirms that the domestic economy remains weak. PPI fell further to -1.2% Y/Y (-0.9% in July), worse than the decline of -1.1% expected and the 30th
consecutive monthly decline. Lower commodity prices were the main reason for the decline in PPI.

Aggregate lending in August amounted to Yuan 957.4bn
(Yuan 273bn in July), below the Yuan 1.135bn forecast and as compared with Yuan 1.584bn in August 2013 and the lowest amount in August since 2009. M2 money supply rose by +12.8% Y/Y, lower than July’s +13.5% and the forecast of +13.5%. The lower than expected
lending is further confirmation that the economy is slowing and that lenders, both the banks and the shadow banking market, are more reluctant to lend.

Iron ore prices declined below US$85 for the 1st
time since 2009. Prices have declined by over 35% YTD. Chinese steel production is growing at a slower rate, mainly due to a slowdown of the property sector in China, which is continuing. Goldman’s believe that new production from Australia and Brazil will
increase the global surplus to 163mn tons next year from an expected 52mn tons this year, with the surplus increasing further to 245mn tons in 2016 and continuing to rise to 334mn tons in 2018.

Brent fell below US$100 for the 1st time since April
2013 and declined further during the week, with October Brent closing at US$97.11. The EIA reports that supply is expected to increase by +1.6mn bpd this year, whilst demand will rise by just +0.9mn bpd. They also cut demand forecasts for next year, adding
that “the recent slowdown in demand growth is nothing short of remarkable”. The stronger US$ is a further negative for oil and other commodity prices.

The A$ declined sharply during the week. The decline
of commodity prices, given the slowdown in China, is impacting the currency. In addition, September consumer confidence declined by -4.6% M/M. Furthermore, investors are unwinding the carry trade. However, employment rose by a record number of 121k jobs in
August, well above the forecast for a rise of just 12k. The majority of the jobs were part time and the exceedingly high number suggests that it is an anomaly. The unemployment rate declined to 6.1%, down from 6.4% which was a 12 year high, with the participation
rate increasing to 65.2%, from a revised 64.9% in July.

South Africa’s current a/c deficit rose to 6.2%
of GDP in Q2, the most in 9 months and well above the deficit of 4.5% in Q1 and the forecast for a deficit of 5.5%. Exports declined by -4.4% in volume terms, mainly due to lower exports of commodities. In addition, the impact of the industrial dispute at
platinum mines was noticeable. Manufacturing slumped by the most in 5 years in July, as a result of strikes. With weak commodity prices, the country’s problems look set to continue, which should result in the Rand weakening even further.

Brazilian July retail sales, seasonally adjusted,
declined by -1.1% M/M (-0.9% Y/Y), the largest fall since October 2008 and well below the gain of +0.5% expected. The recession in the 1st half of the year looks set to continue into H2.

Kiron Sarkar
13th September 2014

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