PMIs to point to persistent weakness

Chris Scicluna
Emily Nicol

Supported by some (largely) positive US earnings results, most Asian stock markets took their cue from the US yesterday when the S&P500 closed up 0.3% on the day. So, for example, despite a disappointing set of Japanese flash PMIs (with the composite index falling below 50 for the first time in more than three years), and new concerns flagged by the BoJ about financial system vulnerabilities (details below), the Topix closed up 0.3%. And most other major markets in the region chalked up moderate gains, with the exception of China where the CSI300 closed effectively unchanged. US stock futures have risen.

The major bond markets, meanwhile, are little changed, e.g. with 2Y JGB yields steady around -0.26%, as the BoJ report broadly supported views that the Policy Board will leave the short-term policy rate unchanged at -0.1% next week. UST yields, meanwhile, are down a touch from yesterday’s highs (10Y yields close to 1.75%). But ahead of Draghi’s last post-Governing Council press conference, having opened higher euro govvies have dropped (10Y Bund yields up 2bps to about -0.375%) after some improved French PMIs (see below). The equivalent German and euro area numbers are due shortly.

Meanwhile, Gilts have followed suit, with sterling also a touch stronger as UK political leaders mull whether to support a bid for an early general election. Their decision will be partly dependent on the EU’s decision on the duration of the latest Article 50 extension. In line with the views of Tusk, Merkel and Varadkar, we expect the deadline to be put back to 31 January, providing the time for an election in December. But the door will likely also be left open to allow an earlier Brexit should Parliament adopt a Withdrawal Agreement Bill before then. We do not, however, expect clear decisions one way or the other today.

Ahead of the conclusion of the Policy Board meeting a week today, a short while ago the BoJ released its semi-annual Financial System Report, which could have some bearing on any consideration that might be given to further monetary policy easing if the Policy Board judges that upwards inflation momentum has been lost. On balance, the BoJ concluded once again that Japan’s financial system “has been maintaining stability on the whole”, with financial institutions’ capital and liquidity generally assessed as being resilient to any unforeseen global crisis.

But the report again noted that the profitability of domestic deposit-taking and lending activities has continued to decline, with the impact of the prolonged low interest rate environment adding to longer-term structural factors such as reduced growth expectations and the secular decline in loan demand associated with the shrinking population. And while the BoJ judged that financial and economic activity has generally shown no signs of overheating, it did note that rapid growth in real estate loans – for which the deviation of the trend relative to GDP reached a record high for the post-bubble period – continued to warrant attention.

The BoJ’s ‘heat map’ of financial activity indices also flagged increased vulnerabilities relating to other factors, including corporate credit and lending attitudes. Indeed, loans to low-return borrowers with narrow profit margins had reportedly increased, while credit costs for regional banks had risen too. In addition, with major banks having expanded global activities, the BoJ noted that Japan’s financial system was becoming more susceptible to the effects of overseas financial cycles.

Turning to the data, while the flash PMIs offered a predictably downbeat assessment of economic conditions at the start of Q4, the extent of the decline in the headline measures was arguably not as bad as had been feared in light of the consumption tax hike and disruption from the typhoon. For example, the headline manufacturing index fell just 0.4pt in October, admittedly the fifth monthly decline out of the past six to leave the index at 48.5, the lowest level since March 2016. While the output component moved sideways this month (48.6), it remained in contractionary territory for the tenth consecutive month. And the new orders PMI fell 3pts to 44.4, the lowest since 2012.

The decline in the services PMI was perhaps unsurprisingly greater, with the 2.5pt drop leaving the headline business activity index at just 50.3, the lowest for more than a year. But while the new orders index edged higher, firms in the sector were less upbeat about their employment intentions signalling the slowest growth for two years. Overall, the composite PMI fell 1.7pts in October to 49.8, the first sub-50 reading for more than three years. The new orders component similarly fell into contractionary territory for the first time since July 2016. And the direct impact of the consumption tax hike was clearly evident in the output price PMI, which increased 3.5pts in October to 53.5, the second-highest reading of the (relatively short) series and only exceeded by the figure immediately after the 2014 tax increase.

Euro area:
Today is a momentous one for the euro area, with Draghi set to hold his final post-policy meeting press conference before Christine Lagarde takes over at the start of next month. Of course, she will find herself with little room for manoeuvre policy-wise, with today’s meeting set to be a non-event for the same reason. After the Governing Council last month agreed a package of new measures – including a 10bps cut in the deposit rate, an open-ended programme of net asset purchases to start on 1 November, a tiered rate framework to start on 30 October, and more generous conditions on the TLTRO-III operations – the options to provide any meaningful additional stimulus are limited and are highly unlikely to have been discussed at this meeting. Instead, the much-publicised marked differences of opinion on the Governing Council will no doubt be a key focus of the press conference.

Draghi might, however, be questioned on the desirability of the upwards shift in yields across the curve since the September meeting, which is in part likely related to the planned tiering framework. In terms of the economic outlook, meanwhile, there seems to be no good reason for Draghi to view the ECB’s current forecasts as too pessimistic. Indeed, he will no doubt emphasise that the risks remain skewed to the downside. And we would also not be at all surprised if the forecasts were eventually revised down again in December.

Data-wise, the flash October PMIs are out this morning after last month’s set suggested a further loss of momentum with declines in all key indicators. Weakness in September was most acute in manufacturing, for which the headline euro area PMI fell to 45.7, the lowest in more than seven years, and the output and new orders indices similarly dropped to the lowest since 2012. The consensus expectation was for a slight improve improvement in October. But the French PMIs, just released, were better than expected. In particular, the composite PMI rose 1.8pts in October to 52.6, with a broad-based improvement across the sectors – the headline services activity index was up 1.8pts to 52.9, while the manufacturing output index rose 1.3pts to 51.0, the latter a four-month high. Overall, however, we note that the composite PMI merely reversed the weakness seen in September, with the index having oscillated around a broadly sideways trend since June. We also caution that it is the German rather than the French economy that is our principal concern in the euro area. And the French PMIs often fail to correlate with those from the euro area’s largest member state.

Politics will inevitably continue to dominate today, but we do not expect any meaningful breakthrough, either with respect to the EU’s decision how to extend the Article 50 or in terms of the main UK political party positions regarding whether to agree to an early general election before Brexit is implemented.

Perhaps inevitably, reports suggest that all EU member states agree that there should be an Article 50 extension. But while most of the key players – Tusk, Merkel and Varadkar – concur that the new deadline should be 31 January in line with Johnson’s formal request, Macron continues to press for a short deadline of 15 November unless a new general election is called. A decision one way or the other is unlikely to come before tomorrow.

Meanwhile, a Parliamentary vote on Johnson’s ‘Queen’s Speech’ policy agenda could provide further justification for a move to an early general election. But the leaderships of both the Conservative and Labour parties are split on whether to push for one or to press on and try respectively to adopt or significantly amend Johnson’s Withdrawal Agreement Bill first. In this context, today will represent the last possible date by which Parliament could set a general election in November under the Fixed Term Parliaments Act, leaving only two weeks to be able to set one before the end of the year.

Today will be a busy day for economic data from the US. Most notably perhaps, preliminary durable goods figures for September are due. In addition, new home sales figures for the same month, the flash Markit PMIs for October, and usual weekly claims numbers are also scheduled for release. In the markets, the Treasury will sell 7Y Notes.

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