An easing of (certain) political risks

Chris Scicluna
Emily Nicol

While US stocks lost ground yesterday (the S&P500 closed down 0.7%) after the ISM manufacturing index slumped below the key 50 level for the first time in more than three years, Asian markets have largely fared better today. Hong Kong has comfortably led the way, with the Hang Seng currently up about 3½% on reports that Chief Executive is set formally to withdraw the contentious extradition bill that triggered the widespread protests. Chinese stocks also made gains (the CSI300 closed up 0.8%). But despite a satisfactory final services PMI, Japan’s main equity indices posted a mix of modest gains and losses (the Topix was down 0.3%) having opened down in the wake of yesterday’s yen appreciation briefly through 106/$.

With the most dovish member of the BoJ Policy Board, Kataoka, calling for further easing including a cut in the negative policy rate, JGBs remained supported (10Y yields still below -0.290%). But USTs have reversed some of yesterday’s ISM-related losses (10Y yields back to 1.48%) in the wake of the better political news from Europe. For example, the decisive defeat for Boris Johnson in his first House of Commons vote as Prime Minister yesterday has seen him lose control of Parliament and reduced risks of a no-deal Brexit at end-October (see below), so Gilts have sold off (10Y yields now up back above 0.45% having fallen below 0.35% this time yesterday) and sterling has strengthened (back close to $1.215).

In addition, with Five Star Movement members yesterday having convincingly voted in favour of the coalition agreement with the Democratic Party (PD) to suggest that the new Italian government will be around to deliver a 2020 Budget, BTPs have made yet further gains (10Y yields now down close to 0.80%). However, comments in an interview from French central bank governor Villeroy suggesting that he is currently undecided on the case for new ECB QE – and thus underscoring the significant uncertainty related to the precise nature of the monetary easing package to be agreed next week – have seen yields on other euro area govvies tick higher.

As had looked increasingly likely as yesterday’s events in Westminster wore on, last night’s key vote in the House of Commons saw PM Boris Johnson defeated decisively in his first parliamentary vote, by 328 to 301 (perhaps inevitably a ratio of 52:48). So, MPs today will now vote on draft legislation – the European Union (Withdrawal) (No.6) Bill – which, if passed, would compel the Prime Minister to request a three-month extension of the Article 50 deadline (i.e. to 31 January) if a deal with the EU has not been agreed by 19 October. Somewhat more controversially, and hence a key focus for possible amendment, the legislation would also provide for possible further extensions of the Article 50 deadline beyond that date, as well as regular reporting by the Government on the progress in its negotiations with the EU.

Given last night’s momentous vote, however, MPs seem bound to approve a version of the Bill this evening, allowing it to pass over to the House of Lords. Progress in that upper house will be far slower, with peers supportive of the government determined to hinder progress. Nevertheless, we do expect the approval of the House of Lords to be granted by the end of the week, to allow the Bill to receive royal assent before Parliament’s prorogation next week (assuming Johnson doesn’t try any further wheezes of questionable constitutional legitimacy to try to block progress).

Of course, Johnson responded to last night’s defeat by stating that, if MPs vote for the Bill today, he will table a motion in Parliament to call for a general election. But having seen a further defection to the Lib Dems during the course of the debate, and self-defeatingly expelled from his party the 21 rebel MPs who voted against him yesterday, Johnson’s working parliamentary majority has gone from +1 to -43 in a flash.

If he tries to use the most efficient legislative path to a new election under the Fixed Term Parliaments Act, however, he’ll need a two-thirds majority in favour. And certainly no one on the opposition benches will trust him right now with the ability to set a date for a new poll which that route would provide. Alternative paths to an election require only a simple majority, but would expose Johnson to opposition action with unpredictable consequences.

So, the plain fact is that, after a mere two days of parliamentary scrutiny as Prime Minister, Johnson has already lost control of the House of Commons, the Brexit process, and the fate of his government. Labour (like the other opposition parties) has made it clear that it will not back a general election at least until the anti-no-deal legislation has received royal assent. But even beyond that point it could be justified in letting the impotent Johnson now stew in the mess of his own making, only supporting a move to a new general election at a time that would be judged most convenient for its own (rather than the government’s) prospects. So, while a third general election in four years might well be along soon, whether it comes in October or November (or even beyond then) remains to be seen, and will depend just as much on Jeremy Corbyn’s whim as that of the Prime Minister.

The political crisis is obviously taking its toll on the UK economy. In this context, also of interest today will be the services PMI for August. And we expect the headline index to reverse some of the 1.2pts increase in July (to 51.4) to signal very subdued growth in the sector in August. While the headline manufacturing PMI fell to its lowest for more than six years there was a modest pickup in the manufacturing output PMI (up 0.7pt to 47.7). As such, the composite PMI might well remain little changed from the 50.7 reading in July. But that is a level normally consistent with economic contraction. Elsewhere, BoE policy makers, including Carney, Haldane, Haskel and Vlieghe, are due to appear before the Treasury Select Committee to testify on the most recent Inflation Report and could well provide an update on the Bank’s assessment of the possible impact of a no-deal Brexit.

While Japanese sentiment surveys have on the whole signalled a deterioration in economic momentum so far in Q3, the flash August services PMI bucked this trend, with the headline activity index rising to its highest since October 2017. And today’s final survey brought only a modest downward tweak to maintain this broadly upbeat assessment. Indeed, the headline PMI stood at 53.3 in August, just 0.1pt down from the flash release and still up a notable 1.5pts from July, at one of the highest levels since the series began in 2007 and leaving it on average in the first two months of Q3 0.7pt higher than Q2. But the detail of the report was somewhat less upbeat. For example, the new orders component saw a sizeable downwards revision (-0.9pt) to 51.8, still signalling expansion and above the long-run average, but nevertheless a thirteen-month low. Despite a significant upwards revision (1.8pts), the business expectations PMI was still at its lowest for two years. And the employment component was consistent with the softest growth in the sector since 2016.

Despite the downwards revision to the services PMI, after the upwards revision to the manufacturing output index (up 0.6pt to 48.9) earlier in the week, today’s composite PMI was nudged slightly higher (0.2pt) from the flash release to 51.9, an increase of 1.3pts from July, the highest level since December and more than 1pt higher than the average so far this year. So, in the first two months of Q3, the composite PMI was on average ½pt higher than the average in the first two quarters of the year at 51.3, suggesting that – probably supported by demand brought forward ahead of October’s consumption tax hike – GDP is on track for another quarter of positive growth in Q3.

The detail of the survey was, however, less encouraging about the near-term outlook. In particular, the new orders PMI was down for the fifth month out of the past six to 50.4, a near-three-year low, while the employment component declined for the fourth consecutive month to 50.7, similarly the lowest since 2016. With respect to inflation, today’s survey suggested further weakness in pipeline prices, with the input price PMI down for the fifth month to 52.8, the lowest since November 2016. And while the output PMI edged slightly higher, at 50.8 it was the second-weakest reading for more than two years.

Euro area:
Today will bring several top-tier euro area releases, which will provide more information about the extent of economic growth in Q3. In particular, retail sales figures for July are likely to indicate a soft start to the third quarter after a surge at the end of Q2, not least reflecting a notable decline in Germany where sales fell more than 2%M/M in July. The final services PMIs are also due and expected to align with the preliminary release showing a modest improvement in the headline index by 0.2pt to 53.4. But despite the very slight upwards revision to the manufacturing output PMI, the composite PMI is expected to be confirmed at 51.8, an increase of 0.3pt on the month but merely in line with the average in Q2, and therefore consistent with still-subdued GDP growth.

After Italy’s Five Star Movement members yesterday voted online by an overwhelming 79% in favour of the draft programme for a coalition with the Democratic Party – which includes the replacement of the automatic VAT increase with offsetting consolidation measures, lower labour taxes, the introduction of a minimum wage, and revisions to the previous government’s migration measures – Prime Minister-designate Giuseppe Conte will present a list of Ministers to President Mattarella today ahead of confidence votes in parliament at the back end of the week. Of course, much attention will be on his nomination for Finance Minister, with reports suggesting Roberto Gualtieri, a Democratic Party member of the European Parliament, Salvatore Rossi, former Director General of the Bank of Italy, and Dario Scannapieco, Vice-President of the European Investment Bank and Chairman of the European Investment Fund, as potential candidates.

In the US, today’s data highlights will be July’s full trade report and vehicle sales figures for August, while the Fed’s Beige Book is also due.

Today’s Q2 GDP figures came in bang in line with market expectations, with growth of 0.5%Q/Q unchanged from the upwardly revised rate seen in Q1 and extending the period of unbroken positive growth to more than eight years. Nevertheless, the annual rate of growth again slowed markedly in Q2, by 0.3ppt to just 1.4%Y/Y, the softest pace for almost a decade and below the RBA’s most recent forecast for growth of 1.8%Y/Y.

Within the detail, net trade more than fully accounted for growth, with the 1.4%Q/Q increase in exports and 1.3%Q/Q decline in imports together adding 0.6ppt. And government spending was again the principal domestic contributor to growth, with the 2.7%Q/Q increase the largest since 2005 and adding 0.5ppt to growth. Household consumption, meanwhile, continued to provide only modest support (0.4%Q/Q). And there was a further notable decline in private investment (-1.6%Q/Q) as the housing market continued to drag on growth, while non-residential construction saw the steepest drop for three years. But as the RBA noted yesterday, there have been somewhat more encouraging signs from the housing market of late. And the further notable adjustment in inventories, which subtracted from growth in Q2 for the third quarter out of the past four and by a sizeable 0.5ppt, might well bode slightly better for GDP in the second half of 2019 too.

The Caixin services PMI broadly aligned with the message from the government’s non-manufacturing PMI published over the weekend, with the headline activity index rising for the first month in four in August, by 0.5pt to 52.1 consistent with ongoing expansion in the sector. And according to today’s survey, the new orders component rose to 53.5, a four-month high. So, given also the pickup in the manufacturing output PMI last month (up 1.1pts to 51.0), the composite PMI rose 0.7pt to 51.6, a three-month high. Nevertheless, this still left the composite PMI on average so far in Q3 0.4pt lower than the average in Q2 and therefore consistent with a slightly softer GDP growth.

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