Observations About the Investment Climate

After putting in another good week, the US dollar is consolidating its recent gains amid quiet and largely uneventful trading that has kept in fairly narrow trading ranges.

Following Fitch's downgrade of Italy before the weekend, Italian bonds are under a bit a pressure, in a bearish flattening pattern--where yields are rising 3-7 bp across the curve and the short-end is where the increase is seen.

Italian shares are off about 0.7%  near midday in Milan, though Spanish shares are off more (-0.85%), after MSCI Asia-Pacific Index rose about 0.7%, with Japan's markets leading the way.  Of note, the slew of data took at toll on China's equities, where the Shanghai Composite fell more than 0.35%.


The recent string of data points to a divergence of economic activity.  Europe remains the weakest and although Germany is unlikely to repeat Q4's 0.6% contraction, last week's disappointing industrial order and output figures, suggests it continues to face headwinds.  The euro area's second largest economy, France, continues to diverge with Germany and that divergence appears to be growing.

While German industrial production was unchanged in January and off 1.3% from a year ago, French date earlier today showed its industrial output collapsed 1.2% in January and is down 3.5% year-over-year.  Moreover, there is resistance to France being granted another year to reduce its  budget deficit to 3% of GDP and this is likely to force additional pro-cyclical measures.

Japan seems to be on the mend, though it is really to early to give attribute it to Abenomics. However, the 21.5% plunge in the preliminary estimate of Jan machine tool orders is disconcerting.  It is the biggest decline in eight months.

The US economy is surprising many observers with its resilience in the face of the end of the payroll savings tax holiday and in anticipation of additional spending cuts.  February retail sales will be reported at midweek and a 0.5% headline and excluding autos is expected. 

It had appeared that China's economy had stopped slowing in Q3 12, but data reported over the weekend were uniformly disappointing.  In particular, industrial production in the Jan-Feb period was 9.9% above a year ago, the slowest pace since last October.

Given that the recent trade data pointed to strong foreign demand, the reduction in output may reflect a weakness in demand and may have been behind the weaker imports (five month lows).  Retail sales also supports this hypothesis.  The 12.3% year-over-year gain for February was down from the 14.3% pace in January.  The Bloomberg consensus called for a 15% pace.  Local reports had warned that the new Chinese leadership was urging a less lavish celebration of the lunar new year.

We do suspect the lunar new year did impact bank lending.  New yuan loans increased by CNY620 bln, which were below expectations but still well above levels since Q4 12 and in the above the Jan-Feb pace reported last year.    CPI came in above expectations at 3.2%, the highest in ten months.  Food prices continue to be the real culprit rising 6.0% year-over-year while non-food prices are up 1.9%. We suspect that the PBOC, like investors, will wait for a cleaner data to decipher the underlying strength of the Chinese economy.

While the Fed continues to buy $85 bln of long-term securities a month, the market awaits more action from the BOE (if not before after Carney joins), the BOJ, (next month when Kuroda takes the reins).  The ECB left the door ajar to another 25 bp cut in the 75 bp refi rate with lower staff forecasts for growth and a further divergence in inflation forecasts from the near-2% target.  Draghi did reveal that unlike in February when the decision was unanimous, there were some on the ECB that favored a rate cut last week.  The Reserve Bank of Australia is also expected to cut rates later in Q2.  Look behind Wed's headline employment figure, as Australia lost full time positions each of past three-months since January.

The Bank of Canada has continues to move away from its earlier inclination to remove accommodation.   Although it reported strong headline job growth, the continued loss of manufacturing jobs (25.6k in February, 55.7k over the past four months) is suggestive of something more important taking place in the Canadian economy.

Several central banks meet this week.  The Swiss National Bank has no reason to change its stance and won't.  Very little has changed since its December meeting.  Norway's central bank meets, and it will likely signal a later, as in next year, rate hike.  February consumer price were reported earlier today and at 1.0% headline and 1.1% underlying, there is no urgency to raise rates.  The Reserve Bank of New Zealand meets.  It has been signaling a desire to hike rates later this year.   Anything but a hawkish comment will be disappointing to the market.

Mexico surprised before the weekend with a 50 bp rate cut, but the peso rallied on ideas that this is a one-off, pro-growth measure as price pressures poised to ease.  On the other hand, Brazil's inflation came in on the high side of expectations and Thursday's COPOM minutes will be scrutinized for insight  the central bank's readiness to raise rates.  A number of other developing countries' central banks meet during the second half of the week, but none (Korea, Philippines, Chile, Russia) are expected to change policy.

We do not place much emphasis on Fitch''s decision to cut Italy's sovereign rating to BBB+ before the weekend.  It is largely a catch-up move as it was the outlier.  If it had waited so long--S&P has rated Italy BBB+ since January 2012, and its concerns sparked by the recent election, it is not clear why it did not wait for few weeks to see the kind of government that is formed.  In any event, the new parliament will sit for the first time on Friday and elect president of each chamber.

Arguably more important than Fitch's rating will be Q4 earnings by Italy's two largest banks (the third largest, Monte dei Paschi is on its third government support program), Intesa on Tuesday and Unicredit on Friday.  The earnings come amid increased inspections by the central bank and encouragements to the banks to make greater (loan loss provisions).  According to the Italian Banking Association, non-performing loans reached a record in December.

The two banks are expected to report a combined loss of nearly 200 bln euros in Q4.  We note that a couple of French banks that have already reported their earnings increased their loan losses reserves for their Italian operations.  Not coincidentally, it does not appear that Italian banks have made early prepayments of their LTRO borrowings.  In fact, Italian banks borrowed more from the ECB in Feb (281 bln euros) than in Jan (273.9 bln euros).