Morning comment: The week ahead, w/c 9 July

Chris Scicluna

Overview:
The UK government is in chaos. After Friday appeared to see Theresa May’s Cabinet unite around her proposals for a softish Brexit for the manufacturing sector (see below), last night’s resignation of Brexit Minister David Davis and his two deputies in protest suggest that the Prime Minister’s new strategy is already at risk of collapse. Davis’ resignation is no great surprise – after all, he had for several weeks been threatening to walk and had long appeared semi-detached from the Brexit negotiations. But, in a sign of the disgruntlement of the Tory rank-and-file, one weekend poll of party members had suggested that some sixty percent consider May’s plan to represent a ‘bad deal for Britain’, and what was left of the PM’s authority appears to be rapidly disintegrating.

The key immediate questions are whether Davis’ departure will be followed by those of other Cabinet members (with Foreign Secretary Boris Johnson the most obvious candidate), and/or whether 48 Conservative MPs will decide to force a formal challenge to May’s leadership (certainly, there are far more than 48 MPs who are dissatisfied with Friday’s Cabinet proposal). But even if May continues to hold on to her position as PM, the noises from Davis and key Brexiter backbenchers strongly suggest that she would now fail to be able to force through Parliament any final withdrawal agreement – which, even if it were based on Friday’s Cabinet agreement, would still likely require further concessions to be made to Brussels.  So, the likelihoods of a no-deal Brexit or Article 50 extension, and/or a new UK general election, all look to have increased this morning. (And this persisting Brexit uncertainty is a key reason why, despite some improved economic data, we have long maintained our view that the BoE will not raise rates next month.)

Nevertheless, sterling remains broadly stable this morning, and firmer than it was ahead of the Cabinet agreement last Friday. And rather than dwell on the UK’s Brexit troubles, today Asian equity markets have run with the positive lead provided by Friday’s advance of Wall Street. With investors perhaps taking particular comfort from the restraint displayed by China in reaction to the first round of US tariffs, the yuan has opened the week stronger and China’s CSI300 has advanced 2.8%, thus paring about half of last week’s loss. Strong gains were also seen in Hong Kong (the Hang Seng rising 1.7%) and Japan (the Topix rising 1.2%), where the latest economic surveys pointed to stability but the weekend’s flooding and landslides which cost more than 100 lives, led PM Abe to cancel his planned trip to Europe and the Middle East this week.   

Japan:
Following on from last week’s Tankan survey, a short time ago the BoJ released the latest edition of its quarterly Regional Economic Report (the equivalent of the Fed’s Beige Book), making public some of the anecdotal information that the Board will consider when it next meets at the end of this month. The key message in the latest survey was one of stability with all nine regions reporting that their assessments were unchanged from the previous report. Six regions (Hokuriku, Kanto-Koshinetsu, Tokai, Kinki, Chugoku, and Kyushu-Okinawa) again reported that their overall economy had been expanding or expanding moderately (the effects of the recent earthquake in the northern Osaka Prefecture were noted in the Kinki region). Three regions (Hokkaido, Tohoku, and Shikoku) continued to report that their economy had been recovering moderately. As in the previous report, the BoJ’s commentary argued that that these reports were based on the assessment that “the virtuous cycle from income to spending had been maintained, as labor market conditions had continued to tighten steadily and private consumption had improved, while exports had been on an increasing trend with overseas economies growing firmly”. In short, there appears to be nothing in this report that would motivate a change in the BoJ’s outlook for the economy or inflation, and therefore in monetary policy.

Turning to the day’s economic data, the Economy Watchers survey for June was a little more positive than that taken in May. After falling to a 20-month low in the last survey, the overall current conditions index rose 1.0pts to 48.1. This improved owed to the household index which recovered 1.7pts to 46.9. By contrast, the business sector index fell 0.9pts to 49.2 – the first sub-50 reading since April last year. The manufacturing index fell 1.1pts to 47.6, marking the lowest reading since August 2016, while the non-manufacturing index fell 1.3pts to 50.6 – a level last visited in March. Looking forward, the overall expectations index – which tries to gauge the direction of conditions over the next month or so – rose 0.8pts to 50.0 in June. In this case both the household index (up 1.3pts to 49.7) and the business index (up 0.6pts to 50.1) pointed to an expectation that conditions would be broadly stable over the period.

Today also saw the release of the BoJ’s bank lending data for June, which provided some further signs that the slowdown in lending growth since the middle of 2017 may have run its course. Growth in total bank lending edged up 0.2ppts to 2.2%Y/Y – the fastest pace since January. Growth in lending at the major city banks – which has driven the slowdown – picked up 0.3ppts to 0.6%Y/Y. Growth in lending at regional banks also edged higher to 3.5%Y/Y, whereas growth at shinkin banks was steady at 2.3%Y/Y. The BoJ’s next Senior Loan Officer Opinion Survey will be released on 19 July and will cast more light on the factors driving the demand and supply of credit.

Finally, Japan recorded a seasonally-adjusted current account surplus of ¥1.85tn in May, which was very similar to a month earlier but well above market expectations. The trade balance produced only a small surplus of ¥0.08tn. However, the surplus on primary income increased to a record high of ¥2.10tn in May.

Looking ahead to the remainder of this week’s diary, following an exceptionally strong reading in April, there will be plenty of interest in Wednesday’s machinery orders report for May. Notwithstanding the upbeat forecasts in last week’s Tankan survey, some degree of negative payback is to be expected from the 10.1%M/M lift in core orders reported in April. The goods PPI for June and Tertiary Industry Index for May will also be released on Wednesday. The week concludes on Friday with the release of the final IP report for May. Finally, over the course of the week we will also be keeping an eye open for the release of the Cabinet Office Synthetic Consumption Index for May. In the bond market the MoF will auction 5-year JGBs on Tuesday and 20-year JGBs on Thursday.

UK:
Last night’s resignations suggest an existential crisis for Theresa May, who this week is still supposed to publish her White Paper for Brexit, central to which is her proposal for a UK-EU free trade area for goods. Following Friday’s Cabinet meeting, under her proposal the UK and EU would maintain a common rulebook for all goods including agri-food, with the UK committing by treaty to continue harmonisation with EU rules on such items, albeit “covering only those necessary to provide for frictionless trade at the border”. A new Facilitated Customs Arrangement (FCA) would supposedly remove the need for customs checks and controls between the UK and the EU. The UK would apply the UK’s tariffs and trade policy for goods intended for the UK, and the EU’s tariffs and trade policy for goods intended for the EU. The UK Parliament would maintain the ability to choose not to apply EU regulations, but at the same time accept that this would have adverse consequences for market access. In addition, the UK would commit to apply a common rulebook on state aid, and also cooperate on competition policy.

In line with May’s long-standing red lines, among other things the arrangements would end the jurisdiction of the ECJ in the UK. Instead a joint institutional framework would provide for the consistent interpretation and application of UK-EU agreements by both parties, but this would be done in the UK by UK courts, and in the EU by EU courts – with “due regard paid to EU case law in areas where the UK continued to apply a common rulebook”.  The proposals also seek to maintain May’s red line to end the free movement of people.

Quite whether the EU would agree to all this is unlikely. Certainly, the EU would frown at the continued pick-and-mixing from the four freedoms, and its scepticism regarding May’s customs proposals, not least due to their susceptibility to fraud, is well known. Likewise, it will be irritated that the UK is attempting to pre-empt the decision on the long-term future arrangements via its proposal for the Irish border.

But while May’s proposals in their current form could not be accepted by the EU, they also look like bad news for the UK economy. The PM’s insistence to end the free movement of people means that she has sacrificed the services sector, abandoning hopes for a common EU-UK rulebook in this crucial area. The Cabinet statement claimed that it’s in the UK’s interests to have regulatory flexibility in this field. But its proposal would guarantee that the UK would lose considerable market access in this sector, which accounts for 80% of the UK economy, about 45% of all exports (by far the largest share among G7 countries), and about 60% of growth in exports over the past twenty years. Indeed, Friday’s Cabinet statement explicitly acknowledged that the new arrangements would not replicate the EU’s passporting regime. And, despite what the government claimed, regulatory flexibility for services will NOT make it easier to strike trade deals with third countries in future.

The UK dataflow will obviously play second fiddle to politics this week. But the most notable of the releases all arrive tomorrow and will be closely watched by the BoE as it seeks further reassurance that the slowdown in Q1 growth was temporary and largely snow-inflicted. Alongside the standard monthly IP data for May the ONS will also publish services output data, and for the first time, a monthly estimate of GDP for the same month. After a shock 1.4%M/M fall in manufacturing output in April, a substantial bounce-back in this sector in May would appear inevitable, consistent with survey evidence from the PMIs and CBI. Data already published revealed that retail sales for the month rose sharply, perhaps in part due to early arrival of summer. Accordingly, a robust monthly estimate for May GDP appears to be on the cards, and bearing in mind the soft start to the quarter, would be consistent with our forecast of Q2 growth of 0.4% Q/Q.

Also out tomorrow will be the monthly overseas trade figures, and the BRC Sales Monitor, the latter giving clues on the strength of High Street spending in June. Towards the end of the week on Thursday, the RICS Residential Market survey will provide an update on the latest changes in the housing market. And the BoE Credit Conditions and Bank Liabilities surveys, due on the same day, will also be of interest. Policy-wise, BoE Governor Mark Carney is scheduled to speak on Wednesday, while his deputies Ben Broadbent and Jon Cunliffe will speak on today and Friday respectively. Market participants should watch these speeches for hints as to how these MPC members will vote next month.

Euro area:
Consistent with German industrial production figures for May released last week, this morning’s trade data from the largest euro area member state for the same month were also encouraging. Goods exports jumped by 1.8%M/M, while imports rose only 0.7%M/M to leave the trade balance  recovering from €19bn, a level last seen only at the beginning of last year, to €20.3bn. However, looking at these numbers alongside readings from the previous month, the picture for Q2 as a whole is not particularly positive. On average,  exports are up by 0.8% compared to Q1, while imports are 2.3% higher, suggesting that net trade are set to provide a second consecutive negative contribution to GDP growth.

Meanwhile, this morning’s news from France also looked a little more positive than of late. According to the Bank of France business sentiment survey, optimism in industry recovered slightly last month, with the relevant index inching up from a nineteen-month low of 100, a level in line with its long term average, to 101. The equivalent indicator for services was also stronger, up from 101 to 103.  And with construction sentiment having remained unchanged at 105, the Bank judges its survey to be consistent with a 0.3% rise in GDP in Q2, a pace in line with our own expectations and 0.1ppt higher compared to Q1.

Looking ahead, Mario Draghi will be speaking at the European Parliament this afternoon. The focus tomorrow will be on the ZEW survey of investor sentiment: not least given heightened trade-war fears, financial analysts’ assessment of the current business situation looks set to deteriorate, extending the downward trend seen since the beginning of the year. French and Italian industrial production figures, which are also due tomorrow, will provide a better picture of what we can expect from the equivalent figures for the euro area, which are out on Thursday. Following last week’s 2.7%M/M surge in German manufacturing and mining output, euro area IP should rise more than 1%M/M, thus more than fully reversing the dip in April. Finally, towards the end of the week, the final releases of June inflation data from Germany and France (on Thursday) and Spain (on Friday) will also be worth watching for hints of any revisions to be made to the final euro area figures out the following week. In the bond market, Germany will issue index-linked bonds tomorrow and 10-year Bunds on Wednesday, while Italy will sell 3-year and 7-year BTPs on Thursday.

US:
After Friday’s broadly favourable payrolls report but softish wage data, and following last week’s uplift in the Fed’s preferred inflation metric – the core PCE deflator – there will be plenty of interest in this week’s first inflation data for June. The PPI is released on Wednesday, followed a day later by the CPI. Base effects provide only a small hurdle to a lift in annual core CPI inflation from last month’s 2.2%Y/Y pace. Other economic reports due include the latest NFIB business survey and JOLTS data (tomorrow); final wholesale inventory data for May (Wednesday); and the preliminary University of Michigan consumer survey for July (Friday). In the bond market, the US Treasury will auction 3-year notes tomorrow, 10-year notes on Wednesday and 30-year bonds on Thursday.

China:
There were no significant economic reports in China today. Looking out over the remainder of the week, tomorrow will see the release of the PPI and CPI reports for June, with the market expecting a slight lift in annual inflation in both cases (the PMI price indices have indicated a lift in inflation pressures of late). However, this week greater interest will probably centre on Friday’s external trade report for June which will set the tone ahead of the following week’s GDP report for Q2. China’s money and credit aggregates for June are also likely to make an appearance late in the week or perhaps over the weekend.

Australia:
There were no major economic reports in Australia today and there only a few reports scheduled over the remainder of this week. Most interest will centre on the tomorrow’s NAB business survey for June, followed a day later by the Westpac consumer confidence survey for June. Housing finance data for May will be released on Wednesday.

New Zealand:
It has also been a quiet start to the week in New Zealand. Looking ahead, tomorrow’s consumer spending report for June will be of some interest while Thursday’s food price data for June will assist analysts to finalise their estimates ahead of the following week’s CPI report for Q2. On Friday the manufacturing PMI for June will be released. The REINZ housing report for June may also make an appearance before the end of the week.

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