German investors confidence at the highest in 42 months

Despite uncertainties related to the US government shutdown and the discussions in Congress to rise the debt ceiling, German investors confidence rose to the highest since April ’10 in October. Zew economic sentiment index rose in October from 49.6 to 52.8, better than market expectations (51.0).

The figure is a positive sign for the IFO business confidence index due on Friday October 25th and it is in line with a 1.5%/2% annualized growth of GDP in Q4. The only negative pieces of news came from the current conditions index, declined from 30.6 to 29.7.

 

 

Further signs of a weak recovery in the Euro zone

Final PMI services indices released today in the Euro zone confirmed that economic activity could pick up in H2 ’13, even if at moderate pace.

 

Euro zone PMI services index rose from 49.8 in July to 50.7 in August, lower than flash estimate at 51.0. Composite index rose from 50.5 to 51.5, lower than flash estimate at 51.7.

 

According to our calculations, the past relationship between the PMI composite and the overall economy indicates, the August PMI corresponds to a 0.5% y/y GDP growth in Q4 ’13.

 

National services indices signaled that services index expanded in Germany (at 52.8 in August) but continued to contract in France (48.9 in August – 12 month high) and Italy (48.8).

 

 

 

August PMI manufacturing indices: recovery in the Euro zone and in China. Emerging Asia ex-China slowing down

PMI manufacturing indices for August released today strengthened the view that Euro zone economy could extend the rebound started in Q2 – when GDP rose by 0.3% q/q – in H2 ’13. Euro zone PMI manufacturing index rose from 50.3 to 51.4, above an estimate of 51.3 published on Aug. 22. A reading above 50 indicates growth.
Euro zone figure is in line with a slight recovery in Q3 and Q4. Economic activity could improve in the quarters ahead but the risk of a return to recession in case of negative shocks are still very high, in our view.
Indices were above 50 in all major Euro zone countries, with the exception of France:

1)      German PMI rose from 50.7 to 51.8 (flash estimate 52.0). The revision in Germany does not seem meaningful. The trend remains positive   and industrial production is expected to continue growing in the months ahead despite market expectations for a correction of orders and output in July (data are due during the week);

2)      French PMI remained unchanged at 49.7. French data could increase concern on the recovery there. However, INSEE index for August rose more than expected, giving an opposite message compared to the PMI index. French outlook is still worrisome as competiveness is low and public finance continue to deteriorate;

3)      Italian PMI rose from 50.4 to 51.3 – the 27 month high of the index;

 

PMI indices also rose in Netherlands - from 50.8 to 53.5 – and in Spain – from 49.8 to 51.1. In Europe, UK PMI manufacturing index climbed from 54.8 to 57.2.
Positive news also came from China, where PMI manufacturing index was at 51.0 against market expectations at 50.6.
However, the picture in the emerging Asia ex-China was less positive, with indices below 50 - signalling contraction for the sector - in South Korea, India, and Indonesia.

Euro zone CPI calls for an ECB rate cut

Flash August Euro CPI decelerated from 1.6% y/y to 1.3% y/y, lower than market expectations at 1.4% y/y. Looking at the details of the release, most of the fall can be attributed to the energy component which decelerated from 1.6% y/y to -0.4% y/y while the remaining components remained broadly stable. Core CPI remained unchanged at 1.1% y/y.

With energy slowdown likely to be temporary, CPI could rebound to 1.5% y/y by year-end.

However, inflationary pressures are likely to remain subdued in the months ahead as indicated by latest ECB monetary aggregates figures. Money supply M1 growth rate fell from 7.5% to 7.1% and M3 2.4% to 2.2% y/y. The following data suggest that CPI should remain weak in the next few months.

 

 

Low inflationary pressures should push the ECB to further ease monetary policy as soon as next week. Indeed ECB is missing both the target of CPI below but close to 2% and on M3 growth rate of 4.5%.

However we do not expect the ECB to ease monetary policy unless Euro zone economy falls back in recession.

Italian confidence indices improve in August. Will the positive trend continue?

Both business and consumer confidence indices improved in August, suggesting that economic outlook is slightly improving also in Italy.

1) manufacturing confidence index rose from 91.8 to 92.9 - the highest since November '11. Despite remaing at value in line with a contraction of industrial output in the next 2/3 months, it signalled that industrial sector could find a bottom soon;

 

2) Consumer confidence index rose from 97.4 to 98.9. It is a sign that consumer spending could improve in H2 '13 even if at modest pace due to high unemployment rate.

The two data strengthened the view that - absent other negative shocks - Italian economy could stabilize in Q3 and return to growth in Q4

How close is the end of US Government bond yields rally?

The trend of the last weeks

US 10 year Government bond yields jumped from 2% on May 22^nd – when Fed President Mr. Bernanke suggested that the Fed might cut back on bond purchases some time in “the next few meetings” and the minutes of April 30^th/May 1^st monetary policy meeting indicated that “a number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting – to 2.61% on Monday 24^th. From the lowest level touched on May 2^nd at 1.63% yields increased by 98bp.

The upward trend of 10 year yields further strengthened following the Bernanke’s press conference on June 19th, when he confirmed that that the central bank could reduce its purchases this year and halt them around mid-2014. The acceleration of the yields increase fuelled concerns that rising government bond yields could have a negative impact on equity markets. However, S&P500 was so far resilient, falling by a mere 3.4% from the historical high at 1655 set on May 22. On Wednesday 26th 10 year yields corrected to 2.52% as final Q1 GDP data disappointed investors: indeed it was revised down from 2.4% to 1.8% annualized, mainly due to weaker consumer spending growth.

Fed’s reaction

The strong increase of Government bond yields alarmed Fed’s members. For example, Minneapolis Fed President Narayana Kocherlakota said in an interview with CNBC on Wednesday 26th that the bond-market reaction to last week's Federal Reserve decision was "outsized". He also highlighted that the Fed needs to defend its 2% inflation target both from above and below.

Limited upside potential

Our base scenario is that from current level government bond yields have limited upside potential. In our view, 10 year government yields will hardly exceed the 2.75% target for year-end set by Deutsche Bank chief economist Joseph LaVorgna in a recent note. Indeed we believe that the economic outlook does not support a further increase of government yields.

First, because US economy lacks a strong engine of growth in the next few quarters:

1)     Consumer spending is likely to continue expanding at moderate pace (1.5/2.0% annualized) as jobs creation remain weak;

2)     Government spending contribute to economic growth will soften for the spending cut become effective since March 1^st; 

3)     Investments are likely to be negatively impacted by the tightening of fiscal policy;

4)     Exports will suffer due to weakening of economic activity in emerging market and recession in the Euro zone.

Second, because inflationary pressures are well contained and are not expected to pick up in the foreseeable future.

The case for being bullish

In our view, the potential for a decline of Government bond yields in the months ahead is higher than the potential for a further increase. In particular should economic activity being weaker than Fed projections for a 2.4/2.5% GDP growth in 2013 and 3.2/3.3% in 2014.

A similar view is shared by Jeffrey Gundlach, head of DoubleLine Capital LP. He said on Tuesday 25^th that “the selloff in the bond market is likely to end in the next few weeks and that now is the time to consider buying riskier debt”. Gundlach characterized the selloff in the bond market as a "liquidation cycle" that will end within weeks, once the benchmark 10-year Treasury hits a high of 2.75%.

USA: CPI and housing market sligthly weaker than expected

May headline consumer price inflation rose by 0.1%, below expectations of a 0.2% increase, and up 1.4% from the prior year. Core CPI, excluding food and energy, rose by 0.2% in line with expectations, and up 1.7% from past year.
These numbers confirmed that inflationary pressures are non-existent now, strenghtening the view that the Fed could continue in its asset purchase programme at current pace.

 

Housing market data came out slightly worse than market expectations. Housing starts set at 914K, below expectations of 950K, and permits at 974K (exp. 975K).