Busy Week Ahead, but ECB Meeting Stands Out

The week ahead is packed with events and data.  The monthly cycle of purchasing managers surveys  and the US jobs report are featured. There are also central bank meetings in six high-income countries and three emerging markets.   Given the recent geopolitical development, in Ukraine, as well ISIS, will give the NATO meeting extra significance.  

At the end of the day, there will be little to learn from the PMI data and most of the central bank meetings. Yes, there may be some headline risks, but our information set will not change very much.  The euro area flash report steal most of the thunder from the final report.   Arguably, more important for the outlook will be German industrial orders and production reports.  Modest improvement is expected.  The German economy is not really contracting, though it did in Q2.  

German exports to Russia are no more than 1% of GDP.  Assume that the sanctions cut German exports to Russia by three-quarters.  Now put that in the context of last year's growth (0.4%) and this year's projected growth of the German economy (~1.7%).  This is not to argue, like many have done that Germany has not interest in a rigorous sanction regime.  Such arguments seem to repeat the error of those who thought the euro zone was going to break up over Greece or Cyprus.  So many investors seem to exaggerate economic influences and dismiss political motivations. 

We have argued the advent of EMU and the euro is first and foremost an economic solution to a political problem, the reunification of Germany.  Europe itself is more a political construct than a geological one.  Political interests overrode economic interests, and that is why EMU survived. Similarly, the political elite is not Philistines.  They can and are putting larger political interests ahead of narrow economic interests.  Yes, there are compromises, but an economic determinist explanation and forecast does not do the situation justice.  

The PMI data is likely to confirm that the UK economy has lost some economic momentum that was recorded earlier this year.  It continues to operate a high level, but the moderation seen in July likely extended into August.  

The US employment data will also most likely confirm what we already know, and if it does not it will likely shrugged off as a fluke.  There is no reason not to look for the 200+ monthly increases in non-farm payrolls to extend the streak to seven consecutive months.  Nearly all the inputs that have been reported that economists use to shape their forecasts improved.  

Fed officials are looking at the general trend and here is what they see.  The acceleration of improvement can be seen in the averages.  The more recent averages are above the long-term term averages.  The three-month average is 245k.  The six-month average is at 244k.  The 12-month average is at 214k, and the 24-month average stands at 203k.  

The other of the labor market are less volatile, but the forward guidance has raised their significance over  the unemployment rate, which is likely to have ticked down to 6.0%-6.1% from 6.2% in July. Average weekly earnings may have ticked up, but the underlying trend remains flat.  A small increase would lift the year-over-year rate to 2.1%.  The three- and six-month averages are at 2.0%, and the 12-month is at 2.1%.  The 24-month average is 2.0%.  

Nor will Chinese PMI data likely change investors' views of the world's second largest economy. The economic data shows an economy that continues to expand 7.0%-7.5%, while being in some kind of economic and political transition, though the destination is not immediately obvious.   The PMI data will not shed much light on the immediate economic challenges will are emanating from the circulation of capital and real estate market.  

The softer Chinese demand for iron ore is thought to be the key factor driving down prices.   The Australian dollar has been resilient, largely in a broad trading range.  This underscores our understanding that the ultimate driving force of currencies from open high-income economies is the market for capital more so than the market for goods.  Australia's AAA rating and high yield appeals to both private and public asset managers.   

Most of the central bank meetings will not amount to much either.  The central banks of Brazil, Mexico and Poland, are expected to leave rates unchanged at 11%, 3% and 2.5% respectively.  Among the major central, banks, the BOE is not expected to say anything at the conclusion of the MPC meeting.  The Bank of Canada meeting will also likely be a non-event.   The Reserve Bank of Australia has indicated a stable rate, and there is little reason to expect a change.   

The Bank of Japan is surely disappointed with the recent economic readings that showed that the pullback in household consumption deepened in July and the half-hearted gain in industrial output.  However, Governor Kuroda is likely to give it an optimistic spin on it, though the debate is likely to intensify below the surface.  

The Riksbank surprised the market at its last meeting with a 50 bp rate cut that was delivered over the objections of the Governor and his deputy.  A follow-up rate cut is possible, but it seems unlikely.  Sweden's central bank may alter its expected repo rate path, which is a type of forward guidance that also has not proved particularly reliable.  

The ECB meeting is the most significant event.   Draghi all but pre-committed the ECB to action by acknowledging the disturbing decline in inflation expectations.  In the past, he said that this would trigger an official response.  The key issue is what action will be announced.  There has been much speculation that the ECB will announce an ABS purchase program.   We think the risk of this is very low for both practical and political reasons.  They might be moving quickly toward an ABS purchases, but there was much ground to cover, including regulatory issues, that have yet to be addressed, it seems.

It also appears to be risking putting the cart ahead of the horse if an ABS purchase program is announced, before the TLTRO is launched, and before the results of the asset quality review.   Indeed, it is through this process, that officials will have a greater understanding of the capacity and limits of bank balance sheets.  

We would attribute a greater chance of some small rate cuts, and possibly pushing the deposit rate into deeper negative territory.  We attribute an even greater probability to the ECB providing more details about what Draghi called the "modalities" of the TLTRO.  While reassuring investors that the ECB will do more if there is no substantial improvement, it may content itself with emphasizing and/or tweaking some of the rules regarding the access to the TLTRO facility, with an eye toward ensuring strong participation in the launch later in the month.  This may include spelling out the ability for smaller banks that don't have access to ECB facilities to participate (through other banks).  Draghi may also explain how in the second of two phases of the TLTRO, banks that are still deleveraging can still participate.  

If our assessment is right, we suspect many investors may be disappointed.  Given the extreme market positioning, we are concerned that many shorts are in weak hands.  A squeeze higher would provide medium and longer term investors with an opportunity to adjust exposures directly or through hedging.  

Geopolitics continues to be a concern for investors.  The Ukraine situation has escalated as Russian forces have entered the east.  In addressing the militants, Putin referred to "Novorossiya", or New Russia, which seemed to confirm his intent on removing another piece of Ukraine, whether in the form of a new state or to be part of Russia, as was the case with Crimea is immediately clear. 

We have argued that diplomacy is about nuances and that these nuances matter. Some observers dismiss the references, for example, of incursion instead of invasion as pusillanimous in the extreme.  Yet, there may be a significant consequence.  If it is a declared war, Ukraine would most likely not qualify for IMF assistance, which it desperately needs.  Over the weekend, the IMF agreed on disbursing another $1.4 bln of the $!7 bln aid package.  

There is a subtext of the events to consider as well.  After the collapse of the Soviet Union, NATO was brought to Russia's doorstep.  The EU was also expanded into what a key part of Russia's elite, and not just Putin, had seen as its sphere of influence.  Russia did not have the political will or resources to resist.  In Georgia and Moldova, Russia pushed back.   In Ukraine, it is making a clear stand.   Just like Russia has not struck at a NATO member, the US and Europe are not prepared to sacrifice their young people to take secure territory in Russia's near abroad.  It took what it could on the cheap, and expresses its displeasure with Russia's behavior where it cannot take.  

More sanctions are likely that seek to further isolate Russia.  These could include access to syndicated bank loans and restrictions on the sale of high-tech gas equipment. UK Prime Minister Cameron suggested limiting Russia's access to SWIFT payment system.  Russia has indicated that its retaliation could include cars, aerospace, and shipbuilding.  

While developments in Syria, Iraq and Iran are still of much concern, events in Hong Kong warn of a potentially new flash point.  The stage is set for a more intense confrontation between China and Hong Kong and between the Hong Kong economic and political elite and the pro-democracy movement.  

Ahead of the Hong Kong election in 2017, Chinese officials indicated that there will not be public nominations for the chief executive.  There will only be 2-3 candidates, and they will need to be approved by a majority of the 1200-person nominating committee.  The next step is for it to be affirmed by the Hong Kong legislature. A blocking minority of 27 members (of the 70 member legislature) is likely.  If it is rejected, the nominating committee will appoint the next chief executive for Hong Kong.  

Hong Kong has been the recipient of hot money flows.  Some appears to be coming from Russian sources.  Some appear to be an effort to play the Chinese stock market, which, thus far in Q3, is among the world's best performers.  The Shanghai Composite is up 8.2% since the end of June, and the Hang Seng is up 6.7%. The Hong Kong Enterprise Index, which tracks mainland companies, is up 6%. The capital flows have exerted upward pressure on the Hong Kong dollar and triggered intervention by the Hong Kong Monetary Authority.  The risk of social unrest may discourage new inflows.