Half a Dozen Thoughts about the Week Ahead

We have argued that there were three main drivers of the capital markets: inspired by talk of Fed tapering, long-term interest rates had bottomed and the unwinding of structural positions based on low and falling interest rates; the sales of foreign assets by Japanese investors; and the liquidity squeeze of China and the slowing of the world's second largest economy.

More recently, investors have shown greater appreciation for the fact that Fed tapering in September, which had become the consensus view, was not a done deal. The conditional nature of that possibility rests on the upcoming economic data, which we misgivings about. 

Although there will be some important revisions to GDP, based on methodological improvements to capture intangibles, it is unlikely to increase the pace of growth, which, when released at the end of the month, Q2 GDP looks to have slowed below 1% (for the second time in three quarters). Broad measures of the labor market continue to improve slowly, with no real acceleration seen, while core price pressures remain subdued.

Japanese investors, for their part, have bought foreign bonds for the past two weeks, according to data from the Ministry of Finance. China's liquidity squeeze has eased.  Taken together, the three drivers have become more muted, changing the short run dynamics in the capital markets.  While this fits in well with the thinner participation during summer holidays, the absence of a compelling macro story may give more room for more modest thematic developments.  

Here are a half a dozen such factors:

1.  China has been announcing a series of reforms that taken together are impressive and illustrate the priority of the XL government (President Xi Jingping and Premier Li Kuqiang) on qualitative rather than quantitative issues.  Before the weekend, the PBOC announced the elimination of the floor for discounting loans.  The PBOC had also advocated eliminating the ceiling as well, but was pushed back against.  

Yet, the development of various wealth management products gives wealthier investors access to higher interest rates, and is a bit of a work around the cap.  Other reforms include the nearly doubling of QFII quotas, expanding RQFII to include yuan raised in London and Singapore, the designation of Shanghai as a free-trade zone for financial services, plans to re-launch government bond futures, and movement towards liberalizing the household registration (hukou), which does not limit so much the movement of people as denying them access to social benefits, leading to greater savings to overcome the disparity.  

2.  The ECB also announced changes in its collateral rules last week, choosing not to wait for the next ECB meeting, even though the changes will not take effect for a couple of months (Sept/Oct).  The delay is reportedly due to the legal and software changes that are required.  The ECB announced it will accept asset backed securities with a lower credit rating (A rather than AAA) and apply a lower haircut.  However, this applies to plain vanilla ABS with a single pool of underlying assets.  

Even though it  is a modest move, impacted about 20 bln euros of securities, it is hoped to a) help revive lending to  small and medium sized businesses and b) induce more cross-border risk taking.   The ECB also increased the haircut (by 8-12%) for another type of collateral: "own use" covered bonds.  The European covered bond market has slowed with issuance in H1 13 just below 70 bln euros, off 40% from a year ago and the average size has fallen to around 800 mln euros from 1.2 bln in H1 12.  

3.  The one new initiative by the G20 meeting of finance ministers and central bankers that appears to be the capturing the imaginations of some is the endorsement of the OECD corporate tax reform proposal.  However, the Financial Times claim that the "Global tax plan signals the end of avoidance" is an exercise in hyperbole.  

First, the OECD proposes to develop rules over the next two years that will make it more difficult to shift profits of intellectual property to offshore units.  Second, it rejected more profound overall changes, such as the one the EU had proposed in 2004 to allocate the tax burden on the basis of sales (formulary apportionment), which the IMF was recently sympathetic toward.  Third, businesses are willing to embrace the OECD's approach because it does not appear very threatening.  As the FT quoted, the US multinational business union association, indicating its support provided that it will be "easily administered by corporations and will not deviate significantly from current laws."  

4.  As widely expected, Japan's 2-party governing coalition appears to have secured a solid majority in the upper chamber of the Diet. This means that Japanese government is arguably the strongest in among the major countries and makes it even more difficult to challenge Abenomics.  This is generally perceived to be positive for Japanese shares and negative for the yen.  More broadly, it shifts the debate over next year's implementation of the controversial retail sales tax from between parties to within the Liberal Democrat Party itself.  Recall that LDP supported the DPJ political suicide move to legislate the retail sales tax hike in exchange for the early election call last year.  However, the LDP is split on the merits of implementing the two part tax hike (2014 and 2015).  

Some critics note that the coalition failed to secure a 2/3 majority which would have given it greater power to change the constitution.  Yet, as we have noted, even if the LDP and its junior partner won every seat they were competing for, they still would not have a 2/3 majority.  This seems like a  tactical move by the LDP and signals that the focus will remain on economics.  

5.  Portugal's main parties failed to reach an agreement after six days of talks.  The President of Portugal had insisted on the talks with the opposition Socialists, but the center-right coalition government appears to have a solid majority, though it had wobbled recently.    The President is expected to make a statement late Sunday.  The issue is over the pace of austerity, which the government remains committed.   The benchmark 10 year yield fell 39 bp last week and is about 130 bp off the high water mark seen earlier this month on that wobble of the coalition.    Consolidation is the most likely scenario as the focus on Portugal has renewed concerns that it may require another aid program when the current one expires next year.  

6.  It is a relatively light week for economic data and events.  There is only one central bank that meets, the Reserve Bank of New Zealand (Thurs) and it is most certainly not about to raise interest rates, though it retains a tightening bias.  In terms of economic data, there is one report from each center than stands out    Australia reports Q2 CPI (Wed).  In recent quarters,it has surprised on the downside, with the core reading below the midpoint of the RBA's target (2-3%).  While the headline accelerated, we expect the core to remain tame and possibly ease a bit, setting the stage for what we expect to be a rate cut in early August.  

The euro area reports the flash PMI for July (Wed) .  Recent reports readings show a modest improvement in the periphery and France, more so that Germany.  The UK will be the first of the G7 to report its estimate of Q2 GDP (Thurs).  Recent UK data has generally surprised on the upside.  Forecasts for Q2 GDP are between 0.6% and 0.8% (quarter-over-quarter).  We have been skeptical of the merits of  pundits claims about a triple dip in the UK economy.  The economy is still about 4% smaller than its peak.  While the low point may have passed, the upside is painfully slow.   

In the US, the June durable goods orders report (Thurs) is the main release.  Strong orders from Boeing, which reportedly rose 40% on the month, should bolster the headline, while excluding aircraft orders and defense orders, are expected to rise by 0.7%-1.0%. Canada reports May retail sales (Tues) and auto sales may drag down the headline rise, but  excluding them, retail sales probably recovered in full from the 0.3% decline in April.  

There are actually three reports from Japan that will draw investor interest.  First the June trade balance (Wed) is expect to show a significantly smaller deficit.  The  Bloomberg consensus is for a JPY573 bln shortfall after JPY821 bln on a seasonally adjusted basis.  On an unadjusted basis, the deficit is expected to fall to JPY150 bln from JPY996 bln.  The MOF portfolio flow data (Thurs)will also be of interest after Japanese investors have bought bonds for two consecutive weeks, which has only happen one other time this year and it was a three week streak in late April through mid-May.    Japan also reports the latest CPI figures (Fri).   The national headline for June and the Tokyo reading for July will likely be in slight positive territory.  However, this is because of fresh food and energy, which makes this more a story of relative price changes and not general prices.  Excluding fresh foods and energy, CPI appears to be running around -0.3%.