Morning comment: Dire data after Brexit relief

Chris Scicluna
Emily Nicol
Mantas Vanagas

Despite another positive session for US stocks (excluding financials) yesterday, Japan’s markets reopened today from their holiday with the TOPIX posting only a modest gain of just 0.2%. The dataflow certainly didn’t help – Japan’s CPI inflation was subdued in February and the details of the preliminary March manufacturing PMI report were again worrisome (more on these below). Combined with reaction to the post-Fed sharp decline in Treasury yields, this sent the 10Y JGB yield down 3bps to -0.07% – the lowest since October 2016.

Elsewhere in Asia, investors seemed even more reluctant to follow Wall Street’s lead, with equity markets generally flat or even modestly in the red (China’s CSI closed down jus 0.1%). A gain of 0.5% in Australia’s ASX200 was one exception, as the 10Y ACGB yield rallied a further 4bps to 1.83%, approaching the record low. And the 10Y New Zealand government bond yield fell to 1.98% for the first time too. Sentiment probably wasn’t helped by a further Bloomberg report which suggested that a trade deal is unlikely to emerge when Steven Mnuchin and Robert Lighthizer return to Beijing for talks with Chinese officials at the end of next week.

And this morning’s European dataflow has added new downwards pressure to yields. The 10Y Bund yield has fallen 3bps and is now approaching zero, and the euro has weakened, after the flash euro area PMIs significantly disappointed expectations, suggesting in particular that the woes in the manufacturing sector have deepened. But sterling (up 1½ cents from yesterday’s trough to above $1.310) is stronger following last night’s decision by EU leaders to extend the Article 50 deadline and thus avoid a no-deal Brexit next week. The agreement, which keeps alive all possible eventual scenarios for Brexit (including a softer Brexit or no Brexit at all), offers a pair of new deadlines, conditional on events next week in the House of Commons (see below for further comment on the PMIs and BRexit).

As far as economic data were concerned, a key focus in Japan today was on the CPI report for February. In summary, all of the key aggregates printed either in line with or below market expectations, and all were either in line with or below their January readings. In seasonally-adjusted terms the headline index was unchanged in February, so that the annual inflation rate remained disappointingly steady at the 15-month low of 0.2%Y/Y reached in January. Weighing on the headline line result was a further 2.9%M/M decline in the price of fresh food (down 11.0%Y/Y). More importantly, the measure used by the BoJ in its quarterly Outlook Report forecast – which excludes fresh food prices from the CPI – rose 0.1%M/M in February. Even so, this was insufficient to prevent an unexpected 0.1ppt decline in the annual inflation rate for this measure to 0.7%Y/Y, thus erasing the small improvement that had been reported in January.

Within the detail, energy prices rose a further 0.4%M/M in February (up 4.5%Y/Y) with a marginal decline in petroleum product prices more than offset by further increases in the price of electricity and gas. Nonetheless, the BoJ’s preferred measure of core prices, which excludes both fresh food and energy prices, also rose 0.1%M/M in February, which was sufficient to leave annual inflation on this measure steady at 0.4%Y/Y – in line with market expectations but, unfortunately, 0.1ppts weaker than where it had stood a year earlier. The measure of core prices that strips out all food items and energy also rose 0.1%M/M, leaving its annual inflation rate steady at an even lower 0.3%Y/Y. Elsewhere in the detail, prices for non-energy industrial goods edged up in February but annual inflation for these products was steady at 0.2%Y/Y. While prices in the service sector also edged higher in February, unfavourable base effects meant that annual inflation fell 0.1ppt to 0.4%Y/Y.

So in summary, it remains the case that core inflation remains nowhere near the BoJ’s 2% target – and shows no sign of moving there in the foreseeable future – despite persistent and extreme tightness in the labour market. And with recent activity and sentiment indicators continuing to suggest that hitherto growth in the economy may struggle to reach trend, it remains difficult to see the BoJ withdrawing monetary stimulus. At the same time, the hurdle to further policy easing appears high given increasing concerns amongst some Board members about possible negative side effects on the financial sector from sustained ultra-accommodative policy settings.

The other main focus in Japan today was on the flash manufacturing PMI for March. Unfortunately the PMI tallied with the downbeat tone in the manufacturing component of Wednesday’s Reuters Tankan survey. Specifically, after declining 1.4pts last month to the lowest level since June 2016, the headline index was steady at 48.9 in March. While that might suggest that overall conditions in the manufacturing sector were no worse than in February, the detail of the report suggested otherwise. In particular, the output index fell 0.5pts to 46.9, marking the weakest outcome since May 2016. Worse still, the new orders index fell 0.8pts to 46.6 and the new export orders index fell 0.9pts to 46.8 – the weakest outcomes since June 2016 and July 2016 respectively. It might seem surprising, therefore, that the employment index rose 0.2pts to 51.8. This probably reflects the impact of persistent skill shortages, which has meant that firms continue to demand more labour even in the midst of a slowdown in production.

The other area of offsetting strength in the PMI report concerned prices. The output price index rose 0.4pts to 52.1, thus erasing the decline recorded in February. After hitting a 16-month low last month, the input price index also rose 0.4pts to 57.1. Given this week’s soft Reuters Tankan and PMI survey, next week’s February IP report – and the forecasts made by firms for the next two months – will be of significant interest. It seems likely that IP will have only reversed a fraction of the 3.4%M/M slump recorded in January.

So, after a lengthy negotiation that overran by more than four hours, EU leaders have finally agreed to an extension of the Article 50 deadline to avoid a no-deal Brexit next week. But rather than setting the new deadline to 30 June as Theresa May had requested, they consented to two alternative scenarios for a shorter extension. If the House of Commons approves the Withdrawal Agreement next week, they will extend the deadline to 22 May. And if approval of a deal is not reached over coming days, the extension will initially be shorter still, to 12 April – the date at which the UK would need to set legislation if it is to participate in May’s European Parliament elections – with the UK by then having to indicate a clear alternative way forward for EU leaders to consider. That, of course, could trigger a further longer extension. And, in reality, all possible Brexit scenarios are still on the table. 

Even if the House of Commons Speaker allows it to go ahead, we strongly doubt that Theresa May can win a majority in favour of her deal outright next week to qualify for the 22 May deadline. Her antagonistic statement to the public on Wednesday evening, when she demonised MPs for their intransigence, seems to have made that task near-impossible, alienating those MPs whose votes she will need to win, and losing the confidence of key Cabinet colleagues (reportedly including her all-important Chief Whip). We would not rule out the possibility, however, that the deal can be passed subject to confirmation by a second referendum later in the year. 

Certainly, then, 12 April would now seem to be the decisive date. If the UK cannot find a new workable way forward by then – to earn the right to a further extension (and the obligation to participate in the European Parliament elections) – a no-deal Brexit could theoretically then occur. But, we think the EU would, if necessary, show further flexibility to avoid that prospect, while there is clearly no majority in the UK Parliament (or among the UK public) for that either.

Moreover, if May’s deal is rejected outright (i.e. with or without a confirmatory referendum attached) next week, we still expect an alternative path for Brexit to be found in the UK. Most notably, the House of Commons on Monday could now be set to vote on a variant of the 'Cooper-Letwin' proposal, narrowly defeated last week, to allow MPs to launch a new process (perhaps as soon as Wednesday) to try to find a new compromise – which might encompass a softer Brexit or second referendum – and eventually find a resolution to the current impasse.

Of course, that would only add to Theresa May’s woes. And although she might try to fight on, given her total lack of authority within her Cabinet, Party, Parliament and among EU leaders, we now see a strong probability that May’s end as Prime Minister is rapidly approaching. She might not even see out the current month. And a General Election cannot be ruled out either.

Euro area:
In the euro area the most notable new economic data of the week have just been released in the shape of the March flash PMIs. And these have been seriously disappointing. In particular, the euro area manufacturing PMI plunged 1.6pts to just 47.6, the lowest since April 2013, suggesting that the contraction in the sector has deepened. And with the services PMI down a fraction to 52.7, the euro area composite PMI fell 0.6pt to 51.3, just a touch above the multi-year lows reached at the turn of the year. And that left the Q1 average at just 51.4, the lowest quarterly reading Q313 and consistent with GDP growth of just 0.1%Q/Q.

At the country level, there was weakening in both Germany and France. In the former, the manufacturing PMI dropped almost 3.0pts to only 44.7, a level unseen since 2012. All the details were very disappointing, but new orders stood out the most. Having at the end of 2017 risen above 64, the manufacturing new orders index plunged to just 40.1, a new post-global-financial-crisis low. The message from the services PMI was somewhat more reassuring, with the headline index declining by 0.4pt to 54.9. But the results from both sectors combined left the composite PMI at 51.5, the lowest level since June 2013, suggesting another quarter of minimal growth in the euro area’s largest member state in Q1.

The French figures were also very disappointing with the composite PMI plummeting to 48.7, returning close to the levels seen at the turn of the year when the Gilets Jaunes protests were taking their toll. The French manufacturing PMI declined by 1.7pts to 49.8, only the second reading below 50 in more than two and a half years, while the services PMI dropped by a similar amount to a very weak 48.7. 

In the US, the week will conclude with the February existing home sales and January wholesale trade reports, as well as the (lesser watched) preliminary PMIs for March. 

The only economic data released in Australia today was the results of the flash CBA PMI surveys for March – of only peripheral interest to the market given their short history (dating back to May 2016). For the record, the composite index increased 0.9pts to an even 50 from the series-low reached last month. The services PMI rose 1.1pts to 49.8, but the manufacturing PMI fell 0.9pts to 52.0 – the lowest reading since July 2016.

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