Week ahead, w/c 22 October

Chris Scicluna
Emily Nicol
Mantas Vanagas

Overview:
Despite a mixed showing from European and US markets on Friday, Chinese equities are on fire today after talk of official buying at the end of last week was followed by weekend comments from the country’s leadership signalling the likelihood of new action to support economic activity and detailed draft proposals for personal income tax deductions to take effect from January. While the yuan is little changed from Friday, the CSI300 is currently up more than 4.0%, with the Hang Seng up 2.2%, and most other Asian markets have been pulled higher in the slipstream.

In Japan, however, despite a weaker yen, the Topix rose just 0.4% while the latest economic activity figures again flagged the risks of a negative print to Q3 GDP, and although the BoJ’s latest financial system report suggested that banks’ easing of lending standards have continued to support the economic expansion it also noted institutions’ decreasing core profitability and regional banks' gradually decreasing capital adequacy ratios. Equities fell in Australia, where defeat in the weekend’s Wentworth by-election saw the Liberal-led coalition government lose its parliamentary majority. We don’t, however, expect an imminent early general election (see below for more detail).

In Europe, BTPs are rallying this morning (10Y spread vs Bunds currently down about 12bps) after Friday night saw Moody’s downgrade the sovereign rating one notch to one level above junk status but (perhaps charitably) place a stable outlook on the rating. S&P is scheduled to take action this coming Friday. By noon today, the Italian authorities are due to respond to the European Commission’s letter of last week, which noted the government’s “particularly serious non-compliance” with the euro area’s fiscal rules, which it considered “unprecedented in the history of the Stability and Growth Pact”. While one report later on Friday suggested the government will reduce slightly its 2019 deficit target by 0.3ppt to 2.1% of GDP, such a move would be highly unlikely to satisfy the Commission, which requires a tightening in the fiscal stance to meet Italy’s commitments.

Looking further ahead, the coming week brings another ECB policy meeting, where Draghi might just give hints regarding the Governing Council’s plans to introduce greater flexibility into its reinvestment policy, a likely rate hike from Canada’s central bank, and the first estimate of US GDP. Brexit will, of course, remain front and centre in the UK, where Theresa May will today address Parliament and will insist that 95% of a deal has been reached, but a new CBI survey has shone light on the dire impact of the government’s repeated ‘no deal’ threats on business investment and costly contingency planning by member firms.

Japan:
The BoJ’s latest reports on the financial sector were the main focus today. And, on the whole, the BoJ concluded that Japan’s financial system “has been maintaining stability on the whole”, with the latest quarterly Financial System Report noting that financial institutions’ lending attitudes have continued to support the economic expansion and should continue to reduce downside risks to the economic outlook over coming quarters too. Certainly, the Senior Loan Officer Opinion survey reported that bank credit standards were little changed over the past three months for firms of all sizes and households, but banks once again cited increased competition from other banks and non-banks as a key driver of easing standards. And looking ahead, banks on the whole forecast that credit standards will continue to ease for corporates and households.

Against this backdrop, banks also reported a pickup in demand for lending from large and small firms, noting increased fixed investment as one of the main drivers. And while demand for consumer loans continued to fall, there was a pickup in demand for housing loans supported by a decline in interest rates, as well as an increase in housing investment.

But while the FSR suggested that financial institutions remained well placed to support ongoing growth in the economy, it also perhaps unsurprisingly noted the possible risks from the banking sector from the BoJ’s exceptional monetary policy measures. In particular, it highlighted the impact of lower interest rates and increased competition among financial institutions as the key drivers behind the downward trend in net interest income at financial institutions over recent years. And so, given decreasing core profitability and gradually decreasing capital adequacy ratios at regional banks, the FSR noted that in the event of another crisis, a decrease in financial institutions’ risk taking would be more likely to intensify than in the past.

Meanwhile, the all-industry data broadly aligned with expectations, reporting a rise in overall activity of 0.5%M/M in August to leave output up 0.9% compared with a year earlier. We had already seen the manufacturing and tertiary sector activity figures (up 0.2%M/M and 0.5%M/M respectively), but today’s release also reported a better showing from the construction sector, where activity rose 0.8%M/M, supported by a near-9%M/M increase in private sector civil engineering work, while public sector civil engineering was up 1%M/M and public sector building work up 1.6%M/M. However, that improvement came on the back of notable weakness earlier in the summer. Indeed, on average over July and August, total construction activity was down 2% compared with the average in Q2. And with manufacturing output down almost 1½% on the same basis, while tertiary activity was similarly down 0.1%, overall output was on average ½% lower than in Q2. With activity in September likely to have been negatively impacted by Typhoon Jebi and the Hokkaido earthquake, today’s release signals the likelihood that GDP contracted in Q3, reversing much of the 0.7%Q/Q growth seen in Q2.

Looking ahead, tomorrow brings the release of the final Monthly Labour Survey results for August, while the preliminary manufacturing PMIs for October are due on Wednesday and the services PPI for September comes on Thursday. The week concludes on Friday with the release of the advance October CPI for the Tokyo area. In the bond market, over the coming week the MoF will auction enhanced liquidity (maturities 5-15.5 years) on Tuesday and 2-year JGBs on Thursday.

Euro area:
Italy’s fiscal policy will certainly remain in focus this week. After the European Commission on Thursday sent its letter stating that Italy’s draft budgetary plan represents “particularly serious non-compliance” from the euro area rules in terms of the structural deficit and expenditure, and government debt, and that the planned fiscal expansion and size of the deviation from requirements “are unprecedented in the history of the Stability and Growth Pact”, the Italian authorities have until noon today to reply. Commissioner Moscovici appeared to try to defuse tensions on Friday to the benefit of BTPs, but we saw little of substance there. Nevertheless, Italian asset prices are benefiting from Moody’s announcement late Friday that, while it had downgraded the sovereign rating by one notch, it would leave the outlook on the rating stable for the time being. While Friday’s reports suggested the government could trim back its 2019 deficit target, assuming that the Italian Cabinet is able to reach agreement on a response (something which cannot be taken for granted given the pressures within the ruling coalition and the erratic behaviour of the leading members), we do not expect any revised plans to be fit for purpose. And so the confrontation with the European Commission seems highly likely to continue.

Beyond Italy, the ECB policy meeting concluding on Thursday will be the most notable event this week. The meeting seems unlikely to bring any substantive policy changes. Certainly, the policy statement will reiterate the ECB’s expectation that key interest rates will remain at their present levels at least through the summer of 2019. And Draghi might well confirm that the net asset purchases will be brought to a conclusion at end-2018 following the reduction in the pace of purchases to €15bn this month. But with Draghi having signalled that the Governing Council would discuss the reinvestment policy by the end of the year, an announcement of measures to introduce greater flexibility in the rules – which might in due course allow for a ‘twist’ operation or other means of containing longer-term yields – might be forthcoming at this meeting. However, we think that is more likely to emerge in December.

In terms of the economic outlook, meanwhile, Draghi will probably insist that – notwithstanding the downside surprise to core inflation in September, continued risks of a tightening of financial conditions and/or deterioration of external demand – the euro area economy has been evolving broadly in line with the ECB’s latest economic forecasts, updated last month. Finally, of course, developments in the BTP market and Draghi’s views on the appropriateness of Italy’s fiscal policy are bound to be one focus of the press conference.

Releases of the latest economic sentiment surveys this week should bring some new insights into the current state of the euro area economy. Most attention will be on Wednesday’s release of the preliminary October PMIs. The euro area composite PMI has fallen significantly since hitting a multi-year high of 58.8 at the start of the year, and has been stuck firmly below 55 since May. This month’s reading seems likely to come in close to September’s level of 54.1. Meanwhile, consumer confidence has been on a downward trend this year, with the European Commission indicator hitting a sixteen-month low of -2.9 in September. The flash estimate for October, which is due tomorrow, seems likely to show a further modest deterioration. German and French consumer surveys from the GfK and INSEE will be released on Thursday and Friday respectively. In addition to the PMIs, Wednesday also brings September bank lending data along with the French INSEE business sentiment survey for this month, and the German Ifo business survey will follow on Thursday. In the bond markets, Germany will issue 5Y Bunds on Wednesday, while Italy will auction BTPs on Friday.

UK:
An estimated crowd of 700k in the People’s Vote march on Saturday demanded a second referendum on the final Brexit deal. But there remains no explicit support for such a vote among the leadership of the two largest political parties, and time is running short if any new referendum is to be held before what would be the key deadline, the European Parliament elections next spring. However, Theresa May will today address Parliament and insist that 95% of the Withdrawal Agreement has now been agreed with the EU. Of course, she will also insist that the EU proposals on the Irish backstop remain unacceptable. The statement will represent another attempt to fend off the criticism from the head-banger Tory Brexiters, with reports over the weekend suggesting that they might be only two members short of triggering a confidence vote in her leadership. Against the backdrop of ‘no-deal’ risks, unsurprisingly UK businesses have upped their preparations for Brexit. The latest CBI survey suggests that nearly 60% of firms have formulated contingency plans ranging from adjusting supply chains (56% of those with plans) to moving jobs abroad (15%).  41% have already implemented some measures, and at significant cost, diverting resources from investing into their normal activities. Indeed, a striking 80% of businesses have delayed or cancelled investment because of Brexit, according to this survey.

Beyond Brexit, the coming week should be a relatively quiet one on the data front, with only the CBI Industrial Trends and the UK Finance lending figures due for release tomorrow and Wednesday respectively. The BoE’s Governor Carney and Chief Economist Haldane are scheduled to speak on Wednesday, so we might get some new insights into the outlook for monetary policy. In the bond markets, the DMO will issue 10Y index-linked Gilts tomorrow.

US:
Turning to the US, it is set to be a low-key start to the week, with just the Chicago Fed national activity indices due today and the Richmond Fed’s manufacturing survey due tomorrow, followed a day later by the little-followed flash Markit PMI readings for October, new home sales for September and the Fed’s Beige Book. On Thursday, however, the focus will be on the advance September readings for durables goods orders/shipments, the goods trade balance and wholesale inventories. There will also be some interest in the pending home sales report for September. Most notably, the week concludes on Friday with the advance GDP report for Q3, with the Bloomberg consensus suggesting a slowdown to a little over 3%Q/Q ann. from 4.2% in Q2. The final results of the University of Michigan consumer survey for October will also be released that day. In the bond market, the Treasury will auction 2-year notes tomorrow, 2-year FRNs and 5-year notes on Wednesday, followed by 7-year notes on Thursday. A very heavy week for corporate reporting will see Q3 earnings revealed by close to a third of S&P500 firms.

China:
There were no new economic data released in China today to distract attention from the promise of stimulus from the government. Indeed, the only releases scheduled over the coming period are the industrial profit report for September (Saturday) and the official PMI reports for October (at the end of the month).

Australia:
Perhaps unsurprisingly, Australia's governing coalition has lost its parliamentary majority after the weekend’s by-election for the Wentworth seat in Sydney vacated by former Prime Minister Malcolm Turbull.

The seat was won comfortably by Kerryn Phelps, an independent candidate, as the affluent voters looked to send a message of discontent to the Liberal party for ousting Turnbull as PM. So, with Australia already on its sixth prime minister in eight years, political uncertainty persists. But we expect new PM Scott Morrison’s Liberal-led administration to soldier on until next May, if only to give him time to build a profile and launch new pre-election policies. A sufficient number of independents are likely to have no interest on pulling the plug on the government and so would seem likely to back any no-confidence motion from the opposition Labor party.

While politics were centre-stage, Australia’s economic diary was bare today. And similar to China, there is nothing in the remainder of this week’s diary that is likely to have much impact on markets, with investors now clearly awaiting the Q3 CPI report to be released at the end of this month.

New Zealand:
There were no economic reports released in New Zealand today. In fact, the only report scheduled over the coming week is Thursday’s merchandise trade report for September. The next economic release of substantial market interest is the Q3 labour report scheduled for 7 November – a day before the RBNZ announces the outcome of its latest review of monetary policy for this year. Given recent upside surprises to both growth and inflation, incoming wage data will be awaited with particular interest.

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