Fundamental Keys in the Week Ahead

Many in the US and Europe are enjoying summer holidays. However, the week ahead is chock full of fundamental events, and is, arguably, the most important week for the next month. Indeed, the events this week will help shape expectations for the period ahead. The US dollar has been trading with a heavier bias against the major currencies, and the events this week have the potential to set the stage for a recovery.

Sometimes there are overriding themes, but in the days ahead, each of the main economic centers generates its own impulses. We try to place these in a larger context and, in doing so, we hope to provide a thumbnail sketch of the main issues and challenges.

China:  The world's second largest economy is slowing and this will most likely be reflected in the official PMI data.  The new government is pressing ahead with numerous financial and economic reforms.  While it has been reluctant provide fresh monetary or fiscal stimulus, it did announce some modest fiscal measures last week, including increased railroad spending and support for exporters.

The attempt to address the over-capacity, which plagues many industries, while admirable, seems too weak to be very effective and it is not even the first time this year that such efforts are being made.  Separately, new pressures, though not as extreme as last month, have emerged in China's money markets in recent days and it may be related to month-end settlement issues (especially of wealth management products). 

Japan:  Rising energy and fresh food prices have lifted headline CPI measures above zero.  However, the exclusion of these two items illustrate that the deflationary forces remain evident.  At the same time, Japan's economy remains the strongest among the high income countries.  In fact, recent data is encouraging upward revisions in economists' estimate of Q2 GDP toward 4.5% (annualized quarterly rate), which would be the second consecutive quarter growth exceeds 4%.   It looks as if a possible compromise on the implementation of the controversial retail sales tax hike is emerging within the government:  implement the tax (2014), but blunt the impact via a supplemental budget.

Almost every day in the week ahead, Japan reports economic data.  The data is likely to show the economy has good momentum at the end of Q2.   The weekly MOF data may draw attention.  After surprising most observers by persistently selling foreign bonds for most of this year, for the past three weeks, Japanese investors have become buyers.  For their part, foreign investors continue to buy Japanese equities, but the enthusiasm (pace) appears to have diminished.  

Australia:  The Reserve Bank of Australia meets on August 6.  While market expectations have been rather fluid, we continue to highlight the risk of a rate cut.  Following the recent CPI readings, especially when adjustments are made to take into account last years' carbon tax, and weaker Chinese  data, the pendulum of market expectations has swung back in line with our views.  We look for RBA Governor's speech early Tuesday in Sydney to recognize the scope for easier monetary policy.   On August 1, Australia reports Q2 import and export prices.  It is here that the reversal of the positive terms of trade shock will be most evident.  Flattered by a weaker Australian dollar, import prices are expected to have jumped 2%, while export prices are almost flat (+0.3%).  

UK:    The UK economy expanded by 0.6% in Q2 and appears to enjoy some momentum in the current quarter.  Output remains below what it was 5 years ago and continues to operate below capacity.  BOE Governor Carney presides over his second MPC meeting.  Although it had been customary for there not to be a statement when there was no action, Carney made his presence felt immediately by issuing a rather dovish statement.  Any statement this time will be read with an eye toward the August 7 Quarterly Inflation Report that may also frame the forward guidance issue.  Although Carney had seemed sympathetic to targeting nominal GDP, it appears opinion has congealed around the idea of an unemployment threshold (not a trigger), like the US.   

Meanwhile, the Bank of England continues to pay 50 bp on reserves (bank rate).  There has been talk that Carney could support a cut.  Although it is possible, we are less sanguine.   Judging from others' experience, 1) reserve holdings may not be very sensitive to the rate, provided it is positive) and 2) lower reserve holdings does not necessarily translate to increased lending, as the euro area illustrates.  

Euro Area:  The flash PMI reading provided more evidence that the euro area is enjoying a bit of a recovery.  Given the somewhat better numbers coming from Spain and Italy, if anything, there would appear to be upside risks to the PMI that will be reported shortly before the outcome of the ECB meeting on August 1.  We expect Draghi to continue to press the new line:  rates will remain low or lower for an extended period.  

It is also the one-year anniversary of Outright Market Transaction program.  It has not been operationalized and the precise rules have yet to be published.  Nevertheless, its mere announcement helped lower interest rates for the euro area, especially the Spain and Italy and large companies.  Households and small businesses do not appear to have participated directly.  

The ECB's intra-meeting collateral rule changes appear aimed at two different problems.  First, private sector lending is continuing to contract.  The collateral changes provide new incentives for lending and securitizing loans to small and medium sized businesses.  Second, the paying down of LTRO borrowings and increased demand for liquidity is reducing the excess liquidity in the euro area banking system and it is beginning to be reflected in higher and more volatile repo rates.   We suspect the urgency of the latter will continue to gradually increase and possibly leading to new initiatives in the Sept-Oct period.  

United States: Speculation around the reduction of the Federal Reserve long-term asset purchases emerged as a key market force in Q2.  It continues to be an important driver, even though investors are well aware that tapering is not tightening and a hike in rates more than a year out still.  

If the Fed was to begin tapering in September, as many expect, there should be stronger signals in the statement from the FOMC meeting this week, the last meeting before September.  The FOMC meeting is sandwiched between two important pieces of data, GDP and jobs.  

A few hours before the FOMC meeting concludes, the government will release its first estimate of Q2 GDP.  The data is subject to statistically significant revisions.  Senior Fed officials maybe informed of the details prior to the meeting Wednesday and the assessment of the economy in the statement must recognize what is now widely expected to be a sub-1% pace.  Although it may play it down and refer to a temporary fiscal drag, the Fed is put into an awkward position.   In September, simply to acknowledge such poor Q2 growth, the Fed's forecasts for this year's growth will likely be pared. 

Also, in the GDP report is the Fed's preferred inflation measure.  In Q2 it is expected to have eased to 1.1% from 1.3%.  It would be the fourth consecutive quarterly reading below 1.5%.  This sets the stage for the repeat of the unusual dual dissents:  the hawkish one from George; concerned about the distortions of the prolonged period of low interest rates, and a dovish one by Bullard; for not expressing more concern over deflationary threat.   While the minutes may show some discussion of lowering the unemployment threshold from 6.5% to underscore its commitment to low interest rates, we suspect that would more likely be announced at a meeting that Bernanke holds a press conference and/or when tapering is announced.  

Recall that with the GDP report, the government's bean counters will offer revisions to incorporate intangibles into their calculations.  It will likely bolster estimate of the size of the economy--the dollar value of the economic activity--but it is unlikely to alter the pace of growth.  Some may scoff at the exercise, but metrics are constantly changing and evolving as the economy changes, new information becomes available, and new techniques are devised.   More comprehensive and accurate measures of economic activity are important for policy makers, business leaders and investors alike.  

At the end of the week, the monthly employment data will be reported.  Generally speaking, and taking into account revisions, US private sector job growth has been remarkably steady.  Both the 12-month and 24-month averages are 196k.  The 3-month average is 199k.  There is no compelling reason to look for a significant change, though we do note that the weekly jobless claims fell around 25k in the reporting period.  

In other details of the labor market, it will be interesting to see if the out-sized 0.4% rise in hourly earnings in June is sustained.  The year-over-year pace has accelerated to 2.2%, a two-year high, from a low of 1.6% last October.   This, even when coupled with the increase in home prices (CaseShiller  May figures due July 29 and are expected to have risen by the fastest pace in 7-years), consumer spending likely slipped in Q2, weighing on GDP.   

We note that the normal auto plant shut downs in the summer are not taking place this year and this may cause some distortions seasonal adjustments in hours worked in manufacturing and output figures.   July auto sales figures will be reported on August 1.  Forecasts call for a slight moderation and sales are expected to remain on pace for their best year since 2007.  

It has been signaled as much as it can that Bernanke will be replaced when his term expires.  An official announcement is expected in September, or possibly October.  Until now the Vice Chairman of the Federal Reserve, Janet Yellen, was widely perceived as the odds-on favorite.   There were, of course, other potential candidates but no one really received much attention.  In recent days Lawrence Summers has emerged as an erstwhile challenger.  

We are suspicious that this is an attempt by the Rubin-wing of the Democrat Party to wrest control of the central bank from the dovish monetarists.   Both Rubin and Summers have been, to varying degrees and at various times, critical of the extraordinary monetary measures undertaken by the Bernanke Fed.   In addition, the Rubin-wing, which, when in power during Clinton's Administration, helped foster the financial deregulation (that is often wrongly attributed to George W Bush), is also critical of attempts to re-regulate.  The appointment of the chairman of the Federal Reserve is not usually fraught with much intensity or drama.   This time may be different; not only is monetary policy in transition, but so is the Fed's regulatory authority.