The Investment Climate and the Week Ahead

The broad economic conditions have been shaped to a large extent by the different policy responses to the Great Financial Crisis.  For reasons that need not concern us here, the US and UK policy response was relatively stronger than the eurozone and Japan's response.   This, in turn, has produced a de-synchronized growth cycle.    

Admittedly, Japan is a bit more complicated.  The first two arrows of Abenomics, namely aggressive fiscal and monetary policy appeared to put the world's third largest economy on a better path of growth and finally broke deflation's grip.  However, the retail sales tax hike, and fear of next year's hike (from 8% to 10%) has derailed the economy.   The impact has been deeper and longer lasting than Japanese officials had expected.  

Most recently, the UK economy appears to have lost some momentum.  As expectations of the BOE's first rate hike get pushed out in time, sterling has weakened.  In fact, last week, it under-performed the euro (1-7% for sterling and -1.3% for the euro), even though Draghi's press conference disappointed many.  

We had highlighted the risk of a potential downside surprise of the September employment report, which did not materialize.  One of the reasons in our thinking was the clear recent pattern for the consensus forecasts to err on the upside of actual. Important economic reports, such as factory orders and construction spending so missed expectations that many economists shaved Q3 growth forecasts lower.  The non-farm payroll growth surprised on the upside.   The unemployment rate fell below 6%.  

Given this backdrop, the market may be pre-disposed to read the FOMC minutes that will be published on Wednesday hawkishly.   The FOMC minutes, like the dot-plot, give greater voice to hawks than actually reflected in policy.  There were two dissents as Fisher joined Plosser.  Yet, unlike the dissents at the Bank of England, Fisher and Plosser's dissents are not about raising interest rates, but how the Fed's forward guidance is characterized.  Is quibbling over words too harsh a judgment?  Fisher himself said he was inclined to see the first hike in Q1.  The consensus seems to be April or June. Is that really the difference between the "hawks" and "doves", rhetoric aside?

The Fed's new Labor Market Condition Index and the JOLTS report offer broader views of the labor market.  They are more important than in many respects than last week's employment report in terms of shaping the Troika (Yellen, Dudley, Fischer) assessment of the labor market.  

The US corporate earnings season officially kicks-off with Aloca’s report in the middle of the week.  Generally speaking, the major investment houses are fairly unanimous in recommending overweight tech and underweight consumer staples and consumer discretionary stocks.  In addition, to tech, analysts are mostly bullish financials and healthcare. 

The Bank of England, the Bank of Japan and the Reserve Bank of Australia meet in the week ahead.  The Bank of England is the least eventful.  It will do nothing and say less.  A press conference will follow the BOJ meeting, where not change of policy is anticipated.   BOJ Governor Kuroda is unlikely to provide any clue that he is thinking about more stimulus.  His comments on the exchange rate will be closely watched, as he was last to embrace the yen's decline.  

The Reserve Bank of Australia may be the most interesting of the three major central banks that meet.  The Australian dollar has fallen roughly 8% against the US dollar since the RBA met last. Commodity prices have tumbled.  World growth has been downgraded.  The Chinese government has not ceased its anti-corruption or anti-pollution measures, or its financial liberalization, even though the economy. 

Investors should anticipate a dovish central bank.  The currency decline is not sufficient in the face of the decline in commodity prices, and give that the OECD's PPP model still shows the Australian dollar nearly 24% over-valued.  It is in third place behind the Swiss franc (~30.5%) and Norwegian krone (almost 28%).    

Australian employment employment report (Thursday) has been especially volatile after a change in the sampling methodology.  The August rise of 121k was incredible in the sense of not being credible.  The market expects a significant unwinding of this outsized gain.  It may simply be embraced be the bears as a fresh reason to continue to build the short position.  Recall that in the latest Commitment of Traders report (for the week ending September 30), the net speculative position in the futures market swung to favor the shorts for the first time since in six months.  

The main economic data are Europe's industrial production figures.  That France likely experienced a contraction is not really news.  If the industrial production rose a little in Italy, as the consensus expects after a 1.0% decline in July, so what?  The government just revised down its estimate of growth to show another year of contraction.  

The more important news will come from Germany and the UK.  These were the two relatively robust parts of Europe.  German orders and output likely fell in August.  The manufacturing PMI warns weakness likely carried into September.  A decline in orders will strengthen that expectation. That the UK economy is cooling is clear, how cold it gets, is not.  

Every quarter since Q3 2010, the UK has reported one month with a decline in manufacturing.  The consensus is for a flat August report after a 0.3% increase in July.    An outright decline would likely weigh on sterling, through the expected interest rate channel, more than a stronger than expected report would necessarily help it in a strong dollar environment.

France and Germany report August trade balances.  They will underscore the divergence between two, with sustained deficits by the former and large surpluses by the later.  At the same time, Germany has sustained a significant trade surplus.  The deficits in the periphery have closed or nearly so.  The eurozone enjoys a significant current account surplus with the world.

It is not exactly obvious that it needs the weaker euro that is being encouraged by officials, or that a weaker euro will have redistribute economic activity in Europe.   The weaker euro will strengthen Germany relative to the periphery, allowing its businesses to be hyper-competitive, and little reason to support a more generous balance of the interests between the creditors and debtors. Similarly, if the recent downturn in Germany is sustained, its interests become more aligned with France and Italy.   

Japan reports its August Balance of Payments.  There is a heavy seasonal influence.  In nine of the past ten years the August current account balance deteriorated from July, which has bettered June for the past eleven years.  You get the point.  More interestingly will be the country breakdown of the Japanese foreign portfolio flows and in  particular, its bond purchases.  

There has been a marked shift in Japan's financial appetite.  In the first seven months of 2013, Japanese investors sold about JPY6.54 trillion (~$72 bln) of US bonds.  In the first seven months of this year, they bought  JPY2.64 trillion (~$2.9 bln).  Japanese investors have stepped up their purchases of French bonds and bought more French than US bonds this year.   In the Jan-July period, they bought JPY3.15 trillion  French bonds, up from JPY860 bln in the year-ago period.  Japanese investors switched from selling almost JPY1 trillion of Australian bonds during the first seven month of 2013 to buying JPY571 bln this year.  

Some of the new purchases may have been funded by new inflows.  Some of these purchases appear to have been funded from the sales of German bunds.  Japanese investors have sold JPY4.6 trillion of German bunds in the year through August.  In the same year-ago period, they bought JPY2.2 trillion.

Turning away from macro-economics, there are a number of factors that global investors will continue to monitor.  Ebola is a human tragedy, but it could also have geopolitical and economic consequences.  We are still in the early innings.  The stepped up efforts to contain/rollback ISIS/ISIL has created unexpected headlines about the US and its Middle East allies.  The impact on the investment climate remains marginal, but this could change rapidly, especially if the battle is brought via terrorism to the US or Europe. 

The Umbrella Revolution in Hong Kong has been impressive.  Unlike the Occupy movement there is a clear agenda (popular election of the chief executive of Hong Kong) and enjoys widespread support, and arguably even greater sympathy.  The real test is yet to come.  The holiday period is ending.  It is difficult to sustain the level of intensity for long. 

Given the holiday, the full market impact is not completely clear.  The Hong Kong dollar has been pushed off its ceiling, something that HKMA intervention was having difficulty doing, but it remains well above the floor.  In fact, with the dollar just above HKD7.76, its earliar gains have been pealed back.   Hong Kong stocks fell 3.6% last week, a bit more than the MSCI Emerging Market equity index (~-2.6%), but in line with the Nikkei and Topix (-3.2% and -3.7% respectively).  The MSCI Asian Pacific Index was off a little more than 3% last week.

Note that the new facility allowing Hong Kong accounts access to Shanghai traded stocks (~$3 bln limit per day) is an important liberalization measure that ought not be lost in the excitement over the massive demonstrations in Hong Kong.  Yet on another level of analysis, Shanghai is a rapidly growing on-shore financial center that may eventually compete with Hong Kong for such activities. 

Lastly, the results of the (first round) of the Brazilian elections are not yet known.  Incumbent Dilma has come on strong over the past week, and this is not the scenario many investors had hoped for or anticipated.  Yet the dollar staged a downside key reversal before the weekend.  It initially made a new high for the move, pushing above BRL2.50, but then sold-off hard, through Thursday’s low and finished just below BRL2.46.  Given the costs (interest rate differentials), it is difficult to be short the real if the momentum flags, and that is precisely what the price action warns.