Consolidation Continues, though Sterling Heavy after Drop in Manufacturing Output

The general theme of consolidation continues in the capital markets today. The US dollar is mixed,though with a firmer bias. Global equities are higher. The MSCI Asia-Pacific Index was up 1.5%, led by a 2% rise in the Nikkei. The Dow Jones Stoxx 600 is up about 1% near midday in London, paced by basic materials and financials. Bond markets are firm and absorbing European supply without much difficulty.

There have been two main developments: China's inflation reports and UK industrial output. China's June CPI reading was above expectations at 2.7% year-over-year. The consensus was for 2.5% after a 2.1% increase in May. The increase was solely derived from food. Food inflation accelerated to 4.9% from 3.2%, while non-food prices were steady at 1.6%. On the month, CPI was flat. Given that the government's target is 3.5% this year, today's report is unlikely to impact the outlook for monetary policy and we do note that money market rates continue to normalize.

While a handful of countries, like Japan and Switzerland, have negative CPI, China reports negative producer prices of -2.7% (from -2.9% in May). The negative producer prices are understood to reflect the significant excess capacity that plagues numerous industries. While occasionally some observers claim that QE in the US exported inflation, while Japan's QE exports deflation, which we tend to be skeptical of, we are struck by the lack of commentary on how China's over-investment and excess capacity exports deflation.  

Consider a specific example.  China produces about half of the world's aluminum supply.  The price of aluminum has fallen sharply in recent years and, a recent report noted, that half its producers are not operating at a loss.  Nevertheless, more smelters are being built.    Meanwhile, capacity is being shuttered elsewhere, unable to cope with China's cheap output.

The UK's industrial production report offered a negative surprise today and given the new more activist era for the Bank of England, ushered in by the ascension of Carney and will include a review of  the policy framework next month and two new deputies in the coming months, the market is particularly sensitive to the disappointing data.   Industrial output was flat, a slight disappointment to the consensus that forecast a 0.2% gain.  The more significant disappointment was with the 0.8% slide in manufacturing.  The market had expected a 0.3% increase.  This was the largest decline since the start of the year and warns economists may have to revise down Q2 GDP estimates.  April industrial output was also revised down to show a 0.1% decline instead of a gain of the same magnitude.   

Sterling had initially extended yesterday's recovery and traded near $1.4980 prior to the report.  The Friday-Monday base just below $1.4860 has been penetrated.  The year's low was set in March near $1.4830 and below that the $1.4780-$1.4800 may offer the next level of support.   For its part, the euro is trading at four-month highs against sterling near GBP0.8660.  The GBP0.8600 area, which had been the upper end of a 3-4 month trading range should now offer support.  GBP0.8700 is the next immediate target, but given that the BOE is seen more likely to ease before the ECB, there may be potential toward GBP0.8800.  

Separately, the UK reported a slightly wider trade deficit (GBP8.49 bln from GBP8.43 bln).  However, this masks a notable divergence.  The trade deficit with the EU was largely flat, while excluding the EU it deteriorated to GBP4.1 bln from GBP3.4 bln.  

For its part, the euro extended yesterday's recovery off a two-day base just above $1.28 to almost $1.29.  There does not seem to be much enthusiasm for the single currency, although Greece's next tranche of aid appears approved and the political maelstrom in Portugal has been resolved.  Initial intraday support is seen in the $1.2840 area.   

The dollar has been confined to a narrow, though firmer, range against the yen.  The BOJ is the only major central bank that meets this week.  No change in policy is expected, but it is poised to raise its economic outlook again.  The JPY101.30-50 offers the initial resistance before JPY102.00.  

There have been a couple of other developments that strike us as important, but do not appear to be impacting prices today.  First, emblematic of the relaxation of fiscal constraints in the euro area, France reported that its Jan-May budget deficit rose to 72.6 bln euros from 66.8 bln in the same 2012 period.  Previously, Italy also reported its budget deficit is larger this year than last.  

One of our thematic points has been that fiscal policy is tighter this year in the US than the euro area.  The relatively tighter US fiscal policy is now being complimented by prospects that the Fed eases off the monetary accelerator later this year, well before the Europe or Japan.  

Secondly, while there is concern about the difficulty the US will have exiting from QE, we have doubted that Portugal will be ready to exit from its aid program a year from now.  There is talk today that Portugal may seek a precautionary line of credit from the EU.  There is also some speculation that Ireland may also explore similar options.