Four Dimensions of the Investment Climate

This week's data and events occur in a particular investment climate. We identify four key elements of that investment climate.

The first and most important of these are the expectations for the Federal Reserve to slow its long-term asset purchases. According to Reuters polls, there has been a shift among views of primary dealers; pushing out expectations in time and quantity.

The July survey had found 11 of the 17 primary dealers in its survey thought the Fed would begin tapering in September, 3 said October, 2 thought December and 1 put it in Q1 2014. The August survey, conducted after the US employment data, found 9 now expect a move in September, 2 in October, 5 in December, 1 in Q4 2013 and 1 in Q1 2014.

The expectations of the size of the first reduction are $15 bln in the latest survey, down from $20 bln previously.  

Another issue, which the survey does not address, is the how the tapering is distributed between asset classes (Treasuries and MBS).  Some observers have suggested that the reduction of Treasury issuance necessitates the tapering (more than the economy).  Other observers are emphasizing the percentage of the MBS market and/or new supply that central bank now owns.  

Measures by Chinese officials have reassured investors in three ways.  First, the government continues to press ahead with financial reforms and is renewing efforts to address the over-capacity problem.  It also has announced a new audit of government finances on all levels.  Borrowing (and investing) by local governments is trying to be reined in, directly and indirectly through efforts (that appear to be showing some good results) to get better control of the shadow banking sector.  

Second, it has clarified the extent to which it is willing to accept a trade-off between these reforms and growth.  The line in the sand is 7% GDP, with apparently some allowance made for the quality of growth.  It has provided some highly target stimulus.   The rise in the latest official PMI prints continue to favor the soft landing in the world's second largest economy.  

Third, the PBOC successfully addressed the month-end squeeze in the money market, avoiding a potential repeat of July's disruption.  

What appears to be a cyclical recovery in Europe is continuing.  The PMI readings continue to edge higher and the forward looking new orders component suggests some positive momentum here in Q3.  The forward guidance by the ECB has helped counter the increase in yields that the favorable economic news could imply and the impulse emanating from anticipation of the Fed's tapering.  Of note, Spanish and Italian benchmark 10-year yields fell 19 and 24 bp respectively over the past four weeks, while the US yield has risen by 9 bp, after the 11 bp decline following the jobs report. 

Political pressures also appear to have eased, or at least stabilized.  The mini-crisis in Portugal has been effectively resolved (10-year yield has fallen 75 bp over the past month).  Spain's Rajoy appears to have neutralized his adversaries.  Italy's Letta government is the most fragile, but it appears Berlusconi's first conviction will not topple it.  Since the Senate must approve any jail term (and most likely won't), the real issue was the ban from politics, which has been sent back to a lower court.   The real challenge for the Letta government is still a month or two off and that is the 2014 budget.  

Capital flows have generally seemed to favor Europe.  We note three channels, merger and acquisitions, US money markets continue to rebuild their exposure to European bank paper, and international fund managers boosting exposure to European bonds and stocks (according to a Reuters survey conducted July 17-30).  

There has been a notable change in the Japanese portfolio flows.   Unexpected by many, Japanese investors have been persistent sellers of foreign assets since Abe's election.   This has changed.  For the past four weeks, according to MOF data, Japanese investors have been net buyers of foreign bonds and by the most in a year.  In fact, we suspect some the bond buying is related to seasonal factors (summer bonuses?) as in recent years Japanese foreign bond purchases rise in July-August. 

At the same time, the foreign appetite for Japanese equities has waned.  The four-week average peaked in April near JPY754 bln.  In the most recent four-week period, it dipped below JPY300 bln.  

The Japanese government increased its forecast for growth this fiscal year to 2.8% from 2.5%.  Anticipating the retail sales tax hike (from 5% to 8% next April), it forecasts 1% growth in the FY14/15.  The retail sales tax is also expected to boost CPI in the next fiscal year, by roughly two percentage points, to 3.3%.  

Data and Events

There will be news from three central banks this week and the BOJ meeting will be the least interesting as it most likely will not take any new initiatives.  The Reserve Bank of Australia will be the only one to take concrete action.  A 25 bp cut is expected.  It is also anticipated that the RBA will acknowledge scope for further easing of monetary policy. The employment data due at the end of the week is unlikely to deter such expectations.  

In the UK, the MPC is not meeting, but the BOE's quarterly inflation report is expected to lay out a new framework for forward guidance.  There has been some speculation of an unemployment threshold like the US, with some condition and flexibility around its inflation target.  

BOE Governor Carney has been twice blessed now.  First, he left Canada without the household debt, which proportionately greater than the US or the UK at their peaks and other internal imbalances from derailing the economy or financial system.  Second, he takes his new post at the BOE just as the UK economy is showing signs of recovery.  The 0.6% Q2 GDP has been followed by a series of data that indicates the momentum has continued into Q3.  

The favorable data stream is expected to continue this week with the service PMI.  The industrial production and trade figures are for June and may be regarded as old news, though may help shape expectations for revisions to the preliminary estimate of Q2 GDP.

Whereas the US calendar is light (service ISM, June trade balance) and consumer credit, the euro zone slate is more active.  After the service PMI and retail sales (expected to unwind the lion's share of the 1.0% rise in May) on Monday, attention will shift to Italy's Q2 GDP (expected to have contracted by 0.4% after a 0.6% contraction in Q1) and Germany factory orders on Tuesday.   Industrial production is reported the following day.  Spain also reports June industrial production on Thursday.  The French trade balance is reported at midweek and the deficit is expected to have fallen, while industrial production figures at the end of the week is expected to have recouped most of May's decline.  

China has a busy week as well.  Trade, inflation, industrial output and retail sales data are due in the coming days.  Food inflation still is driving headline CPI, with non-food inflation running below 1.8%.  Deflation is evident in producer prices and this is seen a symptom of the excess capacity that plagues numerous industries.  After falling in June, both imports and exports are expected to have grown in July and this may produce a somewhat smaller surplus.  Industrial output, fixed asset investment and retail sales are have generally been trending lower, and like the official PMI data, are consistent with a soft landing.