The Week Ahead

In some practical sense, even if not calendar-true, the week ahead is the last week of summer in the northern hemisphere.   September could very well set the tone for the remainder of the year, but before we get there, the week ahead demands some attention.

Three drivers are evident:  the initial conditions of the markets, the data and geopolitics.  By initial conditions, we refer to the recent price action in the capital markets.  Stock and bond markets remain firm.

The S&P 500 has recovered fully from the late-July through early August decline and has reached new record highs.  The major European bourses peaked earlier (UK in May, Germany, France, Italy and Spain in June), but have also been recovering over the last couple of weeks, though remain lower on the month.   The Nikkei's multi-year high was recorded at the very end of last year, though the recent rally has brought it toward the five-month high set at the end of July.  MSCI's emerging equity market index reached its highest level since August 2011 before the weekend.

Bond markets have also generally rallied.  Despite a string of strong US economic data and the prospect of more to come, the US 10-year Treasury yield struggles to rise above 2.40%-2.50%.  Germany's 10-year bund yield is below 1.00%.  Even the peripheral European bond yields continue to make record lows.  Japan's 10-year bond yield finished last week at 50 bp, while Switzerland's was at 48 bp, which is about where the US 2-year yield finished.

While Germany pays nothing to pays nothing to borrow for 2-years, France pays 4 bp.  The US borrows for six months at five basis points.  EONIA has fallen to about half of a basis point, and there is nothing to stop it from going negative.   On the other hand, the premium emerging markets pay over US Treasuries (EMBI+) is near the middle of the 280-320 bp four-month trading range.

After a poor start to the year, the US dollar has performed better recently.  The heavily European-weighted Dollar Index is at its highest level since last September.  On a trade-weighted basis, the dollar is near its best level since July 2013.  If the decline in the euro has eased conditions in the euro area, as ECB President Draghi has suggested, the dollar's appreciation has tighten US conditions, on the margin.

The dollar has been in a narrow JPY101-JPY103 trading range since April and broke out last week to set a seven-month high near JPY104.20.  Japanese investors have stepped up their purchases of foreign assets, and speculators have been aggressive sellers.  The gross short CME futures position has risen from about 66k contracts (JPY12.5 mln per contract) to 105k in the past four weeks.

Sterling, which had been the market's darling until the middle of July amid ideas that the BOE could hike rates this year, has fallen out of favor.  It has fallen for seven consecutive weeks, with a five-month low set before the weekend.

The point of this overview is to suggest two things:  First, the markets are extended from a technical point of view.  Second, the markets are trending, and investors like trending markets, which means there is greater participation.

The economic data in the week ahead will likely reinforce the sense that the US economic strength contrasts with developments in Europe and Japan.   The most important US data include the volatile durable goods orders and the July readings of personal income and consumption.

The headline durable goods orders risk surprising on the upside as Boeing orders surged.  Although there are skeptics, especially among armchair economists, but this is one of the functions of seasonal adjustments to the economic data.  Auto-related orders also may show strength.  Excluding transportation orders, a 0.5% rise is expected, but we suspect the risk is on the upside.  

Personal income and consumption are set to start Q3 on a softer note.  Monthly increases of income average 0.4% in Q2 and 0.6% in Q1.  In July, it is expected to have risen by 0.3%.  Similarly, personal consumption increased by an average of 0.3% a month in Q1 and Q2, but in July may have risen by 0.2%.  We suspect this speaks to the shifting composition of growth.  The core PCE deflator, which for the Fed has a privileged place, is likely to have remained stable at 1.5%. As it the typical pattern, it remains below the core CPI (1.9%).  

The euro area data is likely to heighten deflationary fears.  The preliminary CPI reading is likely to slip to 0.3% from 0.4%.  Before we get the aggregate figure, Spain and German will release their estimates. Germany is unexpected to be unchanged at 0.8%, but Spain's deflation likely deepened to -0.6% from -0.4% in July.   Unemployment for the region is likely to remain stuck at 11.5%.  M3 will draw interest.  Even though the pace of money supply growth is weak, some of the credit extension measures have shown a modicum of improvement.  

While the German IFO on Monday poses some headline risk, a modest decline is expected after other recent survey data, and acknowledgement by the Bundesbank that the German economy has lost some momentum.  The sanctions and counter-sanctions on Russia will not help.    Germany reports July retail sales at the end of the week.  The consensus expects it to have edged 0.1% higher after the 1.0% rise in June.  This is among the first hard numbers for Q3.  Recall that before June, German retail sales had fallen for three consecutive months.  

Japanese data is concentrated at the end of the week. The focus will be on three reports.  Overall household spending is likely to remain weak at the start of Q3 after contracting 3.0% year-over-year in June.  Consumer prices were likely little changed, with some risk on the downside.  Industrial output by have ticked up, but Japanese producers have been more optimistic in surveys than in practice.  It is possible, even with a modest gain in July, that the year-over-year rate dips into negative territory for the first time since August 2013. 

Geopolitical risks continue to run high.  Before the weekend, it had looked like an unauthorized convoy of Russian trucks may have been the beginning of an actual invasion.  The trucks returned to Russia on Saturday.  With the government closing in on the insurgents in east Ukraine, Putin has some hard decisions to make.  The situation in Iraq has taken a turn for the worse as it appears the Sunnis may have withdrawn from talks to form a new government.  The Iranians have refused to allow the UN inspectors into a nuclear facility, which while not on the agreed list, is appears necessary if an agreement is to be brokered by the new deadline in November.  

In addition to these issues, we note that an important political drama between China and Hong Kong will stage a new act new week.  A larger than usual Hong Kong delegation will sit in on discussions by China's National People's Congress on the 2017 to shape the framework that is to lead to the election of Hong Kong's top official in 2017.  Usually only a few Hong Kong delegates have been able to attend such a meeting.  Despite more attending this year, they will have only one vote.   Activists in Macau are following Hong Kong's lead and are set to release the results of an unofficial referendum on August 31. 

Investors are anticipatory by nature, and there is much to anticipate for September.  There is the next batch of US jobs data, and the FOMC will update its forecasts.  However, the greater focus will be in Europe.  The ECB will update its staff forecasts.  This will likely entail downward revisions to growth and especially inflation.  That said, many private economists expected euro area inflation to bottom out in September or October.  

The ECB will also launch the TLTRO facility.  At his August press conference, ECB President Draghi seemed to agree with some market forecasts for large participation in this new lending facility. However, we see downside risks.  Some players may prefer to wait and see, and participate in the December offering instead.  Others may be deterred by the scrutiny and extra reporting that will be necessary.  Some may be dissuaded by a potential stigma, or by the complication of taking on more funds as they repay the previous LTROs.  

In September, the EU may also announce the composition of the next European Commission that Juncker will lead.  This is increasingly important as countries begin drafting the 2015 budgets.  On September 18, Scotland will hold its referendum on whether it should be independent.  A "yes" vote seems less likely than a no vote; the impact of a "yes" vote could roil the UK markets.  We suspect the risks of this may prevent sterling from recouping a significant part of the losses suffered in the decline since mid-July.