Kiron Sarkar’s Weekly Report 10.4.14

The outlook components of the Japanese Tankan survey declined materially and may imply that the economy contracted in Q3 this year. Furthermore, the weak August output data also suggests that Japan could be facing a recession. As the data continues to worsen, further monetary and fiscal stimulus becomes more likely, which will result in a weaker Yen and which, in the shorter term, is positive for Japanese equity markets. Alternatively, the Wall Street Journal suggests that the governor of the BoJ could highlight the flexible nature of the time period necessary to reach his inflation target of 2.0%. However, I remain unconvinced by Abenomics and the BoJ’s policy and believe that Japan faces major economic and fiscal problems. Whilst the Yen closed at Yen 109.76 to the US$, it traded above 110 against the US$ last week, the first time since August 2008. Japanese companies and officials have stated that a weaker Yen is not necessarily a favourable development, though I believe that the Yen weakness will continue and my target is Yen 115+ against the US$ in Q1 2015.

The EU left sanctions on Russia in place, adding that there were no plans to remove them as yet. Indeed, they have threatened to impose additional sanctions, if pro Russian separatists continue to attack Ukrainian targets, which has been the case, despite the so called “truce”. Within the Eurozone (EZ), Germany in particular is maintaining a tough line on Russia. I fear this crisis will run for quite a while.

With large capital outflows (the Russian Economy Ministry forecasts that capital outflows could amount to US$100bn this year) and the Rouble falling to at an all time low, there was speculation that Russia may impose capital controls. The Russian Central Bank denied the report, though one would expect that to be the case even if they do impose capital controls in due course. However, Mr Putin also stated that capital controls would not be imposed.

The Economy Ministry reported that GDP was flat for the year to August and down -0.4% M/M, though forecast +0.5% GDP growth for the current year !!!. The sanctions imposed on Russia as a result of the Ukraine crisis are having a material negative impact on the Russian economy, but politics overrides economic considerations as far as Mr Putin is concerned. Furthermore, the decline is oil prices is yet another negative factor.

There are increasing signs that the EZ economy is stalling, indeed weakening. Even Spain, which had been recovering, is reporting flat to generally weaker data recently. Furthermore, the Catalan government says that it intends to hold an independence vote on November 9th, which, if followed through, is likely to succeed. In addition, France and Italy remain serious problems. Importantly, the German manufacturing/export sectors are under pressure, though domestic consumption is holding up. With EZ inflation at +0.3% Y/Y, the threat of deflation is rising. I remain bearish on the Euro, in particular against the US$. I had a target of US$1.25 for the Euro this Q, though I believe that US$1.20 or even lower is now a distinct possibility. Its not just Euro weakness, but also that the US$ is strengthening on much better economic and financial fundamentals.

Geopolitical concerns are rising. Furthermore, ex the US and the UK,  the other major economies are slowing, as are emerging markets. With the FED set to end its asset purchase programme this month, liquidity will decline, though the ECB’s policies will compensate in part. Investor concerns have resulted in bond yields declining, with the US 10 year declining to below 2.40%, though the much better than expected non farm payrolls report (NFP) resulted in the yield rising to 2.43% at Friday’s close. The much better than expected NFP report increases the pressure on the FED to raise rates earlier than anticipated by markets, though inflation remains contained which provides the FED with flexibility. The key will be wage growth and there is some evidence that wage growth will start to rise in coming months, even though the September NFP report indicated that wages remained unchanged M/M. Whilst equity markets are oversold even after the rally following the release of the the NFP report, financial, economic and geopolitical risks have risen to the extent that I believe that risk/reward is not in my favour. I remain cautious of equity markets. Emerging markets, unsurprisingly, have been sold off and, I believe, remain vulnerable across all asset classes.

The European financial sector may well outperform, following the upcoming asset quality review/stress tests, which should make the banks balance sheets less opaque, as they are forced to deal with their bad debts. Whilst the results are likely to require European banks to make far more provisions (and need more capital) than currently anticipated by markets, with a few banks failing, analysts believe that the fallout can be managed. Furthermore, the ECB is set to provide liquidity at cheap rates, though its TLTRO’s programme and, in addition, is set to buy ABS’s and covered bonds this Q.

US
Consumer spending rose by +0.5% in August M/M, above the rise of +0.4% expected and the increase of +0.3% in July. Incomes were up by +0.3%, in line with expectations and higher than the +0.2% increase in July. The savings rate declined to 5.4% in August, down from 5.6% in July. Core PCE, the inflation indicator most favoured by the FED, rose by +1.5% Y/Y in August, slightly higher than the rate of +1.4% expected, though below the FED’s 2.0% target. Generally a positive report for the US economy, with inflationary trends contained, which will reduce the pressure on the FED to raise rates. The focus will be on wage growth.

Contracts to purchase previously owned homes fell by -1.0% in August M/M, more than the decline of -0.5% expected and the +3.2% increase in July. Cash purchases by investors continue to decline (suggesting a slowdown in prospective price appreciation), with low priced homes and the 1st time buyers market remaining relatively weak, due to low earnings growth to date, though there are some signs that earnings are picking up.

The US September consumer confidence index unexpectedly declined to 86.0, down from a revised 93.4 in August and below the 92.5 expected. It was the lowest since May. Both the current conditions and the expectations components declined. Somewhat softer employment data, combined with increased geopolitical concerns, are weighing on consumers. However, on a positive note, consumers expect a rise in earnings.

The September ISM manufacturing index came in weaker at 56.6, below the reading of 58.5 expected and August’s 59.0. The new orders component was weak, coming in at 60.0, as opposed to 66.7 in August, as was the employment component, which came in at 54.6, as opposed to 58.1 previously. Surprisingly, the prices paid component was somewhat higher at 59.5, as opposed to 58.0 in August. Whilst the index was weaker than expected, respondents suggested that the outlook for Q4 was roughly the same as Q3.

The September ISM non-manufacturing PMI came in at 58.6, as opposed to 58.5 expected and August’s 59.6. The employment component was better than the previous month (the highest since August 2005), with prices paid lower. However, new orders and the business activities components came in lower than expected, though still well into expansion territory.

Employment increased by 248k, as reported by the September NFP, which was better than the increase of 215k expected and August’s upwardly revised 180k. The unemployment rate declined to 5.9%, from 6.1% previously, the lowest rate since July 2008, with the participation rate down marginally to 62.7% (the lowest since February 1978), from 62.8% in August. Somewhat disappointingly, average hourly earnings came in unchanged M/M (+2.0% Y/Y), as opposed to an increase of +0.2% expected and the +0.3% increase in August. However, the average work week rose to 34.6 hours, as opposed to 34.5 in August. Overall a better than expected report. The US$ rose noticeably following the report.

Weekly jobless claims came in at 287k, less than the revised 295k the previous week and the forecast of 297k. Continuing claims came in at a 8 year low of 2.4mn. ADP reported that companies hired 213k employees in September.

US August factory orders came in -10.5% lower, worse than the decline of -9.5% expected and the previous rise of +10.5%. A sharp decline in aircraft orders was the major reason for the decline. Core capital goods orders (ex aircraft and defense) were up +0.4%.

The US August trade deficit unexpectedly narrowed to a 7 month low of US$40.1bn, down from July’s revised US$40.3bn and better than the US$40.8bn expected. Exports increased by +0.2% to a record US$198.5bn, with imports up by +0.1% at US$238.6bn. A decline in petroleum imports contributed to the lower deficit. The narrower deficit will be positive for US Q3 GDP.

Europe
As expected, the ECB left its policy rates unchanged. Whilst acknowledging that downside risks to inflation had increased and that the medium term economic outlook for the EZ had worsened, Mr Draghi did not announce a QE programme involving the purchase of EZ government bonds. Details of the ECB’s covered bond/ABS purchase programme were released, though there was no idea of size, with some backpedaling on earlier indications that the policies will increase the size of the ECB’s balance sheet by E1tr. The market had expected more and the “disappointment” resulted in the Euro strengthening marginally though, unsurprisingly, European equity markets closed materially lower.

Mr Hollande’s socialist party lost its majority in the Senate, with the extreme right wing National Front gaining 2 seats for the 1st time ever. The loss of his majority will make Mr Hollande’s job of trying to govern France even more difficult.

EZ preliminary September CPI came in at a 5 year low of +0.3% Y/Y, in line with estimates, though lower than the  +0.4% in August. Core CPI came in at +0.7%, lower than the +0.9% expected and +0.9% in August, mainly due to lower energy prices. The data increases market expectations that the ECB will introduce a QE programme, which will involve the purchase of EZ bonds, though I remain unconvinced, certainly for this year.  Apart from German opposition to QE, the ECB, I suspect, will want to see how their ABS/covered bond and TLTRO programmes develop, before considering other options.

EZ final September manufacturing PMI index came in at a 14 month low of 50.3, below the initial reading of 50.5. Importantly, the final German September PMI reading was revised lower to 49.9 (51.4 in August), down from the initial reading of 50.3, the lowest in 15 months and in contraction territory. New orders fell at the fastest rate since 2012. The French reading was unchanged at 48.8, though also in contraction territory. However, Italy returned to growth, though Spanish PMI was lower than in August. Factories in the EZ are also reducing prices. They fell by the most in more than 1 year in September.

The EZ September final services PMI came in weaker than the preliminary estimates for Spain, Italy and France, though Germany was revised marginally higher. France and Italy were in contraction territory. The EZ final services PMI came in at 52.4, lower than the reading of 52.8 expected.

The EZ August unemployment rate came in at 11.5% as expected and unchanged from July. German September unemployment unexpectedly increased for a 2nd month. It was up 12k, as opposed to a decline of 2k expected, though the unemployment rate remained at 6.7%. The continuing problems in the Ukraine impacted. Whilst the manufacturing/export sector has shown some signs of weakness, domestic consumption looks positive, with August retail sales +2.5% higher M/M, well above the forecast for an increase of just +0.5% and July’s decline of -1.1%.

Surprisingly, EZ August 2014 retail sales rose by +1.2% M/M (+1.9% Y/Y), much higher than the rise of just +0.1% expected. The summer holidays may have impacted. I would expect retail sales to be softer in coming months. The currency markets ignored the better news, which is telling.

Unsurprisingly, the French finance minister admitted that they will only reach the budget deficit target of 3.0% of GDP in 2017, rather than next year as previously forecast. The 2015 budget deficit is forecast at 4.3% of GDP. However, the official GDP forecasts are based on growth forecasts of +0.4% this year, rising to +1.0% in 2015, +1.7% in 2016 and +1.9% in 2017. These forecasts look far too optimistic and the actual outcome will almost certainly be worse, in particular for this year and next. Furthermore, with debt to GDP rising to near 100%, France’s fiscal position looks bleak. The EU is likely to criticise France for not meeting its commitment to reduce its budget deficit, though the French will ignore the EU.

The Catalan government has set a November 9th date for a referendum on independence from Spain. The authorities in Madrid state that the referendum is unconstitutional. If the referendum is held, the likelihood of a successful vote for independence is material.

UK Q2 GDP was revised higher to +0.9% Q/Q, the fastest in 9 months and above the +0.8% reported initially, mainly due to an upward revision of construction output. Furthermore, revisions to previous GDP data indicates that the post 2008 recession was not as bad as previously reported (down -6.0% rather than the -7.2% previously reported) with output recovering to its pre-recession high in Q3 last year and with GDP in Q2 this year +2.7% higher than at the start of 2008.  The data suggests that the BoE will have to raise interest rates, in my opinion in Q1 next year, despite subdued inflation. Furthermore, wages and salaries rose by +1.9% in Q2, higher than CPI, which adds to the case for an interest rate rise in Q1. UK September construction PMI rose to 64.2, up from 64.0 in August and above the forecast of 63.5. It was the fastest rate of growth in 8 months. However, there are signs that  construction activity will slow in coming months.

The UK September manufacturing PMI reading came in at 51.6 (forecast 52.7), the lowest since April 2013 and below the reading of 52.2 in August. Once again, the new orders component declined. The weakness in The EZ is impacting UK manufacturers.

The UK September services PMI fell from a 10 month high of 60.5 in August, to 58.7 in September. However, the new business, employment, prices and confidence components all increased. Markit, the producers of the index suggest that UK Q3 GDP will have increased by +0.8%, slightly lower than the rise of +0.9% in Q2. Whilst the UK economy remains positive and the best of the major economies in Europe, the problems in the EZ are bound to have an impact.

Japan
Japanese industrial output unexpectedly declined by -1.5% in August M/M (-2.9% Y/Y), well below the rise of +0.2% expected, suggesting that the Japanese economy could be heading for a recession. The weaker Yen has failed to increase output. Whilst retail sales rose by +1.9% (+0.5% expected), household spending declined by -4.7% Y/Y, the 5th consecutive monthly decline and worse than the decline of -3.6% expected. The weaker output data strengthens the likelihood that the Japanese government will increase is fiscal stimulus programme, with the BoJ increasing monetary accommodation.

Whilst base wages rose by +0.6% Y/Y in August, real wages (after inflation, which is currently 3.3% Y/Y) declined by -2.6% Y/Y, as compared with -1.7% in July. It was the 14th consecutive month that wages have been below inflation.

Unexpectedly, the quarterly Tankan survey reported that large Japanese firms forecast that capex will rise by +8.6% for the fiscal year ending 31st March 2015, the most since 2007 and up from +7.4% in the June report. The large manufacturers sentiment index rose to 13 in September, above the reading of 12 in June and the forecast of 10. However, the the outlook component was weaker, coming in at 13, as opposed to 15 in the previous Q. In addition, sentiment among large non-manufacturers (a better gauge of the domestic economy) and small manufacturers declined markedly from the previous survey. At best, the data suggests that a recovery is not underway, though it may also indicate that the economy contracted last Q. The dilemma will be whether the government continues with its plan to raise the sales tax to 10% in October next year, from the present rate of 8.0%.  Failure to do so will have a material negative impact on Japan’s fiscal position, though the higher rate will decrease consumption and, as a result, GDP even further.

Japanese investors bought a net Yen 393.1bn and Yen 184bn of foreign shares and foreign debt respectively in the week ended September 26th, according to the finance ministry. The purchases of shares was the most since January 2009. Purchases of foreign equities and bonds is set to continue and, I suspect, will increase, in particular as the government pension fund, the GPIF, allocates more of its funds to foreign securities, whilst reducing its holdings of Japanese bonds.

Bloomberg reports that the BoJ bought a record Yen 3.5tr (US$32bn) of Treasury bills on Friday, exceeding the Yen 3 tr on 2 occasions in August. The 3 month Japanese T bill traded at -0.02%, with the 1 year -0.005%. The dear old BoJ is buying bonds at negative yields yet again. Very lucky sellers.

China
Pro-democracy protesters have come out in force to demand the resignation of the Special Administrative Region’s Chief Executive Mr Leung and have called for free and open elections. The protest is being handled by the Hong Kong authorities, though there is a fear that mainland Chinese authorities may intervene. China will certainly not allow free and open elections. At present, only Beijing approved candidates can stand in elections for the role of Chief Executive. Mr Leung, however, may be let go at an appropriate time, though for the moment the Chinese authorities have backed him publically.

The final HSBC September manufacturing PMI index came in at 50.2, lower than the initial reading of 50.5 and unchanged from August. It was a 3 month low. The official PMI reading came in at an unchanged 51.1, slightly higher than the estimate of 51.0 expected. The September non-manufacturing PMI declined to an 8 month low of 54.0, down from 54.4 in August. The data suggests that the governments target of GDP growth of +7.5% this year will certainly not be met. Analysts estimate that GDP will rise by +7.3% this year. However, Chinese GDP data is notoriously unreliable, with actual GDP almost certainly materially lower than the published numbers. The property sector and domestic consumption remains weak, though there are some signs that exports are rising as the US economy improves, with the export orders component of the HSBC PMI index rising to a 4 1/2 year high. However, unemployment is rising. Further monetary and fiscal stimulus remains a distinct possibility. To help to contain the downturn in the property market, the Bank of China announced that buyers of 2nd homes would be eligible for discounted mortgages, as long as they do not have an outstanding mortgage on their 1st home. It is the 1st loosening of property policies since 2008.

China’s State Council (China’s cabinet) announced that they would cap the amount of debt which local governments could take on in future and, in addition, ban raising further debt via the notorious financing vehicles. Borrowings, which can only be used for capex projects rather than for general purposes, will need to be no more than pre agreed quotas. Furthermore, the State Council stated that they would not bail out local authorities. The impact of the policies will be negative in the short term, though positive in the medium to longer term.

Other
In yet another sign of weakness in Asian economies, South Korea reported an unexpected sharp decline of -3.8% in industrial output in August, well below the rise of +0.1% expected and an upwardly revised +1.5% gain in July. There are signs that the Bank of Korea is intervening to weaken the Won, in particular as its strengthened against the Yen. Japan is a major manufacturing competitor and the weaker Yen has impacted South Korea’s exporters.

With the Chinese economy continuing to weaken, iron ore prices have halved since early 2013, which could well impact the credit ratings of mining companies and, furthermore, limit their ability to return capital to shareholders. Furthermore, August retail sales rose by just +0.1% as opposed to a rise of +0.4% expected. However, the residential property sector has continued to appreciate. To counter this, the Reserve Bank of Australia (RBA) announced that it is in talks with regulators on introducing “steps that might be taken to reinforce sound lending practices, particularly for investor finance, though not necessarily limited to that”. If the RBA does restrict lending to the property sector, the A$ should weaken. The A$ has declined and I expect it to continue to decline to below 0.85 to the US$ this Q.

The IMF’s Managing Director, Ms Christine Lagarde warned that the global economy was weaker than they had anticipated 6 months ago and that they would be reducing their 2014 GDP forecasts, with 2015 expected to improve only modestly. Rather darkly, she added that there were “serious clouds” on the horizon.

Brent crude oil traded in bear market (down 20% from its recent peak), having fallen to the lowest level since 2012. Saudi Arabia is expected to maintain its output to retain market share and to fund its increasing spending programme, if prices hold above US$90. Furthermore OPEC is unlikely to cut production before its next meeting in November and, in any event, production always exceeds production quotas. Brent closed around US$ 92.30 on Friday. Demand is not keeping up with increasing supply. The EIA forecasts that US production will rise to the highest level since 1970 next year and increasing supplies from a number of countries including Kurdish controlled areas of Iraq, combined with a stronger US$, should keep prices under pressure.

The Brazilian Real fell to a 5 year low, as the prospects of the incumbent Ms Dilma Rousseff winning in the upcoming Presidential elections improved. The Brazilian economy is in recession having declined by -0.6% in Q2 and by -0.2% in Q1. However, CPI continues to rise to 6.62% Y/Y in mid September, above the central banks target of 4.5% +/- 2 percentage points.

The stronger US$ has resulted in gold falling below US$1200 last week. It looks as if it will decline much further.

Kiron Sarkar
4th October 2014

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