Macro Dynamic Remains the Same but the Calendar gets Busy

The economic calendar and central bank meeting diaries are busier in the week ahead.  The highlights include three G7 central bank meetings (the Bank of Japan, the Bank Canada, and the European Central Bank), Chinese Q2 GDP, and the first look at US July survey data (Empire and Philadelphia Fed).  The US also reports June retail sales and industrial production figures.  The Fed's Beige Book may offer some anecdotal insight into economic activity where the virus has jumped and re-openings stalled or reversed.

The underlying macro backdrop is unchanged.  Concerns about the pandemic's growth and the possibility that the antibodies offer only a short-lived reprieve from vulnerability encourage a cautious attitude by businesses and investors.  On the other hand, officials in most major countries seem prepared to provide more assistance and for longer, which underpins the flow of savings into risk assets.  Moreover, the convergence of real and nominal interest rates,  the apparently lagging US response to the health crisis, add to the dollar bear case that has been simmering for some time.

Let's begin with the central bank meetings.  The Bank of Japan's two-day meeting ends on July 15, the same day as the Bank of Canada's.  Neither one seems to have a strong sense of urgency act. The markets have been stable.  Japanese stocks have underperformed over the past month, and it is interesting that the Topix, which is base for the ETFs the BOJ buys, has fallen by about 2.25% over the past month while the narrower Nikkei is virtually flat.  Over the same period, the MSCI Asia Pacific Index, excluding Japan was up nearly 6.5%.

Of interest, the Bank of Japan will provide updated economic forecasts and, reportedly, there is some debate whether to revert back to showing point after providing ranges in April, given the degree of uncertainty.  The BOJ estimated that the world's third-largest economy would contract by 3.0% to 5.0% in the fiscal year through next March.  Both consumption and exports remain weak, and that undermines the case for capex.  There appears to be little upside momentum as the quarter wound down. More fiscal support may be needed, but might not be delivered until after the fiscal half-year in October.

The new Bank of Canada Governor Macklem can be content too with the monetary settings.  Market rates are steady to lower over the past month.  Profit-taking in equities has been limited. The Canadian dollar is around 0.75% weaker against the US dollar since the last meeting and the only major currency not to have risen against the greenback.   Implied currency volatility (three-month) is a little less than 6%, and the 200-day moving averages a little above 6%.  Commodity prices, including oil, have continued to recover from the March-April plunge.  The CRB Index, for example, has retraced roughly half of that drop.  Domestically, the labor market is improving  (about a third more jobs--~963K--than were expected in June after a 290k increase in May), and underlying measures of inflation (Canada has three) are holding up considerably better than the headline, which was below zero in May (most recent data).

The ECB meets on July 16.  It can be pleased that the challenge presented by the German Constitutional Court ruling has been addressed and that the Bundesbank can continue to participate in Public Sector Purchase Program (PSPP).  That said, we wonder if the broader issue of judicial review has been addressed and suspect the principle underlying the German court ruling may be claimed as precedent in the future. There is scope for some technical tweaks, but buying sub-investment grade corporate bonds, like the Federal Reserve is willing to do, is unlikely to be one of them. The more than 1 trillion euro of loans at minus 100 bp also removes the immediate urgency to exclude more reserves from the minus 50 bp deposit rate. 

A key talking point that someone has succeeded in planting with the media centers around the issue of the ECB's flexibility to deviate from the capital key in its bond purchases under the Pandemic Emergency Purchase Program.  The capital key is the share of the ECB's capitalization, and it is based on the size of a member (GDP and population).  With flexibility around it, the capital key has generally conditioned the bond purchases by the Eurosystem.  This sometimes reduced the options officials faced trying to ensure that the transmission mechanism of monetary policy, which meant, influencing yield levels and spreads.

At the same time, the capital key allowed the ECB to stay within its mandate, according to the European Court of Justice, when it has been challenged.  The strict constructionists apparently want to rein in the ECB's discretion as soon as possible and ostensibly keep it on more solid legal footing.  ECB President Lagarde will likely be questioned about this issue at her press conference.  Yet,  it seems that it was someone in that camp that leaked the story, and experience suggests and realpolitik considerations point to someone who lost the issue that often takes their case to the press.  The winning camp has no reason or need.

Turning to the economic data on tap, there are two highlights.  China is the first major country to report Q2 GDP figures.  It is not so much the accuracy of Chinese data that is questioned, after all, the US revises its estimate several times over a couple of years before settling on the right number.  Being able to estimate the output of the world's second-largest economy two weeks after the quarter ends is a feat, and for the speed, some trade-off in terms of accuracy is not unreasonable.  Still, the problem is that China's data is thought, like nearly everything else, to be subservient to the desires of the leaders of the Communist Party.

Nevertheless, there is little doubt that the Chinese economy is, in fact, recovering from the 9.8% contraction in Q1.  The real question is over the pace.  Retail sales and industrial output were likely still contracting on a year-over-year basis in June. Exports and imports are also lower, but the median forecast calls for China's economy to have grown about 2.5% from a year ago in Q2.  That would follow a 6.8% contraction in Q1.  On the quarter-over-quarter basis, China is expected to report growth of around 9.6% after a 9.8% decline in output in Q1.  It seems a bit too good.

At the same time, the dramatic moves in the Chinese markets continue.  Stocks are on fire, seemingly encouraged by official media. The Shanghai Composite is up more than 13% here in July and up 11% for the year. The Shenzhen Composite has gained nearly 31% this year through last week.  While the US and European 10-year benchmark yields have moved lower by 20-25 bp over the past month, China's 10-year yield has risen by as much to push above the 3.0% threshold for the first time since January.  Over the past month, the Chinese yuan has been the second strongest emerging market currency, rising 0.8% against the dollar (the Colombian peso is up 1.4%).

The other economic data highlight comes from the US.  Several high-frequency reports, but because of the new surge in virus cases, and rising hospitalizations, the data, like arguably we saw with the response to the jobs report, maybe too dated to have much impact outside of headline risk.    The June retail sales are likely to show more modest but still substantial gains in retail sales than seen in May.  The median forecast in the Bloomberg survey calls for a 5.6% increase after May's 17.7% surge.  Industrial output likely picked up momentum after the 1.4% rise in May, which included a 2.8% increase in manufacturing output.  The survey showed a median forecast for a 4.4% rise in June, led by a 5.5% jump in manufacturing output.  Housing starts and permits are expected to have accelerated in June, and the market may be sensitive to the geographic breakdown that is provided.

There are few doubts that general price pressures in the US remain muted.  The headline CPI in May was 0.1%.  It is expected to rise to 0.6%.  Core CPI is likely still moving lower as the minor rises are not sufficient to counter the base effect.  The challenge may be with inflation expectations.  Both the University of Michigan's survey (July 17 preliminary) and the market-based breakevens (the difference between the inflation-linked and conventional security) have been steadily increasing.  The former is approaching levels that prevailed before the crisis, while the latter is at its highest levels since late February (~1.40% 10-year breakeven).

Yet, investors seem to be hungriest for data that captures the economic impact of the new growth of the virus.  The July Empire State and Philadelphia Fed manufacturing surveys, albeit narrowly focused, may draw more attention than usual.  They enjoy strong correlations with other survey data.

After hitting -78.2 in April, the Empire State survey has been getting less worse, rising to -48.5 in May and -.0.2 in June.   The Bloomberg survey shows a median forecast of 5.5 for July. It finished 2019 at 3.3 after averaging 4.8 for the entire year.  The Philly Fed had its surge in June, jumping to 27.5 from -43.1 in May.  The median projection shows a milder reading of 17.5 in July.  The devil will be in the details but note that it averaged below 6 in Q4 2019 and below 10 for all of 2019.  Owing to an appreciation that things on the ground could be changing faster than data can capture, for businesses and investors, the anecdotal nature of the Beige Book may be of special interest. 

At the very end of the week, event risk takes the shape of the EU summit that is supposed to resolve the dispute over the Recovery Fund (560 bln euros), and a separate debt issuance (190 bln euros) and, more broadly, the seven-year budget.  If it is a Hamiltonian Moment, as some have argued, it is not hotly contested.  The so-called Frugal Four do not object to the common bond. Their objection is how the proceeds should be distributed.  They are opposed to giving it away and are more inclined to make the lending conditional. The focus has turned to the Dutch, there will be several bilateral meetings with Prime Minister Rutte next week.  Rutte is insisting that the strategic interests of Europe are secured, and that requires more Europe, which means conditionality.  

At the same time, the defeat of the candidate that Germany, France, Italy, and Spain backed for Eurogroup President warns of the risk of a different challenge, and the budget decision requires unanimity. The potential, given short-term market positioning (see speculative positioning in the futures market and the skew in the options market), is for a larger sell-off on disappointment than a rally on news of an agreement. 

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