Three Sets of Influences in the Week Ahead

There are three sets of influences in the week ahead:  impact from last week's price developments, the latest economic readings, and central banks.

One of the key issues for investors is whether last week's price action is the start of something more serious or was a benign, even desirable.  The S&P 500 lost almost 1% last week, its worst weekly performance since April.    The Russell 2000 lost 4%, its, the most in a week in two years. 

The internet sector fell a little more than 3%, its first weekly decline since early May.  Several US tech giants, including Intel, Yahoo, Ebay and Google report earnings in the week ahead.  Of the S&P sectors, technology is expected to have the strongest earnings growth (12.3% in Q2, the highest since Q1 in two years, according to a Thomson-Reuters survey).   

JP Morgan, Goldman, BofA, and Morgan Stanley also report Q2 earnings.  Wells Fargo reported before the weekend and surprised many with a 39% decline revenue from its mortgage lending business. The Thomson-Reuters survey found the financials are expect to be the poorest performing sector, with earnings 3.5% lower than a year ago. 

Weakness in equities was a global phenomenon.  The Dow Jones Stoxx 600 in Europe fell 3.7%, dragged down by the bank shares.   Although the problems of Banco Espirito are unique and particular; not common and general, it was a disruptive force that appeared to ease late last week.  

That it was disruptive, not only in terms of financial shares and sovereign bonds, but also forcing postponement of auctions by a number of banks seems itself to be a warning about the level of anxiety among investors.  Many of whom do think that the asset markets have artificially been boosted by central banks.  They have little choice but to manage savings and wealth, but they are jittery over any development that could herald the end. 

The MSCI Asia Pacific Index fell 1.1%, snapping the longest winning streak in two years.   Falling every day last week, Japan’s Topix lost 2.3%.  The gap lower opening on July 11 may prove to be an exhaustion gap as the Topix closed near the session highs after successfully hold support just below 1250.   Emerging markets performed best, with the MSCI Emerging Markets (equity) index slipped 0.35% on the week. 

The US Treasury market rallied.  The 12 bp decline in the 10-year yield last week was the most in four months, and the yield briefly touched a five-week low, just below 2.50%.  The 10-year JGB slipped a little more than 3 bp last week, but this was enough for the yield to slip to its lowest level since April 2013 (~53 bp).  While UK gilts outperformed with the 10-year yield falling 12 bp last week, core European bond yields were off 4-5 bp. Peripheral bonds were dragged down by Portugal, and ideas that Greece may need more forbearance.

Commodity prices fell.  The CRB Index lost nearly 3.2%.  It was the largest weekly decline since September 2012.  Crude oil prices fell roughly 4% last week, roughly half of what it has fallen since June 20.  It is at its lowest level since late-May.  Expectations of a strong harvest have pushed corn and soybean prices sharply lower. 

The second key issue is whether the economic data is going to change the general understanding of the cyclical location of the major economies.   On balance, this seems unlikely. 

The latest US readings on retail sales, industrial output and housing starts will help solidify expectations that Q2 growth will likely more than offset the contraction seen in Q1.  This will stands in stark contrast to the euro area and Japan.   

Japan will publish a final estimate for May industrial production.   The preliminary estimate showed a 0.5% increase.  However, the data has been overshadowed by the sharp decline in machinery orders, a proxy for capital investment, and a collapse household spending.  Forecasts of a 4-5% economic contraction in Q2 GDP (quarter-over-quarter annualized) are unlikely to change based on the final industrial output figures, barring, of course some significant surprise 

Four euro area countries reported industrial output figures and they all disappointed with some declines in excess of 1% in May.   The 1.2% decline expected on the aggregate level to be reported Monday will offset the 0.8% gain in April and would be the second decline in three months. 

There are other reports from US that may be more important than industrial production.  US housing starts will be reported.  The housing market has been an obvious disappointment this year.   Some recent data has shown improvement.  The consensus expects housing starts to have risen about 2.4%.  Starts contracted by an average of 2.5% a month in Q1 and could post a gain of similar magnitude in Q2. 

Separately, investors will get the first glimpse of Q3 activity with the Empire and Philly Fed reports.  The issue here is, granted an economic bounce after the Q1 disaster, is that momentum being sustained.  The July survey readings are expected to be slightly softer than in June.

The UK data may be particularly interesting because the shifts in forward guidance have left rate expectations more fluid.  Some market participants have brought forward their forecast of the first hike to Q4.  This week’s data include inflation and employment reports.  We suspect the data will encourage more participants to come over to our longstanding view of no hike until next year. 

Consumer prices likely fell again in June after a 0.1% fall in May.  Due to base effects, the year-over-year rate could tick up to 1.6% from 1.5%.  However, that same base effect, however, warns of the likelihood of a further CPI in Q3.  Such a development suggests the BOE need not be in a hurry to raise rates.

The employment data likely will point in the same direction.  The decline in the claimant count appears to be slowing, and earnings growth is anemic.  The 3-month average decline in the claimant count is less than the 6-month average, which is less than the 12-month average. 

At the same time, earnings are growth in May (reported with an extra month lag) is expected to slow to a miserly 0.5% pace.  It is reasonable to expect weak wage growth to crimp consumption and deter investment.  No matter what the unemployment rate falls to, without wage growth, it cannot be considered inflationary.

The third issue for investors is whether officials will provide new policy signals.  The Bank of Japan is not going to change its asset purchase program.  However, in light of recent data, it may reduce its growth forecast.  The Bank of Canada also meets.  The downside risks to inflation have subsided somewhat, though the June CPI will be released at the end of the week—after the BOC meeting.  Bank of Canada Governor Poloz appears to be continuing to explore the 50 shades of neutrality. 

The minutes from the recent RBA meeting will be released.  Investors will be looking for some confirmation that the recent shift back toward pricing the next move to be a rate cut is correct.  In addition, the minutes may show greater concern for the persistent strength of the Australian dollar.  Some of the recent strength of the Australian dollar appears to be stemming from foreign purchases of Australian bonds.  The triple-A rated country pays a yield that is typically in line with considerably lower rating sovereigns, like Poland. 

There are two potential sources of more insight into the trajectory of Fed policy:  the Beige Book and Yellen’s Congressional testimony.  The Beige Book, compiled in preparation for the FOMC meeting at the end of the month, is likely to confirm both improved labor market conditions in most regions and little wage pressures. 

The Beige Book will be consistent with the economy evolving toward the Fed’s mandates.  This will also likely be the thrust of Yellen’s message.  She may be pressed on whether the Fed should be more concerned about inflation and the role of monetary policy in securing the Fed’s third mandate, financial stability.  In her testimony to Congress, she will be representing the Federal Reserve and not simply her views.  The risk is that she sounds a bit more hawkish that she has when she articulates her views.   

There are two central banks from emerging market economies that are expected to change rates.  Turkey is expected to cut its one-week repo rate, while South Africa may hike its repo rate by 50 bp. 

There are three other sources of headline risk.  The negotiation over Iran’s nuclear development is approaching the deadline.  The tension between Russia and Ukraine is escalating again.  The BRICS hold a summit, which could see more details of their development bank proposal.