Contours of the Investment Climate

The foreign exchange market has begun the new week quietly, but the global bonds and stocks are firm, while gold and oil continue to recover from their recent dramatic slide. The dollar has traded in narrow ranges just below JPY100.  The euro briefly slipped though the pre-weekend low in early European turnover, but is little changed as North American dealers return.

The Australian dollar remains heavy and has recorded new 5-week lows.  Of note, news that the ultra-dove Svensson will step down from the Riksbank has given the krona a fillip.


Global equities are firmer.   The MSCI Asia-Pacific Index gained about 0.6%, without the help of Shanghai Composite, which eased slightly.  The Nikkei led the move and rose to new five year high.  Korea cut this year's decline by a quarter with a 1% rise led the domestic sectors of health care and utilities.  The Philippine's stock market, however, solidified its position as the second best in Asia this year, with a 2.3% rise, bringing the year-to-date gain to 22.5%.

European bourses are following suit with the Dow Jones Stoxx 600 up 0.75%, led by financials and consumer service sectors.  In terms of countries, Italy continues to lead the recovery more than a 2% gain, giving it a month to date gain of more than 5%.  Most of the other major European (and North American) markets are down on the month. 
There were three developments from late Friday that will impact the investment climate this week. First, the G20 was not critical of Japan's efforts to reflate its economy.  We felt that comments from senior US Treasury and IMF officials prior to the meeting hinted at this and we argued that market has misunderstood the US Treasury's semiannual report on the foreign exchange market.  Japan may have violated the spirit of the rules of engagement as they have evolved from the G7/G20, but they have righted themselves by 1) refraining from offering bilateral exchange rate targets, 2) moved away from changing the BOJ's mandate and the earlier notion of buying foreign bonds and 3) focused on domestic policy objectives.  

Second, Fitch cut the UK's credit rating to AA+ from AAA.  This follows a similar cut by Moody's in late February.  Fitch has quickly resolved the negative watch it had placed on its ratings in late March, two days after Chancellor of the Exchequer Osborn cut his growth forecast and raised his debt projections in his budget speech.  Fitch cited the weaker growth and fiscal outlook in its statement explaining the downgrade. The rating agency recognized the strong fiscal financing flexibility, the fact it prints its own currency, which has reserve status and that its debt has a relatively long average maturity.  However, Fitch argued that its vulnerability to adverse developments and fiscal shocks is not consistent with an AAA rating.  

UK gilts are trading a bit heavier today.  Our own models warn of scope for additional pressure on the UK's ratings.  Nevertheless, as we have point out previously, sovereign ratings of large open and relatively transparent countries add little value.  They rely exclusively on publicly available information that investors have largely already taken on board.  

Third, Italy took an unprecedented step this weekend to give the current president another term.  Napolitano will speak to parliament Monday and lay out his strategy.  He favors the establishment of a new (coalition) government rather than a return to the polls.   Although the path seems convoluted, we continue to see a new government with a limited political agenda (rather than a technocrat government) as the most likely outcome. The limited agenda would have to include electoral reform and some pro-growth measures.   Italian markets reacted positively to the developments and the yield on the 2-year note slipped to new record lows, while the 10-year yield is nearing 4%, a level not seen since late 2010. 

Meanwhile, PD leader Bersani resigned after he failed to carry a substantial number of deputies in support of Prodi for president.  Many observers who are surprised of Berlusconi's success in Italian politics often fail to appreciate how ineptitude of his opposition.  Bersani snatched defeat from the jaws of victory in the Feb election and played his hand poorly since.  Renzi, Bersani's rival within the center-left, appears to be one of the main beneficiaries of Bersani's resignation.  Ironically, the ascendancy of Renzi, who is a likely PM candidate in the next election,  appears to be part of the evolution of the Italian left away from its communist roots and toward a more centrist position.  

In the week ahead there are a few data points that stand out.  The first is tomorrow's flash euro area PMI. March's decline was disappointing and suggests the economy likely contracted by around 0.5% in Q1.  Even if the April reading steadies, a move back above the 50 boom/bust level is unlikely until Q3 at the earliest.  

On Thursday the UK becomes the first G7 country to report Q1 GDP.  A flattish reading is likely, which allows for a +/- 0.1 or 0.2%, which is largely a rounding error.  A negative reading will get some chins wagging about a triple dip, but we find such talk quite vacuous.  This is a unhelpful characterization of what is happening and pretends there has been a recovery in between dips.  Instead, the UK economy is best understood as bouncing along its trough.  

This stands in contrast to the US GDP figures will are reported the following day.  The US economy is expected to have expanded by 3% of more at an annualized clip in Q1.  Despite the end of the payroll savings holiday and delays in tax refunds, the US consumer appears to have fared well, though dipping into savings to do so.  In addition, the rebuilding of inventories also is expected to have boost growth.  

To be sure, as the quarter ended the consumer and the economy lost momentum and the early Q2 data warns of another spring swoon.  Growth in the current quarter may be slowing back toward a 2% pace, which is about what it is averaged since mid-2009.

HSBC reports China's April flash PMI on Tuesday and the consensus expects a 51.4 reading down from 51.6 in March.  It seems that the non-performing loan problem is rivaling the economic slowdown for attention.  Non-performing loans rose 20.7% year-over-year in Q1 Separately, the H7N9 flu continues to spread, while not making headlines, is a story many are watching closely. 

The Reserve Bank of New Zealand meets on Wednesday and it will keep the official cash rate steadfastly at 2.5% not just now but the remainder of the year and into 2014.   Australia reports Q1 CPI the day before and is unlikely to deny the central bank scope to ease should the economy slow further.  Separately, there are number of emerging market central bank meet (Hungary, Philippines, Colombia and Mexico) this week.  Only Hungary is expected to change policy by delivering a 25 bp rate cut. 

The US is in the middle of earnings season.  Rarely does a particular corporation's earnings have impact in the international capital markets.  However, we note that Apple's earnings are to be reported on Tuesday and shares finished below $400 for the first time since late-2011 amid concerns.  The shares of many of its suppliers in Asia have also sold off as the introduction of the new product cycle (5s iphones) may be pushed into Q3 from Q2.