What to watch out for over the hot summer nights of July and August
Thursday, July 15, 2010 at 4:56PM The key themes over the forecast period are likely to be driven by European stress tests, Fed meetings, minutes and testimonies, Chinese GDP and Purchasing Managers Index as well as UK inflation and consumer confidence reports.
European stress puppies are likely to be the dogs that don’t bark over the summer, but in conclusion we can expect the most plausibly optimistic central scenario. Politicians and regulators face a classic prisoners dilemma, where each country wants to give as many of its domestic banks a clean bill of health, but recognise that the €urozone as a whole will need to force combined capital increases of at least €80-90bn.
The stress tests are unlikely to alleviate market concerns over the eventual requirement for European restructuring. US Nobel prize winner Robert Mundell, and progenitor of work on optimal currency areas, estimates a 40% risk of Greece restructuring, while Spain, Portugal and Ireland have a 20% probability of restructuring and our favourite of the PIIGS, Italy has a 10% risk over the next few years.
The importance of these estimates is that a few months ago, Mundell would chop off his right arm before admitting the risks of restructuring the single currency. If the intellectual father of the €uro can rationalise its restructuring and potential break-up, then it is already in the price. The discussion in the Sunday Times provides a neat encapsulation of the problem: the PIIGS would be better outside of the deflationary system, if only they could find a means of divorce that does not include political suicide and the collapse of their domestic banking system.
This key point was emphasised by the Spanish auction last week, which showed good cover. This proves that there is demand for Spanish bonds at the right price: the syndication was set at 26bps over the existing 10yr bond. Further supply in the remainder of the month suggests that further concessions will be required, but investors are right to assume that volatility in peripheral spreads is likely to subside over the forecast period.
This does not mean that they are screaming buys, quite the opposite. We believe that the agenda is shifting from the European sovereign debt crisis to global economic slowdown. A double dip recession is not inevitable, but it is far greater than the zero indication provided by the yield curve. The yield curve is providing a false positive for the economy because short-term rates are anchored at zero; it is impossible for the curve to signal recession. As Keynes and Japan have proved, you can get recessions at zero interest rates.
Zero interest rates will be the focus of the Fed’s minutes on Wednesday, as well as the forthcoming FOMC meeting in three weeks time and the following Humphrey Hawkins testimonies. The Fed will argue that the stimulus of zero interest rates is sufficient to provide a modest recovery in activity through bank and consumer deleveraging as well as fiscal austerity.
The Fed will point to the slowdown in 2002 as evidence of the peak in leading indicators at high levels as proof that the recent data does not signal a double dip. However, the Fed was sufficiently concerned in 2002 to cut interest rates in November and again in July 2003. More importantly, the Fed will argue (while it is confident that the economy will maintain modest growth rates) that downside risks have intensified.
The key figures to watch out for over the next month are the retail sales data, regional business sentiment indicators including small business sentiment, housing, durable goods orders, employment and the Fed’s own senior loan officers survey. Weekly retail sales were not as bad as feared and the heat wave contributed to an improvement in higher value added items at the end of the month, highlighting some upside risks to non-auto sales. But since auto sales fell by 5% during the month and energy prices were also weak, headline sales are expected to fall by 0.2-0.3% from upward revised levels in May.
This data is consistent with more consumer caution. Consumers built up savings during 2009 and then ran them down during the first quarter in anticipation of stronger employment data during 2010. Savings rates have stabilised around 4%, above the leveraged bubble but below their long-term average. Consumers have the means but do they have the will to continue spending.
The only thing that consumers have to fear is fear itself; if they maintain or even increase expenditure from the first quarter level they will give businesses the confidence to increase investment and employment, allowing the recovery to accelerate to escape velocity. Companies are doubly exposed to the twin paradoxes of fear and thrift. Corporate savings are at their highest rates for a generation, while investment ratios are low. They have ample incentive to increase investment as the limits to leverage and costs cutting are exposed. Over the past year companies have eliminated the gap between consumption and production but need to see more consumption demand to build inventories and move to the next stage of the recovery.
However, if companies are worried about the risks of the economic slowdown and consequently delay investment, then this will become a self-reinforcing expectation. The most disturbing aspect of the ISM manufacturing decline was the seven point fall in new orders. This makes the durable goods order data crucial to financial markets’ understanding of both second quarter GDP data and prospects for the second half of the year. Non-defence capital goods orders rose by 31% annualised rate in the three months to May, while shipments increased by 17.7% over the same period. This is consistent with growth of 3.5-7.5% in the preliminary second quarter estimate at the end of this month. However, there is also room for disappointment in the June numbers, which will provide a poor start to estimates of the third quarter.
Second quarter earnings are likely to be strong on the back of decent economic growth, but evidence of a poor end to the second quarter will weigh upon estimates of third quarter activity and consequently estimates of slower third quarter GDP growth. We believe at this stage the slowdown will be modest, with 2.2% growth pencilled in for the third quarter.
Housing will be one key area of weakness in the third quarter. Last month, housing starts fell by 10%, pending and new home sales fell by more than 30%, and the NAHB index fell from 22 to 17, close to its all time low. The weakness was caused by the ending of Federal subsidies and is payback for improvements at the start of the quarter. However, this was mafia payback with the correction greater than the prior boost. Existing home sales are expected to fall by up to 30% in June, but the focus will be on new home sales to see if there has been any bounce from these “oversold” levels. Mortgage purchases have continued to contract during July, after a 15% decline in June and 17% in May, despite continued decline in mortgage rates.
The 3 point fall in the ISM manufacturing index was greater than implied by the regional business sentiment indicators. Sentiment indicators tend to have a high degree of monthly autocorrelation, but a bounce in the regional indices such as Philly and Richmond Fed and/or the July ISM would not be inconsistent with our gradual slowdown thesis, although they will undoubtedly affect short-term market sentiment.
However, the most important indication of the consumer and corporate fear factor will be determined by the SLOS. The recovery in banking profitability over the past year should provide another easing of lending conditions, but like the Bank of England’s survey released 10 days ago, the easing of restrictions over the past three months is likely to have been less than expected due to weak demand. The sharp decline in consumer credit in the past two months is evidence that the US is following Japan in that it was not the supply of credit that was decisive in determining deflation but the demand for credit.
This underlines our view that the next couple of months could provide some volatility in the economic data after greater than expected weakness during June, but the trend is clearly towards slower economic activity, greater threat of deflation and continued extension of the bull market for government bonds over the medium term. Recession is not inevitable; politicians could offset some of the 2% of GDP tightening of fiscal policy (split 1% Bush tax cut repeal and 1% state and local government tightening) due over the next year, but the approach of mid-term elections in which all of the House of Representatives and 36 Senate seats are up for re-election are hardening the resistance of the Republicans to any stimulus measures. The tide is turning against hope and current opinion polls suggest that the Democrats will lose their majority in the HOR, reducing significantly President Obama’s ability to offset this fiscal austerity next year (cf, the Sage of Omaha’s favourite bedtime reading “When the Money Runs Out” about hyper-inflation in Weimar Germany).
Recession can be avoided through liberal use of quantitative easing. However, as per his 2002 speech, Bernanke is likely to try to guide long-term rates lower following the example of the 1950’s when the Fed set targets for the term structure and investors adhered to these strictures. However, the treasury market was almost entirely domestic in the fifties, whereas it is now 60% owned by overseas investors, who are likely to take a dim view of interest rate targets suggesting that moral-suasion will fail and that massive and sustained purchases of treasuries will be required.
The Fed will not buy mortgage bonds in QE2. It does not want to create another bubble in housing, but it will buy treasuries. Press reports have suggested that Bernanke wants to double the size of the Fed’s balance sheet to $5tr, if only the regional presidents will agree. It will take time and a plethora of weak data to persuade these recalcitrant FOMC members to agree further QE.
The prospect of weaker economic activity over the autumn and winter will resume widening of peripheral European government bond spreads over the period. The justification for this will be twofold. First, liquidity is likely to be at a premium in the next big bond market move, big is beautiful. Secondly, the next global economic slowdown is likely to be deflationary. Fiscal austerity is already driving internal deflation amongst the PIIGS, additional global pressure will further damage investor sentiment. Equally concerning will be the bank funding concerns from financial institutions that have $5tr to refinance over the next couple of years ($1.3tr in US and $2.3tr in Europe).
The G20 meeting in Toronto placed a great deal of emphasis on China to save the global recovery, but China is too small and selfish to save the world. Chinese second quarter GDP growth is due on Thursday and is expected to match consensus expectations of 10.5%, down from 11.9% in the first quarter. Chinese growth peaked in the first quarter and is slowing more rapidly than expected. Latest export data notwithstanding the key figures are likely to be next month’s PMI data. June was depressed by three extra days holiday, but we expect concerns over global slowdown to keep indices around current levels in July before dipping below 50% in August or September. This will be the trigger for more government stimulus, but the law of diminishing returns suggests that this second package will not be as large as 2008, nor as effective in boosting international investor sentiment. There are too many investors waiting for Chinese stimulus with baited breath.
The UK is likely to be the quietest of major economies this month; little will be heard from the MPC ahead of next month’s Inflation Report. CPI data later this week is expected to slow the annual rate from 3.4% to 3.2%. This is the measure that the Bank is tracking for policy. It is also tracking average hourly earnings, which are likely to rise slightly over the summer due to base effects, but remain weak on an underlying basis as job opportunities and public sector pay are both restrained.
Consumer confidence is the key to the next stage of the UK recovery. Retailers surveys suggest that consumer spending has been disappointing over the past couple of months and this has been reflected in weaker consumer confidence. The gfk index for consumer confidence has fallen by 4 points over the past four months, while the more volatile Nationwide survey showed its largest monthly fall for two years last month.
Stuart Thomson | Comments Off | 

