Drivers: The Week Ahead

Four events stand out in the first week of October:  the situation in Italy, UK Prime Minister May's speech at the Tory Party Conference, the EMU PMI, and the US jobs data.  We suspect that the market overreacted to the Italian government's 2.4% deficit projection.  It is not an unreasonable outcome given the election.  Italy may still very well run a primary budget surplus in 2019, and outside of Moody's, the other rating agencies may grant Italy some time.  The EC itself may not be as confrontational if there is a lesson to be learned from the experience with Greece.  May's Chequers plan is not acceptable to the EC without a backstop for the Irish border, which the UK rejects.  Nor is it acceptable to her party critics who may still launch a leadership challenge.  A confirmation of the eurozone's flash PMI will leave it with the lowest quarterly average since Q1 17.  The US jobs data expected to be near the recent averages and hourly earnings growth may slow. 

Italy:  What has been an internal debate in Italy will now become an external confrontation with the EC over the trajectory of fiscal policy.  There may be leeway than displayed by the knee-jerk reaction of investors and the tut-tutting by many economists. The beginning point is not that the Italian government projects a 2.4% budget deficit (of GDP) for the next three years.  It is that Italy runs a primary budget surplus on average for the past seven years of 1.5% of GDP.   The deficit is 0.4% more than the finance minister had indicated was the most he would accept. This is about 7 bln euros on its roughly 1.75 trillion euro GDP.  The 3.7% slide in the Italian stock market before the weekend wiped out 24 bln euros. 

Rating Agencies:  There is fear that Italy may be downgraded and at a time when the ECB is winding down its bond-buying program.  Moody's Baa2 rating has a negative outlook, and a decision is likely in October.  It seems to be the most likely to cut Italy's rating.  S&P is reviewing  Italy's BBB rating, and a decision is scheduled for October 26.  Recall that last October, S&P surprised many with its first upgrade of Italy's rating in at least 30 years.  It may not be in a hurry to say this was in error.  Fitch's BBB rating for Italy was given a negative outlook in August, but it is unlikely to cut its rating soon.  It has assumed a 2.2% deficit for 2019 and 2.6% for 2020.  DBRS is the fourth rating agency that is used by the ECB.  It gives Italy a BBB (high) rating and is willing to tolerate some deterioration of the debt/GDP ratio especially if the external environment remains strong and the fiscal measures boost growth.   

Italian Politics:  It is not unreasonable that the League and the Five Star Movement insist on implementing the programs on which they had campaigned.  The 2.4% deficit projection is not nearly as onerous as some had feared.  Although this within the 3% deficit-GDP mandated by the Growth and Stability Pact, it shows a reluctance to adhere to the 60% debt cap rule.   Power lies with the two deputy prime ministers, who had been outmaneuvered in naming the finance minister.  The centrist-bloc of the President, Prime Minister, Finance Minister, and Foreign Minister are on the defensive.  A resignation by the finance minister would be another blow to investor confidence if it comes to that.  Di Maio and Salvini appear to be looking forward to European Parliament Elections next spring and must deliver the goods.  The issue is whether tax cut and "citizens wage" will help boost growth or whether it will be more than offset other factors, such as higher interest rates, the loss of business confidence and weaker international trade environment,   On the other hand, the left appears demoralized and without a clear alternative. 

UK:  UK politics is more interesting and important to investors than economics.  Before the weekend Q2 growth was confirmed 0.4%, but the year-over-year pace was shaved to 1.2% from 1.3%.  Growth in H1 was the slowest since H1 2012.  Real sector data appears to be outperforming the survey data, and the September PMI composite is expected to ease 54.0 from 54.2.  That would put the Q3 average below the Q2 average.  May's speech to the Tory Party Conference at the middle of the week is the next key event on the tortured road to Brexit.  Tactically, she was going to outflank the hard Brexit camp with a focus on limits on immigration.  However, with the state of her Chequers Plan following the rejection of the EU's Irish border backstop, it may not be sufficient to ward off a leadership challenge,  That said, the PredictIt shows betters have May a 3:1 favorite to be Prime Minister at the end of the year.  It also has May a 2:1 favorite as the next European leader to be out of office over Italy's Conte.  The euro traded heavily against sterling most of last week but recovered smartly ahead of the weekend after testing the 100-day moving average near GBP0.8820. A move now above the GBP0.8940-GBP0.8950 area is needed to denote anything of technical importance. 

Eurozone PMI:  ECB President Draghi often has referred to survey data, and the PMI is among the most important.  We suspect that if the flash 54.2 composite reading is revised, it will be to the downside as German and Italian momentum seems poor.  However, even if there is no revision, the average in Q3 would stand at 54.3, the slowest since Q1 17, and follows 54.7 average in Q2 and 57.0 in Q1.  This does not seem as much of a slow patch as a return to more sustainable levels after a bout of pent-up consumption and investment demand was met.  Draghi pinned his confidence to the Phillips Curve, arguing that tighter labor market conditions are boosting wages and underlying inflation.  It does not appear to be lifting consumption.  Retail sales have risen by 0.1% on average a month through July this year and 0.2% in the first seven months of 2017.  The year-over-year pace in August will likely be lifted by the easy comparison to August 2017 when retail sales fell 0.4%.  The shoe is on the other foot in September when last year's 1.1% gain drops out of the year-over-year comparison. Given Draghi's recent remarks about inflation, the price components of the PMI may draw closer attention as well.

US Employment:  Jobs growth in the US remains solid.  In fact, average monthly jobs growth this year  (207k) is running ahead of the 2016 and 2017 averages (195k and 182k respectively).  With a new cyclical low in weekly jobless claims and generally strong economic readings, economists see no reason not to expect continued robust jobs growth, and most forecasts are coming in just below 200k.

Jobs and the Economy: Manufacturing employment, which the Trump Administration wants to grow in part by forcing companies to re-shore their international supply chains, may draw the market's attention.  Recall that the US lost manufacturing jobs in August for the first time this year and only the second time since Trump was elected.  US manufacturing jobs have not be lost for two consecutive months since the August-October 2016 period.   Our concern is two-fold.  The first relates to trade.  We are not convinced that the US trade policy is why manufacturing job growth has been strong.  For example, the booming energy sector appears to be flattering the numbers.  The retaliatory tariffs may also become a drag.  Second, the unexpected decline in core durable goods orders (excluding aircraft and defense) reported last week is troubling.   The 0.5% decline was led by computers and electronic products, but there was also a decline in motor vehicle orders.  We suspect that Q2 GDP, which was confirmed at 4.2% might be the peak of the fiscal stimulus-induced late-cycle surge.

Hourly Earnings:  Hourly earnings have eclipsed the jobs growth and unemployment rate in importance for investors.  Earnings growth accelerated in August to 2.9%.  This pace likely overstates the case and will most likely have slowed in September.  The base effect will be a drag if last September's 0.5% increase is not repeated.  In fact, a return to trend could see the year-over-year pace slow to 2.7%.  Hour earnings growth is barely keeping pace with inflation, but the income associated with the 1.6 mln net new jobs this year is helping consumption as is some part of the nearly $87 bln expansion of consumer credit through July.

Emerging Market Highlights: Turkey reports September inflation on October 3.  The lira's depreciation is boosting inflation, and the CPI is expected to rise above 21% from a little below 18% in August.  The US dollar may find support a little below TRY6.0 after falling nearly 7.5% in September.  India's central bank meets on October 5 and a 25 bp rate hike of the repo and reverse repo rates (to 6.75% and 6.50% respectively) is widely anticipated.   The dollar has risen against the rupee for the past five weeks and seven of the last eight.  It appears to have entered a consolidative phase.  Mexico and Poland central banks meet, but no policy changes are expected. 

  

Misc:  The Reserve Bank of Australia meets on October 2.  The cash rate is expected to remain at 1.5% not just now for the next few quarters.  The US pays 78 bp more than Australia to borrow for two years, the most in 20 years.  The 10-year premium of 39 bp is the most since the early 1980s.  The Australian dollar has fallen more than 12% since peaking in January near $0.8135.  It is testing support near $0.7200.  Our medium-term technical target is closer to $0.6900.  Chinese markets are closed, but both the official and Caixin manufacturing PMIs showed the bite of the trade tensions with the US. The government's measure fell to 50.8 from 51.3 in August.  Export orders fell to 48.0.  September was the fourth month that the reading was below the 50 boom/bust level.  The Caixin manufacturing survey fell to 50.0 from 50.6, the lowest since May 2017.  The government's non-manufacturing survey, which reflects the domestic economy and construction, jumped to 54.9 from 49.0 and matches the highest level since March 2017.    The dollar rose against the yuan for the sixth consecutive month in September.  Bearish sentiment toward the yuan will be expressed via the offshore yuan (CNH). The PBOC has drawn a line, indicated that dollar moves above CNY7.0 will be resisted.   There was a flurry of NAFTA negotiations over the weekend as both Canada and the US sought a last-minute agreement.  The Canadian dollar rallied 1% ahead of the weekend on some optimism and a stronger than expected July GDP.  Quebec holds provincial elections on October 1.  The demise of the Parti Quebecois has made room for the Coalition Avenir Quebec, which is polling a few percentage points ahead of Quebec's Liberal Party.  The left Quebec Solidarie also may pull voters from Parti Quebecois and may win its first seat outside of Montreal.  The key for it is the youth turnout.  

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