Week Ahead Outlook (Conditional)

There are two broad courses for the capital markets in the week ahead. The first is a continuation of what we have experienced for the past two weeks. Greece's financial and political crisis, and the dramatic drop in Chinese shares, and the extensive policy response dominate the market's focus. Alternatively, the pressures emanating from these two forces could subside.

Our analysis leads us to think the odds favor the second scenario. However, before turning to the economic data and events that could replace Greece and China in commanding the attention of investors, we share the following observations.

First, the cost of parliamentary approval will likely precipitate a domestic political crisis. At the very least some cabinet reshuffle may needed to pass the legislation needed to fulfill the commitment to "prior action" that begins the implementation process of various reforms. Some European officials have emphasized the lack of trust. How can the creditors have confidence in the implementation of a program against which the Greek government campaigned? The risks are growing that trust cannot be rebuilt with a Tsipras-led government. Could Schaeuble and the interests he gives voice to accept a third assistance program were it accompanied by regime change?

Second, both the step away from a Greek exit and the stemming of the Chinese equity market meltdown are not long-term solutions. The high drama in Greece simply the beginnings of the negotiations for a third assistance program. Greece is taking on more debt so it can service its existing debt. It has been able to finance itself by falling deeper into arrears of its domestic goods and service providers.

China's government's actions to arrest the equity market's slide will come at a medium and long-term price. China's reform agenda and commitment giving greater sway to market forces are called into question by the government's policy response. It may make the A-shares inclusion in MSCI global indices less likely than many perceived to have been the case previously. Investors will have to anticipate overhead supply as stability in the markets will be met with the resumption of IPOs and sales by institutions part who were recruited into China's plunge protection team. Rather than let the stock market return to reasonable valuation measures, China's officials may be creating the conditions for an even large over-valuation. Moreover, they have facilitated a moral hazard that will likely come back to haunt it.

China releases a slew of economic data in the coming days. The key takeaway is that while lending (new loans) remains strong, and the stock market was rallying for most of Q2, the economy appears to have slowed. Even though the quarter ended only two weeks ago, the official estimate of Q2 GDP will be announced on Tuesday. The Bloomberg consensus is for a 6.8% rate, which would be the envy of most countries (if it were accurate) but also be the weakest Chinese growth since 2009.

Third, if an agreement to negotiate a third aid package is reached, Greece faces an imminent banking crisis. The ECB cannot raise the ELA ceiling in conditions, and, in fact, may start more earnestly to claw it back. The Bank of Greece has limited options.

On Tuesday, Greece has a JPY20 bln samurai bond that matures. Only about half is reportedly still outstanding. Although it is a small sum (~85 mln euros), the failure to redeem would constitute a default, and it could trigger cross-default clauses. The next day, the government owes civil servant wages and pension payments. There has been some speculation the scrip could be introduced. That scrip could be a step down a slippery slope and be the basis for a new Greek currency.

Three G7 central banks meet in the days ahead: the Bank of Canada, the European Central Bank, and the Bank of Japan. As is well appreciated, the ECB and BOJ are already engaged in quantitative easing. Neither is likely to change policy. The BOJ may tweak its economic forecasts. If so, it would likely be in the direction of lower growth and inflation. The ECB may prove somewhat more interesting, depending on the evolution of the Greek crisis. There is scope for the ECB to increase the universe of bonds it buys. Draghi is likely to stress that the ECB stands ready to assist countries adversely impacted by Greece. Separately, the Draghi is likely to recognize that the cyclical recovery remains intact, but is fragile and uneven, and needs structural reforms to buttress it.

The Bank of Canada could surprise by delivering another rate cut. Bloomberg survey found 28% expect a cut at this week's meeting. Another 23% say the cut is delivered in September. Given the string of disappointing news, including the contraction in April GDP, and the renewed slide in oil prices, a case for a rate cut seems clear.

We suspect that standing pat is worse for the Canadian dollar than a rate cut. A rate cut would be seen as the last one. Often the last cut in a cycle elicits a different market response than the first cut in a cycle. A decision to maintain the current stance could encourage speculation of a rate cut in September, and hang over the Canadian dollar.

III

The US economic data is likely to help economists fine-tune Q2 GDP estimates, but in terms of policy Fed Chair Yellen has already shared her assessment. There is room for additional improvement in the labor market, which is expected to materialize, and this will allow the Federal Reserve to raise rates later this year. What Yellen said before the weekend will likely serve as the basis of her remarks before Congress this week. Yellen will seek to explain the Fed's thinking. She will likely avoid the announcement of new initiatives or policies.

Yellen was also clear that while events in Europe and China should and will be monitored, currently the direct impact on the US appears modest. Unless the situations deteriorate markedly, they are not particularly salient in the setting of US monetary policy. US macroeconomic fundamentals are more important.

Yellen revealed before the weekend that her own views are broadly consistent with the central tendencies of the Fed's forecasts. This confirms our analysis that she sits near the middle of the FOMC, contrary to claims that cast her as an extreme dove.

The US economy appears to have expanded between 2.25% and 2.50% in Q2. Signs that it is accelerating from there are elusive. The July Empire and Philly Fed surveys are expected to confirm steady if not robust activity. Of note, industrial production is expected to have risen in June after falling in all but one (March 0.01%) month this year. Housing starts are expected to have rebounded after a weak May though permits may pullback after the outsized 11.8% rise in May.

Headline CPI for June may be the first positive reading of the year. The core rate is expected to tick up to 1.8% from 17%. It is been in this range since February. It has been in a 1.6%-1.9% range since last July.

The UK reports June inflation and employment data. Headline CPI may slip back to zero from 0.1%. The core rate is expected to remain steady at 0.9%. However, the important inflation signal will come from the average weekly wage data, which is part of the employment report. Average weekly wages are looked at on a three-month year-over-year basis that has an additional lag. While the other employment data will be for June, the wages data will be for May. It is expected to rise to 3.3% from 2.7%. The rise excluding bonuses is expected up 3.0% (also from 2.7% in April.

Such a report is likely to boost speculation that the period of no dissents at the MPC will likely end as early as next month. The upward pressure on wages also comes as the claimant count decline moderates. It is expected to be off 9k in June, which is just below the three-month average pace and well below the six-month average of 22k decline.

The implied yield June 2016 short-sterling futures contract fell from 113 bp on June 26 to 88 bp in the middle of last week. The implied yield rose last Thursday and Friday to close the week at 97 bp. The risk is that the earnings data sees short-term UK yields rise. Assuming it is not overshadowed by other developments, it could help sterling outperform.

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