Eurozone still awaits a glimmer of sunlight
FT subscribers can click here to receive Market Forces every day by email.The clouds keep gathering over the eurozone economy and a new week finds government bond yields heading lower and equities under pressure.
Ugly export data from South Korea, with the won trading in the basement on Monday among major currencies, underlined how the trade war and a slowing Chinese economy were weighing heavily on the global economy.While market sentiment of late had been leaning towards a modest bounce in eurozone economic data, the worrying aspect of Monday’s Purchasing Managers’ indices preliminary readings from IHS Markit showed weakness was becoming entrenched in manufacturing and sapping the service sector. The composite PMI for the eurozone plumbed a six-year low of 50.4 in September from 51.9 in August, and it now sits just above 50, a reading below that level marking a contraction in activity. The PMI was just shy of 60 back in January of 2018 and its subsequent decline now shows signs of breaking lower.
The eurozone preliminary manufacturing PMI set an 81-month low of 45.6, while German manufacturing fell to 41.4 in September, its lowest level since mid-2009. And the service sector PMI slid from 53.5 to 52, its lowest reading in eight months, which is really the more worrying development. Among the main sectors of the Stoxx Europe 600 index, Auto & Parts, Basic Resources and Banks all dropped some 2 per cent, reflecting the prospect of harsher cyclical headwinds. Earlier on Monday Mario Draghi, who will soon hand over the European Central Bank presidency to Christine Lagarde, warned that the eurozone economy faced a much more “prolonged sag” than was expected even a few months ago. Peter Garnry, head of equity strategy at Saxo Bank, says:“The most important question now for investors is when the manufacturing recession evident across many OECD countries will begin to have spillover effects into the services sector and the broader economy.”This matters for a very important reason as the calendar year enters the home stretch next week. Peter adds:“Fourth quarter is known to be the kitchen sink quarter on writedowns and layoffs, so if sentiment has finally become weak enough for companies then layoffs could be accelerating over the coming three months.”A renewed drop in bond yields also weighed on the single currency. Since late-August the euro has been confined to around the $1.10 mark, but that looks tougher to uphold. TD Securities argues that Monday’s data mean a test of key support in the euro around $1.0925 versus the dollar beckons, with a clear break of that level opening the door for a drop towards $1.0840. A weaker euro is a welcome development for the eurozone economy, particularly when the ECB’s monetary policy is seen having limited impact and Brexit remains unresolved with potentially damaging consequences for UK and European business confidence and activity. But a sharply weaker euro will only antagonise US trade hawks and President Donald Trump, with the risk of sparking a new front in the trade war. Over at Capital Economics they believe risky eurozone assets face an early taste of colder weather:“The sharp drop in September’s flash PMIs reinforces our view that eurozone equities will fall and ‘peripheral’ government bond spreads will widen over the rest of this year, even as the ECB loosens policy further. Meanwhile, ‘core’ bond yields are likely to remain close to their historical lows for some time.”Ms Lagarde has her work cut out and that runs beyond corralling a divided ECB governing council. Quick Hits — What’s on the markets radarUS PMIs for September revealed a modest divergence, while service sector employment contracted for the first time in almost a decade, at 49.1. The US manufacturing PMI was a touch better than expected (51 versus a forecast 50.4) at a five-month high. The services sector also picked up, but a reading of 50.9 was below an estimate of 51.4. All up, the composite PMI was 51, up from 50.7, although IHS Markit noted:“The latest reading was much softer than the average seen over the past decade (55.0).”Still, the contrast with the global economy was enough to steady Wall Street after an opening decline. India’s equity market likes corporate tax cuts, with the BSE Sensex index closing 2.8 per cent higher on Monday for a two-session gain of more than 8 per cent since the government announced the measures late last week. There’s no shortage of research downplaying the long-term fiscal consequences and jumping on board the equity rally. South Korea is seen as a barometer for trade and China and Monday’s news was not pretty. Exports contracted at a year-over-year pace of 21.8 per cent during the first 20 days of September.Brown Brothers Harriman struggles to see any upside here:“Between the US-China trade war and Korea-Japan tensions over exports of strategic materials, we expect Korea trade numbers to remain dismal well into 2020. Indeed, as a regional bellwether, Korea data do not bode well for the other Asian exporters.”The New York Fed saw less demand for Monday’s rolling over of its overnight repo, but a more important test looms on Tuesday. The NY Fed will begin its first of three 14-day term repo operations, for up to $30bn each, that are designed to ensure there are sufficient funds in the system over to the end of the third quarter. The two-week repo remains elevated, quoted at 2.45 per cent to 2.70 per cent and, as the chart shows, we did see funding strains in late December, late March and late June.
While repo should settle down courtesy of the Fed’s fixed-term fire hose, with 14-day operations also due on Thursday and Friday, the likelihood of QE “lite” is being assessed by many across the street. Bank reserves held at the Fed have fallen to $1.4tn, and by resuming purchases of Treasury debt, the central bank can help reverse that process. Lou Crandall at Wrightson Icap is a well-read and highly respected Fed watcher. In his Money Market Observer, he writes: “It is a foregone conclusion that the FOMC will resume net outright purchases of Treasuries at the October 30 meeting. The Fed will frame the change in balance sheet policy as a technical response to the market structure issues that came to the forefront last week, but some investors will view it as a form of stimulus.”Expanding the balance sheet will reflect three considerations: offsetting the growth in currency circulation (expanding at an annual pace of $80bn) plus accommodating the trend growth in reserve demand (a 5 per cent growth rate on the current $1.4tn balance is $6bn of bond purchases per month) and what Lou calls:“Additional amounts to build in a greater cushion over time.”Coupled with the Fed’s existing reinvestment programme, that entails a monthly purchase programme of about $30bn, and as Lou adds: “Even at $30 billion a month, the Fed would absorb roughly 30% of projected net Treasury issuance in 2020.”Your feedbackI’d love to hear from you. You can email me on email@example.com and follow me on Twitter at @michaellachlan.