Emerging market (EM) bond sales in the 1st half of this year have exceeded total sales in 2013, as investors seek higher yielding assets. The market is pricing in a rise in US interest rates in Q3 next year, though I expect, US interest rates to rise earlier than current market expectations.  However, as US rates increase and the US$ rises, I suspect that a number of emerging market issuers will face significant difficulties and, in addition, refinancing will become a material problem. A sell off of bonds will also negatively impact EM currencies.

Japanese investors significantly increased their purchases of foreign assets, mainly bonds, in May. Interestingly, in the Eurozone (EZ), they preferred French as opposed to German bonds, on the basis that they offer a higher yield and that the politics of the EZ makes them “safer” than would be suggested by the data. Indeed, Japanese investors were net sellers of German bunds, whilst they bought just over Yen 1.9tr of French bonds, more than their Yen1tr of purchases of US bonds.

European markets were lower on the week – the concern that a major Portuguese bank (Espirito Santo) missed its debt payment weighed on markets. Furthermore, European economic data, including factory output data, came in well below expectations.

While there is some evidence that UK growth is cooling, I wouldn’t be surprised if one or more members of the Bank of England’s (BoE) monetary policy committee votes to increase rates in the next few months. Such a move would be positive for Sterling.

US bond yields, having risen following the much better than expected non farm payrolls report, declined last week. The 10 year closed at 2.52%. The weaker European markets, as a result of worse than expected economic data, combined with problems with one of Portugal’s largest banks, drove investors to the safety of bonds.  However, I continue to believe that the 10 year US bond yield will rise to closer to 3.0% by the year end as the economy continues to improve and as expectations of an increase in interest rates by the FED are brought forward.

Whilst US markets closed somewhat weaker, money continues to be allocated to equities which, combined with a lack of alternatives, suggests that markets should trend higher. The results and, in particular, forward guidance during the current US earnings season will clearly be important.

US
The June small business optimism index came in at 95.0, lower than the 96.6 in May and the 97.0 expected.  The employment component was higher for the 9th consecutive month, though capex, economic outlook and sales expectations were lower, which is a surprise given the improved labour markets.

The May JOLTS survey points to a strengthening US employment market, with job openings at their highest level since Q3 2011.
US jobless claims declined to 304k, lower than the 315k expected and the 315k the previous week.

The FED minutes revealed that QE3 is expected to end in October. Whilst being more upbeat on the US economy, the FED minutes did not suggest that they would raise interest rates anytime soon. The market expects rates to rise in Q3, though I must admit, I believe the FED will act earlier. Various means to reach policy normalisation (ie rate hikes) were discussed, including the overnight reverse repo rate and on interest paid on excess reserves. Interestingly, ”many” Fed members wanted to keep reinvesting the income of the FED’s asset purchase programme until or after interest rates are increased. Overall, the minutes were more dovish than many, including myself, had expected.

Consumer credit  rose by US$19.6bn in May, slightly below the forecast of arise to US$20bn and the increase of US$26.1bn in April. Non-revolving credit comprised the majority of the increase. Credit is expected to increase in coming months, adding to growth.

Europe
German industrial output, seasonally adjusted, declined by -1.8% M/M in May, worse than the decline of -0.3% in April and the unchanged reading expected. It was the largest drop in 2 years and 3rd consecutive monthly decline. The Bundesbank had warned that the German economy would slow materially in Q2, though rebound in the 2nd half of the year.

French industrial output declined by -1.7% lead by a -2.3% decline in manufacturing, much worse than the rise of +0.2% expected. Italian data was also poor. Industrial output declined by -1.2%, as opposed to the rise of +0.2% expected. Furthermore, Italian and French April data was revised lower.

UK factory output declined by -1.3% in May M/M, the most since January 2013. The forecast was for a gain of +0.4%. The strength of Sterling may be having an impact.

The UK’s British Retail Consortium reported that prices fell by -1.8% Y/Y in June (-1.4% in May), the largest decline in prices since June 2006 and the 14th consecutive monthly decline. Supermarket wars, combined with discounting of clothing and a stronger Sterling has resulted in prices declining.

As expected the BoE left interest rates unchanged at 0.5%.

The UK May trade deficit rose to £9.20bn, higher than the £8.81bn in April. Exports rose by +0.6%, whilst imports increased by +1.7%. With a surplus on services, the total trade deficit came in at £2.42bn, up from £2.05bn in May.

Japan
The May current account surplus increased to Yen 522.8bn from Yen 187.4bn in April and as opposed to the forecast of Yen 417.5bn. The trade deficit declined to Yen 676bn, from Yen 780.5bn previously. However, export growth has slowed and Japan’s current a/c surplus has declined Y/Y to just Yen 191bn for the year to May 2014, as opposed to Yen 4.9tr for the year to May 2013. Imports of energy to generate electricity, following the closure of its nuclear plants, has been a major factor in the increased trade deficit. The government is trying to restart the nuclear electricity generating programme.

Reuters reports that the BoJ may reduce its economic forecast next week to reflect the greater than expected negative impact of the sales tax rise on 1st April. The BoJ had forecast that the economy would grow by +1.1% for the fiscal year ending 31st March 2015, though Reuters suggests that the forecast will be reduced to +0.9%.

Japanese core machinery orders fell by -19.5% in May M/M, the largest decline on record and much worse than the gain of 0.7% expected. Whilst a generally volatile data point, the decline suggests that consumer spending will decline following the sales tax rise and that export growth is weak, with capex low, though the recent Tankan report suggested that capex would increase by +7.4% in the fiscal year ending 31st March 2015.

China
Bloomberg reports that the Chinese Central Bank is straying into fiscal policy to support the economy, rather than limiting itself to monetary policy as it should. It certainly seems to be the case and just confirms, in my view, the  likelihood that the economy has slowed by much more than indicated by the official data. This has resulted in the government taking further steps to help bolster the economy. Furthermore, the government increasingly seems to be using the PBoC to direct credit as it deems necessary.

Chinese PPI declined by -1.1% Y/Y in June, more than the decline of -1.0% expected and as compared with the decline of -1.4% in May. CPI rose by +2.3%, below the forecast of +2.4% and +2.5% in May. The government’s CPI target is +3.5%. The lower than expected CPI and PPI allows the government to increase its stimulus. measures to bolster its economy. However, the finance minister stated that the country would not embark on a stimulus lead growth plan.

Chinese exports rose by +7.2% in June Y/Y, lower than the estimate of +10.4%. Import rose by +5.5%, lower than the rise of +6.0% expected, resulting in a trade surplus of US$31.6bn, lower than the estimate of US$36.95bn. It must be remembered that the data has been and probably continues to be suspect. The Chinese finance minister stated that the country would not stop intervention in the Yuan as the economy was weak and capital flows were not steady enough.

Local authorities seem to be relaxing curbs on property purchases to avoid a decline in prices. The sector remains key problem for the Chinese economy, given (highly?) overvalued property prices.

Other
The Australian unemployment rate rose to a near 11 year high of 6.0% in June, from 5.9% in May. The slowdown in China has affected Australia’s mining sector in particular.

The 1st budget by the new BJP administration in India failed to meet expectations. The problem of increasing costs associated with subsidies was not addressed. The budget was similar to that proposed by the former government and both revenue and cost estimates seem optimistic. The euphoria which welcomed the current regime may well start to dissipate in coming months. S&P has warned some time ago that India may lose its investment grade rating, a view they repeated following the announcement of the budget.

Kiron Sarkar
12th July 2014

Category: Think Tank

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