Wednesday , July 15 2020
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Liquidity and Macro Compete for Upper Hand

Summary:
It is sometimes said that two emotions drive the capital markets, fear and greed.  That may cast it in moralistic terms, but there does seem to be two attractors that the pendulum of market sentiment is presently swinging between. On the one hand, central banks have eased monetary policy through conventional and unconventional measures. Governments have responded as well.  Varying from country to country, officials have replaced a large part of the income that has been lost until now.  Easy financial conditions encourage investors and speculators to buy riskier assets. That said, the quarter-end could see some large portfolio adjustments after the dramatic rise in most equity markets.   On the other hand, fundamentals matter.  Two things are shaping the macroeconomy. First, of

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Liquidity and Macro Compete for Upper Hand
It is sometimes said that two emotions drive the capital markets, fear and greed.  That may cast it in moralistic terms, but there does seem to be two attractors that the pendulum of market sentiment is presently swinging between.

On the one hand, central banks have eased monetary policy through conventional and unconventional measures. Governments have responded as well.  Varying from country to country, officials have replaced a large part of the income that has been lost until now.  Easy financial conditions encourage investors and speculators to buy riskier assets. That said, the quarter-end could see some large portfolio adjustments after the dramatic rise in most equity markets.  

On the other hand, fundamentals matter.  Two things are shaping the macroeconomy. First, of course, is the virus.  New flare-ups are happening in several countries,  and the issue is the effectiveness of public health practices in containing them.  The danger of calling it a second wave is that it assumes the first wave was over.  This may be the case in some Asian countries, and it looks as if Europe has a handle on it.  However, many US states are struggling, and at least seven are reporting record increases.  After a brief lull, mostly reflecting the clamp down on the east coast, the US is making new peaks in the contagion.  Re-openings have ceased in a couple of states that previously won praise from the White House for easing restrictions early.  This may have a cooling-off effect that might be broader than the locales getting hit. 

That will have a knock-on the other force impacting the macroeconomic assessment: the strength of the Q3 recovery.  News is important for what it means about tomorrow.  The collective wisdom of the participants is far from perfect, but it is a superior discounting mechanism to the alternatives.  The markets anticipate developments.  Investors and consumers appear more optimistic about the future.  The preliminary purchasing managers' surveys for June and other survey results support notions that the worst is passed.   

However, the seeming inability to contain the virus will take a toll on the economy.  This means the US policymakers may need to provide more support for longer and/or unfavorable divergence that could bring back the focus on the perennial twin-deficit problem.  The famed flexibility of the US labor market is a double-edged sword.  Despite data surprise models strong showing, all data is not equal, and the weekly jobs data has been proving considerably stickier than economists forecast.  The preliminary June PMI figures show the eurozone composite rising above the US composite for the first time in four months.

Taken together, the global financial relation story and public health divergence are negative for the dollar.  However, since somewhere shortly after the US employment data for May on June 5, a corrective/consolidative phase unfolded that saw the dollar correct higher.  That phase appears to potentially be entering a final stage where impulsive moves could be seen before the resumption of the underlying trend. 

The US economic highlight of the holiday-shortened week is the national employment figures that will be reported on July 2.  As seems intuitively obvious is the economic models are not particularly useful, and after last month's big miss, economists and investors have been chastened.  In May, the US economy grew about 2.5 mln jobs, the median forecast in the Bloomberg survey was for a 7.5 mln job loss.  Now the median is for a 3.0 mln job gain, while the range is from about 1.0- to 5.8 mln.  Manufacturing employment is forecast to have increased by 425k, almost double May's 225k rise. 

Some classification errors in the household survey that generates the unemployment rate are unlikely to be corrected.  It is not the BLS protocol.  Still, there are several dimensions of the labor market, and the overall picture is that a gradual (relative to the blow, not compared with the historic series) recovery has taken place in the last couple of months.  Roughly speaking, employers reported a decline in their payrolls by about 23 mln, and if the median is right, the US would have created nearly 5.5 bln jobs in May and June. 

The other key high-frequency data point is US auto sales.  Consider the context.  In 2019, the US sold 16.9 mln vehicles.  The pace was nearly halved in April (8.58 mln at a seasonally adjusted annual rate).  It recovered to 11.2 mln in May.  A further gain in June is needed to keep the consumer-recovery story intact. In addition to the transfer payments, the jump in US consumption in May also aided by an estimated 106 mln debt payments (mortgages, student loans, auto loans, and credit cards) were missed.  In June 2019, 17.8 mln vehicles were sold (saar).

The eurozone reports the preliminary June CPI figures.  Under normal conditions, or should we say, previously, this was an important report for market participants in good part because it was important to the ECB.  Now, regardless of the print, the ECB is committed to an open-spigot and multi-dimensional emergency monetary policy.  The latest wrinkle was the announcement of a new repo facility for foreign central banks with euro-denominated sovereign or supranational bonds. 

In May, the CPI was a little above zero (0.1%), and in June, it may have slipped to a little below zero (-0.1%).  The core rate is considerably stickier but may have eased to 0.8% after being at 0.9% for in April and May.  It had finished last year at 1.3%.  Fitch recently shared its forecast that the core EMU prices at 0.5% at the end of 2021. The rating agency put the core PCE deflator at 1.0% at the end of next year. 

While Markit makes available preliminary estimates for many countries' PMI, there is no advanced release for either China's own PMI or the Caixin version.  The preliminary PMIs steal the thunder of the final reading, and China's PMIs in the coming days are new information.  The composite of China's own PMI was at 53.0 in January and collapsed to 28.9 in February.  That was the low-water point.  It jumped back to 53.0 in March and then edged to 53.4 in April, where it remained in May.  It is unlikely to have changed much in June.   Manufacturing and exports continue to struggle, while the non-manufacturing sector recovery seems gradual. 

Some may naively think that the state version would be more optimistic that Caixin's version.  However, this is not the case, and the composition is different.  Caixin draws more from smaller businesses rather than the state-owned behemoths.  The Caixin composite was at 52.6 at the end of last year.  It slipped in January and fell to 27.5 in February.  Since then, it has surged to 54.5 in May.  Anecdotal evidence warns that of the risk of disappointment.

Two political events in Europe should be on radar screens.  The first is the Merkel-Macron meeting to coordinate the position on the European Recovery Fund.  Recall that Germany assumes the rotating EU presidency in H2.  The challenge with the Recovery Fund is not a common bond, though most outside observers have focused on the supposed "Hamiltonian moment."  However, this is not the chief obstacle.  From the so-called Frugal Four, the pushback is against simply giving away the proceeds of the common bond sales, as in grants.  The lack of structural reforms since the financial and sovereign debt crisis in many countries, they, argue, is like comorbidity of the virus. It leaves the victims particularly exposed to the ravages of the pathogen.  

Grants that appear to be ultimately fiscal transfers to the South could change the balance of forces in the domestic politics of some northern European countries and support new populist efforts.  If Germany and France want to give grants, nothing is preventing bilateral arrangements, which seems to be the attitude in some capitals. Note too that central and eastern Europe are already beneficiaries of funds from the EU and see little new for them in the Recovery Fund. Poland's presidential election (first round June 28) likely to confirm the challenge the EU faces is not just from the Frugal Four.  

That is a fair segue into the other political event.  EU and UK trade talks will intensify next week.  It is almost like a mini re-start.  Both UK Prime Minister Johnson and EC President von der Leyen appear to have softened their stances, but to boost the chances of an agreement, it has to filter down to the negotiators. One stumbling block has been the "level playing field" issue that is supposed to keep state-aid, environmental, and employer regulations aligned.  In addition, the two sides are apart on fishing rights and governance.  EU negotiator Barnier said that October was "the real moment of truth," but we suspect investors will become more cautious if there is little progress in the coming weeks.   

Disclaimer


Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.

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