The European debt crisis and the US debt ceiling debate have dominated headlines and driven market action in recent weeks, but we think the real story unfolding is that of slowing growth in major economies. Just in the past week, the Eurozone ZEW survey, Eurozone consumer confidence, and Eurozone composite PMI’s all fell by more than expected. In Germany, the manufacturing PMI new orders index fell to 47.6, indicating contraction ahead in the core’s growth engine. In China, the MNI July flash manufacturing PMI survey dropped from 50.1 to 48.9, also pointing to anticipated contraction ahead in the manufacturing base of the world’s second largest national economy. In the US, June existing home sales declined again, suggesting renewed deterioration in US real estate, one of the major drags on the American recovery. Down under in Australia, the may Westpac leading index fell -0.1% and 2Q business confidence dropped from +11 to +6. US 2Q GDP due out at the end of next week will be another bleak reminder of the state of the recovery.
Clearly, the road ahead for the global recovery is sloping uphill and yet risk markets (e.g. S&P 500, MSCI World Index and the CRB commodity index) are nearer to their recent highs. (Just looking at the MSCI World index, we think we’re in the process of completing the right shoulder of a potential long-term head-and-shoulders topping pattern.) We think this is mostly the result of a relief rally as EU leaders have repeatedly shown up to douse the flames of the European debt crisis, preventing a worst case outcome. But optimism based on a catastrophe being avoided is likely unsustainable for any length of time.
In the face of increasing signs of growth stalling, what are policymakers in major developed economies proposing? In a word, contraction. European leaders are fixated on austerity measures to solve the debt overhang and the UK continues down the road of its own fiscal reform plan. In the US, the phasing out of government stimulus is now acting as a drag on the economy, even as US politicians are having a one-sided debate over how much to cut future spending. And unemployment in all these economies remains stubbornly high, with no sign of meaningful improvement on the horizon.
Under these conditions, we find it difficult to embrace risk assets and think the current risk rally is most likely a multi-week opportunity to short risk/get long safe haven assets. Certainly the relief rally following the EU Summit may have more room to run, but we believe it’s destined to fail within the next few weeks. It may be prolonged if the US is able to strike a deficit reduction deal and avoid default, or it may reverse sharply if the US does indeed default. We’ll look to get long JPY, CHF and gold on pullbacks/ look for opportunities to sell AUD, EUR, and GBP, in coming weeks.
With just ten days to go until the Aug. 2 deadline to raise the US debt limit and avoid a default, US politicians remain far apart on reaching a compromise. Senior congressional leaders have indicated they will take action to avoid a default, but we can’t completely rule out that possibility given the level of rancor in Washington. We still think the most likely outcome is a bill to solely raise the debt limit, leaving the spending/deficit debate to play out on the hustings in the 2012 elections. If a clean debt limit increase is passed, we would expect a short-term USD rebound, followed by further USD weakness as risk sentiment would temporarily be supported. After that, we would expect the risk rally to stall once more, in line with our more pessimistic view on the pace of the global recovery. Should the game of chicken lead to a default, we think the USD could potentially see a sharp decline of around 5%, though the likely temporary nature of any US default may actually make the greenback a buy on dips in that scenario.
The initial market reaction to the Greek debt deal has been positive. The euro rose to a high of 1.4400, and although it lost some of those gains prior to Friday’s close it was mostly down to a bout of risk aversion caused by the explosion in Norway.
Most importantly for the EU authorities, Italian and Spanish bond yields have moderated sharply. Spanish yields are back below 6 per cent and Italian yields are 60 basis points lower. Yields are moving away from the crucial 7 per cent level that typically signals a bailout will be imminent and the cost to insure Greek debt also tumbled by more than 500 basis points on the news.
The main details the new package for Greece include: a second bailout for Greece worth EUR109bn funded by the EFSF rescue fund, an extension to the maturity of the bailout loans from 7.5 years to 15 and up to 30 years, a cut in the interest rate to around 3.5 per cent or above the EFSF’s cost of financing and private sector participation.
The EU authorities persuaded the ECB to accept a partial default for Greece and the financial sector indicated its willingness to accept haircuts on their holdings of Greek debt. The private sector is expected to write off EUR37bn of debt for Greece, equivalent to reducing its debt to GDP ratio by more than 10 per cent to 125 per cent of GDP over the next 4 years.
New steps have also been taken to limit contagion throughout the currency bloc and ease market tensions. The scope of the EFSF and ESM rescue funds has been increased to include helping to finance the re-capitalization of Europe’s banks and to intervene in the secondary bond markets to help ease pressure in exceptional market circumstances. The new deal means that the EFSF essentially become Europe’s “bad” bank.
These measures should be welcomed and if they work properly should act as effective stabilization tools to reduce the spread of contagion throughout the currency bloc. However, we have reservations about the plan in its current form.
Firstly, the EFSF’s scope has been widened but its size has not. At EUR440bn it won’t be able to recapitalize that many banks and its operations in the financial markets will be limited. Some commentators have argued that the fund needs to be boosted to EUR1 trillion before it could cope with a bailout of Italy or Spain.
Secondly, it is likely that investors will need to take a larger haircut than the EUR37bn to reduce the Greek debt burden to a sustainable level. This level of debt relief for Greece is not enough and at 120-130% of GDP, Greece’s debts are still too big for its economy to deal with. The private sector may have been happy to contribute this time, but it is not certain their will accept any more losses on their investments in future.
Although Portugal and Ireland secured cuts to the interest rates on their bailout loans, private sector involvement is for Greece only and at this stage Portuguese and Irish bondholders will not be taking any losses.
Although barely mentioned, the most important part of the plan was the announcement of the EU Commission’s Task Force, which will work with the Greek authorities to boost competitiveness, growth, job creation and training. Without a credible growth strategy Greece won’t be able to sort out its public finances.
So far the credit rating agencies seem to like the deal. Fitch has assigned Greece a “restrictive default” rating, although it said that the reduction in interest rates and the extension to the maturities of the EFSF loans would help Athens regain solvency. It also said that new bonds issued by Greece wouldn’t get a default rating and may be given “low speculative grade” status.
But Fitch said that unless Ireland and Portugal sort out their finances then public sector involvement will be necessary for the other bailed out members of the Eurozone, however, it said there was no chance of an imminent downgrade for either member state.
The EU authorities have probably done enough to stop any further flare-ups for the next couple of months. The markets’ reactions today is encouraging, but for the risk of contagion to be contained in the long-term Greece needs to show it can bring down its deficit and reign in its public finances. It receives its next tranche of bailout funds in September when the EU/ECB and IMF will check-up on Greece’s public finances. If Athens doesn’t show some progress then markets will get spooked as the Eurozone will be accused of giving bailouts for free.
In the background to the sovereign debt issues there were further signals last week that growth is deteriorating. The composite PMI for the manufacturing and services sector fell from 53.3 in June to 50.8 in July, just above the crucial 50 zone. This survey has a close correlation with GDP, so suggests growth is slowing. We need to hear more from the ECB, but if growth continues to weaken then it may delay their program of rate normalization. Already rate expectations over the next year have moderated, if this continues it could thwart the euro’s rally.
EUR/USD has so far failed to surmount daily trendline resistance from the 1.4700 June highs, currently in the 1.4450/60 area, which also coincides with the top of the daily Ichimoku cloud. While that level holds, the prospect remains that EUR/USD may see lower to the 1.3950/1.4000 recent range lows. We would also look to fade any moves higher in EURCHF, ideally in the 1.20/22 area, for a decline to potential new all-time lows. The debt deal is a step in the right direction, but Europe hasn’t put a lid on this crisis yet.
New Zealand’s economic recovery has picked up steam as evidenced by the latest spate of upside data surprises. The recent release of Q1 GDP showed a +0.8% QoQ rise and a +1.4% YoY increase, much better than consensus expectations suggesting downside earthquake impacts may have been overstated. Sector by sector analysis confirms a pick-up in NZ economic momentum – the housing market is showing signs of stabilizing, confidence indicators have rebounded off post-earthquake lows, and capital investments have been firming.
The RBNZ is set to announce the Official Cash Rate (OCR) on Wednesday, July 27th and market expectations are for the OCR to be held steady at 2.50%. However, the RBNZ may ramp up its recently shifted hawkish tone - the central bank noted that removal of policy accommodation would be determined by the ‘speed of the recovery’. As noted earlier, recent economic data has printed higher than expectations and this past week’s release of Q2 consumer prices did not buck the trend – NZ CPI increased +1.0% vs. consensus estimates of +0.8% (QoQ) and +5.3% vs. expected +5.1% (YoY) – suggesting current accommodative OCR levels may no longer be appropriate. We think the RBNZ will keep policy on hold, but believe accompanying statements will be more hawkish in nature as suggested by the faster pace of recovery and rising inflation expectations. Accordingly, we believe Governor Bollard & company will implement a minimum +25bp hike to the OCR by end of year.
The risks to further kiwi and NZ economic strength can be attributed to the fragile global growth picture. While EZ periphery debt concerns seem to be appeased for now, recent crisis resolution agreements lack details particularly in regards to private sector involvement and may not be the cure-all that some market participants have perceived it to be. The uncertainty regarding the U.S. debt ceiling debate is another risk – the longer the debate drags on, the larger the risk for a potential U.S. default which would result in substantial negative shocks to financial markets globally.
The last and certainly not the least risk to sustainable NZ growth prospects comes from China. Fears of a sharp slowdown in China growth have been brushed aside with EZ sovereign debt concerns taking center stage. However, recent data suggests it may be too soon to put China hard landing fears in the rear view mirror. July HSBC Manufacturing printed below 50 at 48.9 indicating general contraction and suggests the potential for sharp growth deceleration in China should at least be in the side view mirror.
United States: Monday – JUN Chicago Fed National Activity Index, JUL Dallas Fed Manufacturing Index Tuesday – MAY S&P/Case Shiller Home Price Index, JUL Consumer Confidence, JUL Richmond Fed, JUN New Home Sales, Fed’s Hoenig testifies on monetary policy Wednesday - MBA Mortgage Applications (JUL 22), JUN Durable Goods, Fed’s Beige Book Thursday – JUN Pending Home Sales, Weekly Jobless Claims Friday – Advance 2Q GDP, JUL Chicago PMI, JUL Univ. of Michigan Confidence Survey, JUL NAPM-Milwaukee, Fed’s Bullard & Lockhart discuss monetary policy
Eurozone: Tuesday – Germany AUG GfK Consumer Confidence Survey Wednesday – EZ JUN M3 Money Supply, Germany JUN Import Price Index, Germany JUL CPI Thursday – EZ JUL Consumer, Economic, Industrial, & Services Confidence, Germany JUL Unemployment Rate, Germany JUL Unemployment Change, ECB Bank Lending Survey Friday – EZ JUL CPI Estimate, Germany JUN Retail Sales
United Kingdom: Monday – BoE Asset Purchase Facility Quarterly ReportJUL 25-29 – JUL Nationwide House prices Tuesday – 2Q A GDP, MAY Index of Services Wednesday – JUL CBI Business Optimism, BOE’s Miles speaks in London Thursday – JUL CBI Reported Sales, JUL GfK Consumer Confidence Survey Friday – JUN Net Consumer Credit, JUN Net Lending Sec. on Dwellings, JUN Mortgage Approvals, JUN M4 Money Supply
Japan: Monday – JUN Corp Service Price Index Wednesday – JUN Retail Trade, JUN Large Retailers’ Sales, Weekly Securities Purchases Thursday – JUN Jon to Applicant Ratio, JUN Jobless Rate, JUL Tokyo CPI, JUN Natl CPI, JUN P Industrial Production Friday – JUN Vehicle Production, JUN Construction Orders, JUN Housing Starts
Canada: Wednesday – Teranet/National Bank HPI Friday – MAY GDP, JUN Industrial Product Price, JUN Raw Materials Price Index