Big Picture Look at Next Week

The 2007-2008 financial crisis elicited a dramatic policy response that saw interventions by the state on a scale not seen in a generation or more.  Yet, what is a distinguishing characteristic now is the weakness of the state.  This assessment is not simply limited to the continued shutdown of the US federal government and the approaching debt ceiling within a fortnight.

The laborious process of forming a new government in Germany will likely delay key decisions in the euro area, especially regarding the back stop for banks ahead of the beginning of the asset quality review.   The center-right Free Democrats will not be represented in the Bundestag since it was founded in 1948.  The Italian government survived a vote of confidence, but it is not completely clear what kind of mandate it has.  It barely survived the VAT debate and faces a Senate vote on Berlusconi's eviction.  Letta himself faces a challenge for party leadership in early December.

There are also more modest perturbations. The UK government is expected to announce a modest cabinet reshuffle in the first part of this week, as Prime Minister Cameron eyes next spring's local and EU parliamentary elections.  The junior partner in the coalition is slipping in the polls (shades of the German Free Democrats?) and seems divided, while Labour is being denied a major issue with the economic rebound.  

Japan's Prime Minister Abe formally decided last week to proceed with the retail sales tax, which has acted as the "third rail" of Japanese politics and helped trigger the downfall of the previous government, led by the DPJ.   With weak wage growth and rising inflation, real incomes are being squeezed and the retail sales tax risks punishing the household sector even more.  Although Abe's support remains strong, the outlook is less clear.  

France's Hollande support has continued to deteriorate; falling below 25% in September according to last month's IFOP poll.  The erosion was particular pronounced among his government's allies in the Green party.  Meanwhile, Hollande's ability to make good on his pledge to lower unemployment by the end of the year is looking increasingly questionable.  

Portugal's Prime Minister's party took a shellacking in recent local elections.  The ability of the country to exit its assistance program next year as intended countries to look questionable at best   It has yet to convincingly demonstrate full access to the capital markets at reasonable rates.  Ironically, that leaves Spain's Prime Minister Rajoy appears to be rising above the summer scandal accusations and opposition calls for his resignation.  An improving economy may be helping, but the property bubble is still deflating and the improvement in employment appears mostly seasonal.  With last year's VAT hike dropping out of the inflation measures, disinflationary forces are strengthening and may pose new challenges for Rajoy.  

In the week ahead, the Netherlands, Germany and Italy will be selling bonds; trying to raise a combined 11.5-14.5 bln euros, but the more interesting sale will be the ESM's inaugural bond offering.  The proceeds will be used for assistance for Cyprus and refinancing the bills, and floating rate notes used for Spain's bank recapitalization program, according to reports.  Given the capital structure and the likely concession for its first bond sale, the ESM bond may trade through the similar EFSF bond.  

The closure of the US government may prevent the collection and release of economic data, but it will not prevent the Treasury Department from issuing new notes and bonds.  It will raise $64 bln in 3- and 10-year notes and 30-year bonds in auctions Tuesday through Thursday.  

As the intransigence in Washington continues, the risk of default is rising, even if still modest levels, as reflected in various market measures, including credit default swaps.  The yields demanded for T-bill expiring in the second half of October have risen and investor appear to be exiting from Treasuries maturing closest to the debt ceiling deadline.

The Bank of England is the only G10 central bank meeting in the week ahead.  Given the forward guidance, even if the market is skeptical about the time frame offered for the first hike, the MPC is unlikely to change its stance.  Although Governor Carney's modus operandi is still new, a statement is not expected.  

The Federal Reserve will release the FOMC minutes from last month's meeting, which decided not to slow its bond purchases.  Polls had shown than 2/3 had expected the Fed to taper.  Some Fed officials have suggested it was a close vote.  It was not, in the sense that there was only one dissent from the FOMC.  That there were other a couple of other regional presidents, who do not vote on the FOMC,  that wanted to taper, like Dallas Fed's Fisher, would not be surprising, but this does not mean it was a close call.  

Moreover, drag caused by the closure of the government, the lack of data, including the employment report, some private sector reports, like auto sales, the ISM and consumer confidence, underscores why the Fed is not likely to taper in October.  We remain skeptical about a December tapering as well and see more anecdotal reports suggest others are moving in this direction too.  

Europe reports August industrial production figures.  The risk is that the PMI survey data, which economists and policy makers watch closely continues to run ahead of the actual data.  In July, which saw the manufacturing PMI rise above the 50 boom/bust level for the first time since in two years,  the euro area industrial output fell 1.5% on the month (seasonally adjusted).  In August, the manufacturing PMI rose from 50.3 to 51.4.    

That said, industrial output is likely to have bounced back by 1.0% or a little more in August.  German industrial production is expected to have risen 1.0% after falling 1.7% in July.  France is expected to have completed retraced July's 0.6% decline.  Italy may have retraced about half of its 1.1% July fall. Spain appears to be the main exception, with a decline in August on par with July's 1.4% drop.  

The UK and Sweden also report August industrial output figures.  After a flat July, industrial output is expected to have risen 0.4%.  In Sweden, the growth of industrial output may have slowed from the 0.7% pace seen in July, but due to base effects, the year-over-year contraction may deepen.  Industrial orders continue to expand at a slower rate than output.  

Japan reports August machinery orders Thursday in Tokyo.  A source of disappointment with the mostly upbeat Tankan survey was a decline in the projected capital expenditures.  This in turn must frustrate Japanese policy makers, for which improved capex is key component to Abenomics. Machinery orders, one component of capex, were flat in July and expected to have risen 2.5% in August.  

Japan will report is August current account figures first thing Tuesday in Tokyo.    On a seasonally adjusted basis, the surplus is expected to have nearly doubled to JPY634 bln.  About a third of the improved may have come from a smaller trade deficit.  An increase in the investment income likely accounted for the bulk of the remainder.  

Among emerging markets, we note that Brazil's central bank is likely to hike its overnight rate (Selic) 50 bp to 9.50% on October 9.  China's market re-open after the week long national holiday.  The MSCI Asia-Pacific Index lost about 1% last week, though this is partly a function of the Nikkei's 5% loss.  The MSCI Emerging Markets equity index rose by about 0.8%.  

HSBC will report its non-manufacturing PMI measure for China.  The official one was released last week and it rose to 55.4 from 53.9 and may have stolen some HSBC's thunder.   The HSBC August estimate was 53.8.    China is expected to report new yuan loans and aggregate financing figures.  As was the case in August, so too in September, the growth in aggregate financing is easily outstripping growth in yuan loans, suggesting shadow banking activity is strengthening.