Monday, March 9, 2009

Weekly Focus: Last in, First out

China was very much in the spotlight during the week, credited with both the ups and downs of the global stock market. The good news from China is that there are more and more signs of a turnaround in the economy. The PMI industrial activity indicators currently suggest that the economy bottomed out in Q4, which is earlier than we and most others had anticipated (see Flash Comment - China: Ray of light in continued rebound in manufacturing PMI). Other indicators also point to a turnaround in the Chinese economy. Credit growth has accelerated rapidly in recent months, which has normally been a sign of rising investment activity, and car sales have recovered well in recent months, with China overtaking the USA as the world's biggest car market.

Although Chinese exports are still under the weather and unemployment has risen, it now seems that the big fiscal policy stimuli, low interest rates and the lifting of credit restrictions, together with strong growth in real income due to falling inflation, have given the Chinese economy a serious shot in the arm. However, global equity markets reacted with some disappointment during the week when the Chinese premier failed to announce a fresh stimulus package in his opening address at the National People's Congress. We have to say, though, that China is currently the country least in need of further stimulation. The steps already taken seem to be working, and so the administration can now afford to wait and see.

China was one of the last countries to be dragged into the global financial crisis, and now looks set to be one of the first to come out the other side.

Euroland: ECB very downbeat on the economy

On Thursday ECB cut the refi rate by 50bp to 1.5%, which did not come as a surprise. More interesting was the press meeting where Trichet delivered one of the most downbeat forecasts for Euroland so far with GDP growth of - 2.7% in 2009 and 0.0% in 2010 while at the same time lowering projections for inflation. ECB now expects inflation to be around 1.0% in 2010. This is significantly below ECB's objective of inflation below but close to 2%, and gives plenty of room for further rate cuts. The very downbeat view on the economy emphasises that further rate cuts are needed and we believe that ECB will cut again already in April and bring the refi rate down to 1.0%.

Trichet did not reveal whether 1.0% will be the minimum for the refi rate as indicated by the German member Axel Weber a week ago, but we believe that rates will be on hold at 1.0% and other instruments will be applied instead. ECB is likely to embark on what Trichet calls credit easing and buy corporate credit.

Trichet highlighted that ECB is already using non-standard measures through its supply of unlimited liquidity and the width of collateral it takes. This has led to a sharp rise in ECB's balance sheet. On new measures Trichet did not reveal much but said ECB is studying new measures and that it did not exclude anything. However, when talking about this he said it would be explained further "when" ECB embarked on this - quickly changing it to "if and when". ECB announced it would continue to give unlimited liquidity on its tenders at all maturities and that it would last beyond 2009.

Key events of the week ahead

  • Wednesday German industry orders in January will show a 2.5 % decline following a large drop in December.
  • On Thursday we will receive Euroland industrial production for January, which is dragged down by falling exports, declining investments and the need to bring down inventories. We expect a 1.5% decline m/m.
  • On Friday Euroland retail sales in January will show a 0.5% m/m decline - in line with the 0.6% fall we have seen in German retail sales.

Switzerland: Will SNB be the fourth big central bank to turn to quantitative easing?

The event of the week in Switzerland is the Swiss National Bank's (SNB) Q1 monetary policy meeting on Thursday. Since the last meeting in December, when the bank lowered its target for the 3M LIBOR to 0.50%, the economic slowdown has gained in momentum and consumer prices have fallen faster than expected. The GDP data for Q4 released on Tuesday showed a drop in output of 0.6% y/y and confirmed that Switzerland is in recession, as growth was also negative in Q3. In line with rapidly weakening aggregate demand in the economy, inflationary pressure has eased, catalysed by falling energy and food prices.

An obvious response to the combination of accelerating economic contraction and fading inflationary pressure would be to reduce the upper end of the target range for the 3M LIBOR by 25bp to 0.75%. This solution was used last time interest rates approached zero in 2003. Although we think it likely that the SNB will opt for this solution once again, its impact will be limited. For one thing, the SNB is already offering repos at 0.05%, so Switzerland effectively already has a zero interest rate. For another, it will be hard to bring the 3M LIBOR significantly down from its current 0.49% until money markets normalise.

The focus is therefore instead on whether the SNB will ease monetary policy by alternative means. Although interest rates are effectively zero, monetary policy is still far from impotent - as the SNB has been at pains to convince the market. The SNB still has the option of increasing the supply of liquidity through the money, bond or currency markets - in other words, quantitative easing. It also has the option of actively reducing interest rates in specific markets by making sterilised purchases - in other words, credit easing. Given the considerable uncertainty about both whether the SNB will turn to alternative instruments and, if so, which instruments it will use, there is also considerable uncertainty about the market reaction.

The futures market is already pricing in a reduction in the 3M LIBOR to around 0.30%, so the market reaction will probably be muted if the SNB simply lowers the upper end of the target range. On the other hand, an announcement of quantitative easing could put the CHF under pressure, while any intention to buy up bonds could cause the yield curve to flatten.

Key events of the week ahead

  • Monday, 08.15 CET: February unemployment.
  • Monday, 10.30 CET: Swiss finance ministry presents IMF report in Berne.
  • Thursday, 14:00 CET: SNB's interest rate decision. We predict a 25bp reduction in the upper end of the target range, but the focus is on alternative instruments.
  • Friday, 09.15 CET: February PPI.

UK: Bank of England starting the printing machine

In the past week, the Bank of England (BoE) delivered its last rate cut of 50bp, taking the Bank Rate to an all-time low of 0.5%. At the same time, the BoE announced a programme of buying GBP75bn of credit bonds and medium- to long-term government bonds (see BoE statement). The programme is financed by bank reserves, which effectively means it is printing money to buy bonds. And in effect this equates to financing part of the budget deficit by starting the printing press. The new measures come as the BoE sees inflation way below its target of 2% in the medium term. And with the interest rate weapon exhausted, the next step is to increase the money supply further through the purchase of bonds. The bond market reacted with a sharp decline in longer-term government bond yields. The 10-year government bond yield declined 50bp to 3.10% and the yield curve flattened substantially as the two-year bond yield was little changed. EUR/GBP was largely unaffected as the statement from the ECB was also very dovish. In the short term, we believe EUR/GBP will continue range-trading around 0.89. In the longer term, the GBP is undervalued, though, and we ultimately see the GBP strengthening versus the EUR.

In the past week, data out of the UK have been a bit mixed. PMI manufacturing fell back again to 34.7 in February from 35.8 reversing last month's rise. PMI service, however, managed to rise for the third month in a row to 43.2 in February up from 42.5 the previous month. In the housing market, HBOS house price statistics showed a decline of 2.3% m/m reversing last month's rise. Looking at a three-month average, house prices are now falling 0.7% per month - a slight improvement from late 2008 when house prices were falling by around 2% per month. Thus taking a step back, house prices are still falling but the pace of the decline is tapering off. We expect this development to continue for the rest of the year (see chart). Next week we will have more information on the housing market with the release of the RICS survey. The RICS survey paints a similar picture as the survey has risen gradually since reaching the bottom in mid-2008. Some of the leading parts of the RICS survey (buyer enquiries and newly agreed sales) point to further increases in the main RICS index. Data for car sales showed a decline of 21.9% y/y in February up from a decline of 30.9% in January. Looking at the seasonally adjusted numbers, car sales have stabilised in recent months after falling rapidly in 2008. This is a pattern also seen in Germany and in several Asian countries. Hence global car sales may be bottoming out due to rebates and better access to financing in some places.

Key events of the week ahead

  • Tuesday: The RICS housing survey is released. We expect a small rise (see main text above).
  • Tuesday: Industrial production for January is released and is likely to show another big decline in January.
  • Tuesday: BRC retail sales survey has improved recently pointing to slightly better consumption. We look for an unchanged number.

USA: Worst of the consumer slowdown seems to be behind us

Although we anticipated a general improvement in industrial indicators in H1, we had expected a drop in the ISM manufacturing index during the week given the weakness of the regional PMIs. So we were in for a pleasant surprise when the index actually managed to edge up in February to 35.8. This level is still consistent with marked negative growth rates in the economy in Q1, but underlines how significant a factor the credit shock was in the sharp slowdown in industry in the latter part of 2008. As presented in Research US: Manufacturing recovery ahead, we expect this shock to ease in the coming months, and we can see the ISM manufacturing index hitting 45-50 in the summer.

The focus in the coming week will be on February retail sales. Most were surprised by the increase in retail sales in January, and it looks like we might be in for another surprise in February. Although auto sales continued to slide in February, there are other indicators pointing in the other direction. The signals from chain-store sales in February have been positive, and the rise in gasoline prices will also boost overall retail sales. We therefore expect retail sales to be unchanged from January overall and climb 0.3% m/m ex autos. There are therefore signs that the worst of the consumer slowdown is now behind us, and there are a number of factors that suggest recovery lies ahead. Fiscal policy easing, low energy prices and lower mortgage rates have together given households a big lift in real incomes. There is no doubt that the tightening of credit conditions and sharp drop in house and share prices will put a damper on spending for many quarters to come, but there are signs that the tightening of consumer credit is slowing, and there are limits to how far credit growth can fall from today's already negative levels.

Key events of the week ahead

  • Tuesday: Ben Bernanke speaks on the regulation of the bank sector in Washington.
  • Thursday: We expect February retail sales to be unchanged from January overall and climb 0.3% ex autos.
  • Friday: We expect the University of Michigan consumer sentiment index to decline from 56.3 in January to 55.2 in February

Asia: Signs of improvement in the Chinese economy

China has been very much in the spotlight over the past week. Economic data from the country are continuing to surprise on the upside. First and foremost, the PMI industrial activity indicators from the National Bureau of Statistics and CLSA both rose nicely in February for the third successive month. This suggests that industrial production in China is stabilising and may even have bottomed out in Q4 08. This would be somewhat earlier than we anticipated in our current forecast, as we thought we would have to wait until Q2 09 to see clear signs of stabilisation in industrial production. Based on developments in new orders in the PMI data, it is clear that the strength in China stems primarily from the domestic market. Fiscal policy easing and better access to credit from Chinese banks seem to have rapidly given domestic demand a real shot in the arm. It also seems that exports are at the very least falling more slowly. The weak outlook for the global economy and exports is still a major challenge for the Chinese economy, though, and this is the reason why we are still only guardedly optimistic about the Chinese economy. That said, we have now reached the stage where we can no longer rule out the possibility of Chinese growth in 2009 turning out to be stronger than our current forecast of 6.8%.

The opening of the National People's Congress discussed in last week's Weekly Focus was also centre stage during the week, thanks to speculation that Chinese premier Wen Jiabao would announce a fresh stimulus package in his opening address. As it happened, he did not, and equity markets managed to be both euphoric and disappointed. Ultimately, though, it is not so surprising that there was nothing new from Wen. It seems that the steps already taken are working, so it makes some sense to hold fire for a bit and save on ammunition. The Chinese do not want to fuel another stock market bubble, and the administration has shown a degree of concern about the relatively strong growth in prices in the domestic stock market since the beginning of the year. Further monetary policy easing has therefore probably been put on hold in the short term, and we cannot rule out the possibility that we have already seen the final rate cut in the present cycle.

Key events of the week ahead

  • In China, we expect a big week in terms of incoming data. Given the recent positive PMIs, it will be particularly interesting to see if this stabilisation can also be detected in exports and industrial production. Note that the industrial production figures will be for both January and February together.
  • In Japan, there will be a particular focus on the revised GDP figures on Wednesday. We predict a slight downward revision.

Foreign Exchange: USD rebound not yet over

The USD has made a strong start to 2009 and has been the best-performing G10 currency to date. There are several reasons for this, including movements in relative interest rates and equities, which have both favoured the USD, and lower oil prices, which are increasingly helping energy-intensive American house-holds back onto their feet. There is also still an overhang of USD scarcity in financial markets from last year, which has prompted the Federal Reserve to extend its swap arrangements with other central banks until October. This latter factor is crucial to an understanding of why the USD is finding natural support in the market. We (and others, including the BIS) also think this is one of the main reasons why the USD has bounced back so strongly after being on its knees last summer.

Technically, the EUR/USD is in a downtrend, with lower peaks and higher troughs, but can the USD strengthening continue, and what will be the main drivers? We can see at least three factors suggesting that the EUR/USD cross will stay around or below 1.20 for most of 2009. First, there is the impact of short-term factors such as the technical trend, risk aversion, investor sentiment and futures positioning, which all indicate that the USD will continue to rebound steadily. Second, there is relative monetary policy, with the Fed proving the dynamic central bank, having already begun quantitative easing and taken interest rates close to zero to provide the greatest possible stimulus for the economy yet without weakening its currency, while the ECB has been more hesitant and is also battling with a number of debt-encumbered member states and the looming risk of deterioration in one or more of the new member states in the east. We do not expect the EUR to splinter, but it is highly likely that the weaker basis for the common currency and the risk of Europe being stuck in a lasting recession will be priced into financial markets, leading to EUR weakening. Third, there is relative growth. In the short term, things are definitely not looking good in the US, with a virtual collapse in output and an explosion in unemployment, but this has already largely been discounted, and we expect the big positive stabilisers to kick in as intended, with the result that we will see US growth returning to around trend as early as the beginning of next year. But we see no reason to be as positive about Euroland, where we expect the growth picture to be more fragmented, and the risk of a lasting slump should by no means be ignored.

The coming week brings fewer interesting data than the past week. Worth noting, though, is the substantial flow of economic data from Japan, which have been far from favourable and have highlighted how hard the world's second-biggest economy has been hit by the financial and economic crisis. For data elsewhere, the coming week's inflation figures will probably prompt a mere shrug of the shoulders, as price stability does not currently have investors' attention, but the data for industrial production, retail sales and consumer confidence could have a greater impact if they spring any surprises - especially if those are on the upside.

Besides the USD, which still has plenty of potential to our mind, we find the NOK and SEK attractive against the EUR. That said, the timing is crucial here, and we would not advise investors to go down this route unless they have nerves of steel, but for those with an appetite for risk there is the possibility of almost unique potential without trans-Atlantic exposure. An equally weighted basket of SEK, NOK and - to exploit the high interest rate spread - DKK against the EUR could be an interesting play for this investor segment. Judging from option prices, investors expect fewer strong GBP movements than a couple of months ago, and this may be one of the first signs of recovery in the hard-pressed GBP, which remains deeply undervalued. However, we consider rapid recovery in the GBP unlikely - the financial markets are still having too rocky a ride.

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