Morning comment: Tankan, China, French PMIs & Brexit

Chris Scicluna
Emily Nicol

Overview:
Wall Street kicked off yesterday with the positive price action seen earlier across Asia and Europe, lifting the S&P500 to an initial 0.7% gain. However, that rally quickly faded. At the close the S&P500 was virtually unchanged, with gains in consumer staples and utilities offset by losses in financials and materials. The bond and currency markets were likewise little changed. 

After US markets closed, last night’s EU summit discussions on Brexit in Brussels predictably concluded with Theresa May leaving empty-handed, with nothing of substance to offer her critics within her own party or the Northern Irish DUP and clear evidence that she alienated other leaders. Sterling, however, was little changed, although – of course – the EU was never going to offer her the legally binding reassurances on the backstop that she was seeking. Nevertheless, in a reflection of her poor performance, which brought damning comment from other leaders and diplomats, the final summit conclusions gave her even less than the initial draft had offered – proposed assertions that the activation of the backstop would not be desirable for the EU and that the backstop would, if necessary, be in place only for a short period, were deleted. And the Commission will now publish new plans for a no-deal Brexit next Wednesday. May appears completely snookered at present. And, while another special EU summit on Brexit might be convened in January, her deal appears to have no chance in its current form of winning a meaningful vote in the House of Commons. Cross-party cooperation is going to be required to extricate the UK from the current appalling mess.

With no clear direction from Wall Street, and nothing to cheer from Brussels, Asian bourses were left to find their own direction today. And that direction has proven to be down. In Japan the TOPIX fell 1.5%, notwithstanding the BoJ’s Tankan survey reporting stronger-than-expected business conditions and capex plans (much more on this below). And while it might be tempting to attribute a 1.7% decline in Chinese equities – and broader Asian weakness – to China’s generally disappointing November activity reports (more on this below too), markets were already weaker before those data hit investors’ screens. So the decline in these markets – broadly replicated elsewhere in the region and to a lesser extent in US equity futures – probably simply reflects the ongoing nervousness generated by the current slew of economic uncertainties, be it regarding trade protectionism, Brexit or political stress in Europe. Indeed, there was further evidence of the consequences of the latter this morning as the flash French composite PMI for December fell sharply to below the key 50 mark for the first time in almost three years, suggesting an economic contraction in response to the disruption caused by the Gilets Jaunes protests.

In the bond market, following the news from Brussels and the French data, European govvies are unsurprisingly making gains. The 10Y Treasury yield has declined 4bps since the end of the US session to below 2.88%. In Japan, meanwhile, JGB yields nudged lower even as the BoJ continued its QE taper with a cut to its purchase of 5-10Y bonds (to ¥430bn from ¥450bn previously).

Japan:
The main data focus in Japan today was the aforementioned BoJ Tankan survey for the December quarter. In summary, as had been suggested by the MoF/Cabinet Office Business Outlook earlier in the week, the BoJ’s comprehensive survey of just under 10,000 firms continued to cast Japan’s economy in a very positive light, with the key measures of current business conditions generally a little firmer than market expectations. This accords with other survey-based, production and spending indicators which appear to be pointing to the likelihood of a return to positive GDP growth in Q4. Expectations regarding developments in business conditions over the next three months were slightly more guarded – not surprising given the global event risk that lies ahead – but nonetheless unequivocally positive. Perhaps not that surprisingly therefore, and notwithstanding this week’s modestly disappointing rebound in October machinery orders, firms’ forecasts for capex remained extremely upbeat amidst intensifying skill shortages. Unfortunately for the BoJ, the survey’s pricing indicators continued to offer only limited evidence that firms’ output prices are responding to building pressures on spare capacity and direct pressures on firms’ input prices.

Turning to the detail, amongst all firms a net 16% of respondents considered business conditions to be favourable – up 1ppt from the September survey and just 1ppt below the 26-year high recorded at the beginning of this year. A net 10% of respondents were optimistic about business conditions over the next three months – the weakest forecast since Q217, but nonetheless a very optimistic forecast by the standards of the past two decades or so. The large firm business conditions index for the manufacturing sector was stable at +19 (1ppt above market expectations) while the large firm business conditions index for the non-manufacturing sector rose an unexpected 2ppts to +24 (3ppts above market expectations). Looking ahead, a net 15% of large firms in the manufacturing sector and a net 20% of firms in the non-manufacturing sector were optimistic that business conditions would remain favourable over the next three months. It is worth noting that the forecast of large manufacturers was based on an assumed exchange rate of ¥109.41/$ over FY18 – about 2 yen weaker than in the September survey but still a little firmer than the average exchange rate over the year to date. Presumably firms would be slightly more confident if the yen were to remain around its current much weaker level.

As is usual, medium- and small-sized firms were not quite as optimistic as their larger counterparts. That said, the business conditions index for medium-sized manufacturers rose 2ppts to +17 this quarter while the index for medium-sized non-manufacturers fell 1ppt to +17. It was encouraging to see that the index for small manufacturing firms remained steady at +14 for a third consecutive survey, while the index for small non-manufacturers improved 1ppt to +11, its highest for 27 years. Looking at the industry detail for large firms, consistent with past surveys, firms operating in the general purpose and production machinery industries reported particularly favourable business conditions in December (recording readings of +47 and +40 respectively), as were firms operating in the construction and business services sectors (+42 and +38 respectively). These industries were also the most optimistic about likely business conditions over the next three months. By contrast, optimism remained much less prevalent amongst those firms operating in the textile, forestry, shipbuilding and retail sectors. In no sector were business conditions viewed as outright unfavourable or expected to become unfavourable over the next three months.

Among the other key findings of the survey, for all industries aggregate sales are now forecast to rise 2.7%Y/Y in FY18, up from 2.1%Y/Y in the September survey. Sales in the manufacturing sector are forecast to increase 3.2%Y/Y, while slightly slower growth of 2.5%Y/Y is forecast in the non-manufacturing sector. Aggregate current profits are forecast to decline 0.8%Y/Y in FY18, but this represents an improvement in the 3.6%Y/Y decline that was forecast in the prior survey. Manufacturing profits are forecast to rise 0.9%Y/Y – a forecast that should prove too pessimistic if the yen remains at current levels – but non-manufacturing profits are forecast to decline 2.0%Y/Y. The overall profit margin for all firms is forecast to be 5.63% in FY18, down only slightly from 5.83% in FY17 and a little higher than forecast in the September survey. Importantly, this remains far above the average recorded through history, especially in the manufacturing sector where the forecast profit margin for FY18 sits at a lofty 7.15%.

Separately, and unsurprisingly, the Tankan continued to indicate that firms are facing substantial labour shortages. Amongst all firms, a net 35% of respondents reported an employment deficiency – up 2ppts from three months ago and the tightest conditions have been since 1992. Labour shortages are especially acute amongst medium- and small-sized firms. Equally unsurprisingly, given the generally positive economic outlook, firms indicated that they expect conditions in the labour market to get even tighter over the next three months. A net 5% of firms reported that they have insufficient production capacity to meet demand – an outcome that was unchanged from the September survey.

Faced with increasing capacity constraints, firms still seem very willing to boost investment spending. Indeed, in contrast to market expectations that capex plans might be pared somewhat in light of growing concerns about the global economic outlook, spending plans have strengthened compared with the September survey. Capex spending (including land but excluding software and R&D) by all firms is now forecast to grow 10.4%Y/Y in FY18, up from 8.7%Y/Y previously. Large firms forecast capex growth of 14.3%Y/Y, up from 13.5%Y/Y previously. While the plans of medium- and especially small-sized firms are less buoyant, these firms posted the largest upward revisions compared with the September survey. Not surprisingly, the outlook remains especially positive in the manufacturing sector where firms now forecast capex to rise 15.4%Y/Y. Non-manufacturing firms expect capex to increase 7.5%Y/Y, but upward revisions in this sector accounted for all of the upward revision to growth in aggregate.

Turning to the outlook for inflation, the Tankan indicated, at best, limited improvement in the pricing environment. A net 24% of large manufacturers reported a rise in input prices in the December survey (down 3ppts from the September survey). However, only a net 6% of such firms reported passing on these pressures in the form of higher output prices, down 1ppt from the September survey. Among large non-manufacturers, a net 20% of firms reported higher input prices (up 2ppts from the September survey), while a net 8% of firms reported that they had charged higher output prices (up 1ppt to a 4-year high). Among smaller firms increases in input prices were even more widespread and yet these firms’ success in raising output prices was even less than that at large firms. Looking ahead to the next three months, large firms were less optimistic about their ability to raise output prices, especially in the manufacturing sector. By contrast, small firms were slightly more optimistic, but coming off the aforementioned weaker base. Data on firms’ specific forecasts for inflation and their own output prices will be released on Monday, alongside additional industry detail from the survey. While inflation pressures are clearly stronger than they have been for some time, at this stage it seems that firms continue to display limited downstream pricing power.

Finally, while of late the BoJ has shown more concern that its sustained ultra-easy monetary policy settings might have an unduly negative impact on the financial sector, there remains limited evidence of such in the Tankan survey. In the section of the survey completed by just over 200 financial institutions, a net 12% of such institutions reported favourable conditions over the past three months – unchanged from the September survey – and a further 9% forecast favourable business conditions over the next three months (but just a net 4% of bank respondents). From the perspective of firms, there was no signs that they are finding financial institutions unwilling to supply credit. Indeed, a net 24% of firms described the stance of financial institutions as “accommodative” – unchanged from the September survey. And a net 1% of firms reported receiving lower interest rates on loans.

Turning to the day’s other news, METI’s final IP report for October confirmed that industrial output rose 2.9%M/M and 4.2%Y/Y in October. The strong base provided by the October outcome means that growth should easily erase 1.4%Q/Q decline in output that occurred in Q3, with an outcome of around 2%Q/Q a quite reasonable prospect. Together with the 1.9%M/M lift in the Tertiary Industry Activity Index reported earlier this week, the rebound in IP implies that the All Industry Activity Index will post a very strong rebound when this is released next week. Some other key aggregates within the final report saw unfavourable revisions, however. Shipments rose a revised 3.5%M/M in October, less than the 5.4%M/M increase estimated initially, so that annual growth was also revised down to 5.7%Y/Y. Inventory levels fell 1.3%M/M – 0.1ppts less than estimated previously – and were down 0.7%Y/Y. Meanwhile, revised data indicates that the overall inventory-shipments ratio fell just 0.5%M/M in October – nowhere near as sharp as the decline estimated in the preliminary report – but was still down 1.4%Y/Y. Reflecting the rebound in activity, capacity utilisation rose 4.0%M/M in October and was up 3.9%Y/Y. Production capacity fell 0.5%Y/Y despite ongoing capex spending.

As far as the near-term outlook for manufacturing is concerned, further light was cast by the release of the flash manufacturing PMI survey for December. The headline business conditions index edged up 0.2pt to 52.4, leaving the index still 0.6pt below the average recorded this year. Within the detail, the output index rose 1.3pts to an 8-month high of 53.7 and the new orders index rose 0.5pt to 51.4 (albeit still down 1.5pts compared to this year’s average). More worryingly, the new export orders index slumped 2.7pts to 48.0 – the weakest reading since August 2016 – while the employment index fell 1.0pt to 51.9. Elsewhere in the survey, the pricing indices moved decisively lower this month, perhaps influenced by lower oil prices. The input prices index fell 2.2pts to an 8-month low of 58.5 and the output prices index fell 1.7pts to a 7-month low of 51.9. So all up, the PMI would seem to point to ongoing trend expansion in manufacturing sector, but with less momentum than that seen in recent years.

Euro area:
Today will bring the most notable euro area releases of the week with the December flash PMIs. And the French flash PMIs, just released, were shocking, with the headline manufacturing, services and composite indices all in contractionary territory. Indeed, amid the disruption from the ongoing ‘Gilets Jaunes’ protests, the composite PMI was down almost 5pts on the month – the most since the euro crisis in 2011 – to 49.3, its weakest level since February 2016. While the weakness was widespread across both the manufacturing and non-manufacturing sectors, the largest impact was reported among services firms, with the respective PMI down 5½pts to 49.6. And with French auto manufacturers and their component providers reportedly still suffering weaker demand, the overall manufacturing output PMI declined 2.3pts to 47.7, its weakest reading since April 2015. So, despite having held up at the start of the fourth quarter, today’s survey saw the composite PMI fall almost 2pts in Q4 from Q3 to 52.5, a level consistent with only modest GDP growth and the lowest quarterly reading for two years.   

In contrast to the French indices, the German PMIs broadly aligned with expectations, albeit still maintaining a downward trend in both the manufacturing and services sectors in December. So, the composite PMI was down 0.1pt on the month to 52.2, a four-year low, to leave the quarterly index down more than 2½pts to 52.6, the lowest since Q213. And given the German and French data, the euro area composite PMI now seems bound to take another step down from November’s reading of 52.7, to the lowest level since 2014. And the Q4 average will also certainly be the weakest since 2014, strongly suggestive of another subdued quarter of GDP growth in the euro area and weaker than the 0.4%Q/Q rate forecast yesterday by the ECB.

Beyond the PMIs, Q3 labour cost figures will also be watched by the ECB. And after yesterday’s final November inflation figures from Germany and France matched the flash estimates, both 2.2%Y/Y on the EU harmonised measure, tomorrow will also bring the final estimates from Italy and Spain (both 1.7%Y/Y).

And beyond the data, today’s Euro Summit will discuss measures to strengthen the policy framework of the euro area including banking union, reforms to the ESM bailout fund, and possible new budgetary instruments. Given the progress made by Finance Ministers expect further incremental progress rather than the giant steps required to increase significantly the resilience of the euro area to future adverse economic shocks. 

US:
In the US, the week will end with the retail sales and IP reports for November, which will cast further light on how activity is tracking during Q4. The headline retail figure is likely to come in on the soft side weighed by a slowing of new auto sales and lower prices of gasoline, although a decent showing around the Thanksgiving Holiday should provide some support. The IP data should reveal a sixth successive monthly increase in manufacturing output. October business inventory data and the little-followed flash December PMIs will also be released today.

China:
The main focus in China today was on the release of the remainder of the key activity indicators for November which, on balance, were clearly weaker than market expectations.

Beginning with the disappointing news, growth in industrial production slowed 0.5ppt to 5.4%Y/Y – a sharp contrast to the steady growth that markets were expecting – so that year-to-date growth slowed 0.1ppts to 6.3%Y/Y. This outcome – equalling the low-point reached during the GFC – was driven by weaker growth in the manufacturing and mining sectors (now 5.6% Y/Y and 2.3%Y/Y respectively, down from 6.1%Y/Y and 3.8%Y/Y previously). Growth in power generation picked up to 9.8%Y/Y from 6.8%Y/Y, providing a small positive offset. The news from the tertiary sector was also discouraging, with growth in retail spending slowing 0.5ppt to a 15-year low of 8.1%Y/Y – also contrasting unfavourably with the 0.2ppt strengthening that the market had expected. This reduced year-to-date growth by 0.1ppt to 9.1%Y/Y. Only some of the weaker outcome could be explained by the fact that CPI inflation slowed 0.3ppts to 2.2%Y/Y in November, so slower growth in volumes also appear to have contributed to the decline in nominal growth. Looking further into the detail, spending on autos fell 10.0%Y/Y and spending on phones fell a very unusual 5.9%Y/Y (the latter contrasting with a 7.1%Y/Y increase in October). Growth in spending on fuel also slowed sharply, reflecting lower prices.

On a slightly brighter note, growth in fixed asset investment rose 0.2ppt to 5.9%Y/Y in November (measured as usual on a year-to-date basis). This represented a slightly larger improvement than the market had expected. As was the case last month, the improvement was driven mostly by stronger growth in the state sector. Growth in public spending increased 0.5ppt to 2.3%Y/Y, providing further signs of a positive impact from fiscal easing. Growth in private sector investment edged down 0.1ppt to 8.7%Y/Y, but remains within the narrow range of outcomes traced this year. By industry, growth in manufacturing sector investment increased a further 0.4ppt to 9.5%Y/Y, but slower growth was reported in the agriculture and mining sectors. Growth in closely-watched property development was steady at 9.7%Y/Y. Summarising the various monthly indicators, Bloomberg’s measure of monthly GDP grew 6.35%Y/Y in November, down from 6.55%Y/Y in October. This is the slowest pace recorded since February 2016. Even so, somewhat surprisingly, the urban unemployment rate was estimated to have edged down 0.1ppt to 4.8%.

Looking ahead, with the full force of US tariff policy likely yet to take effect (even more so if tariff rates on many goods eventually rise to 25% from 10%), today’s data are likely to step up pressure for further policy support to the economy in the months ahead. The quantum and form of any response will depend on whether negotiations between the US and China are successful in breaking the current impasse before the scheduled deadline of 28 February.

Australia:
The only economic report in Australia today was the flash Markit PMI for December – a series that doesn’t attract much attention due to the short (2½ year) history of the survey. With that said, the news was disappointing this month, with the CBA-sponsored composite index falling 1.5pts to 52.4 – just 0.4pt above the August low. Conditions weakening in both the manufacturing and services sectors, with the headline manufacturing PMI falling 0.9pts to 53.7 and the headline services PMI down a steeper 1.5pts to 52.2 (0.5pt above the October low). Recall that earlier this week the NAB Business Survey had pegged business conditions at a 2-year low, but at levels that nonetheless remain better-than-average across the long history of the survey.

New Zealand:
The REINZ housing report revealed a 2.6%Y/Y lift in the number of home sales in November, representing a step back to trend following the surprising 15.5%Y/Y lift reported in October. The REINZ house price index, which adjusts for the impact of compositional shifts in sales, rose 3.5%Y/Y, down slightly from 3.8%Y/Y last month. Prices fell a modest 0.6%Y/Y in the previously-overheated Auckland market, but recorded an average increase of 7.6%Y/Y elsewhere in the country. Meanwhile, the Business-NZ manufacturing PMI edged down 0.2pt to 53.5 in November, still leaving it a little firmer than it had been around the middle of this year. Within the detail the new orders index fell 0.7pts to 56.3, representing a modest pullback following a 4pt bounce in October. The production index fell 1.4pts to 51.5 and the employment index fell 1.1pts to 51.3, although these moves were partly offset by a lift in the inventory and delivery indices.

In other news, following its recent review of bank capital, the RBNZ announced that it will begin consulting on a proposal to raise banks’ capital levels increase materially. According to the RBNZ, the proposal is to almost double the required amount of high quality capital that banks will have to hold. In practice, actual changes to the amount that they hold will depend on each banks current level of capital, how much extra they choose to hold above the required minimum, and whether they are a large or small bank. The RBNZ expects that generally banks will face an increase of between 20-60%, accounting for about 70% of the banking sector’s expected profits over a proposed 5-year transition period. Even so, the RBNZ said that it expected only a minor impact on borrowing rates for customers – an impact that in our view would nonetheless make it even less likely that the RBNZ would rush to tighten monetary policy. The consultation period will end in March next year.

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