Brexit Comes to a Head, and while Europe and US Data Rebound, the Equity Rally Falters

Brexit comes to a head.  By nearly all reckoning, the Withdrawal Bill will be resoundingly defeated in the House of Commons on March 12.  The margin of defeat may not match the first rejection, but it will be the death knell to the path that had been negotiated for a year and a half. 

On March 13, the House of Commons will vote on leaving the EU without a withdrawal agreement.  Most, except the most extreme partisans, think that such an act would result in a dramatic economic shock in the first instance.  In any event, there does not appear to be a majority favoring such a course.  

On March 14, the House votes on postponing Brexit.  There are several considerations here.  Those who favor Leaving are suspicious that a delay means dilution or, even worse a reversal.  Then there is a question of delay.  A short delay may not resolve anything.  A long delay is complicated by the EU elections at the end of May, and the protracted uncertainty is not good economically or politically.  Investors will be incredulous if this measure also fails to secure a majority and a violent market response is likely.   

Once again, there does not appear to be a well thought out strategy of how to use the delay to move forward.  Labour has formally called for a second referendum, but the path to it seems rather torturous and again leaves a fog of uncertainty hanging over business and households.   

That said, the weakness at the end of last year overstated the case.  The monthly GDP contracted by 0.4% in December and likely expanded by 0.2% in January.  The composite PMI suggested the recovery likely continued in February.  The manufacturing sector is generating mixed signals though.  The February manufacturing PMI slipped to 52.0 from 52.6, but economists expect manufacturing output to have edged 0.2% higher after falling 0.7% in December.  

As a driver, the UK data offers little more than headline risk with that 400-kilo gorilla of Brexit looming over it.  However, it is symptomatic of what we have been suggesting is the next turn in the plot.  Just as pessimism grips many, the data will show that after collapsing in December, many economies were bouncing back at the start of the New Year.  

The pessimist case is well known.  The OECD lowered this year’s growth forecast. The ECB’s slashed this year’s growth projection by a third and still warned of downside risks. China seemingly acknowledging its economy is going to slow even as it launched various stimulative measures includes substantial tax cuts and bank recapitalization.  Canada’s monthly GDP contracted in the three of the last four months of 2017. The data so far for 2019 shows the world’s largest economy nearly ground to a halt.  The Atlanta Fed’s GDP tracker puts Q1 GDP at 0.5% at an annualized pace.  The NY Fed’s model sees it Q1 growth at 1.4% and little improvement in Q2. 

Conventional wisdom may be lagging the facts on the ground.  Before the weekend, France, Spain, and Italy reported better than expected industrial output or manufacturing figures for January.  Yes and Italy.  Industrial output surged 1.7% in January, according to government data.   The median estimate by in the Bloomberg survey was for a 0.2% gain after a revised 0.7% decline in December (initially -0.8%).  German industrial production will be reported Monday, and it is likely to recover in full the 0.4% decline in December.  The aggregate figures will be released in the middle of the week and may have jumped 1%, if not more in January after contracting 0.9% in December.

A broadly similar story is likely to be told by the US high-frequency data.  December retail sales collapsed by 1.2% and the GDP-components dropped 1.7%.   In January headline retail sales may have been flat, but the GDP-components are expected to have risen by 0.6%.   The industrial recovery did not take place in January.  Then industrial output fell 0.6%, led by a 0.9% decline in manufacturing.  However, when the February update is released at the end of the week, industrial production is expected to have risen by 0.6% and manufacturing by 0.5%.  

We suspect the decline in the workweek reported with the jobs data may have flattered average hourly earnings but taken at face value the 3.4% year-over-year increase is the largest in the in this cycle.  On Tuesday, the US reports February CPI.  The 0.2% rise the median forecast calls for would be the most since last October.  It was unchanged in November, December, and January.  A 0.2% increase would keep the year-over-year rate steady at 1.6%.  The year-over-year core rate has not been below 2% since last February.  It has been at 2.2% for the past three months, and likely remained there for a fourth month in February.  

China will release its monthly reports for lending, industrial production, and retail sales.  Its February inflation readings were in line with expectations.  Any economic weakness will be quickly shrugged off on three grounds: distortions by the Lunar New Year holiday, the market already reacted to this given the news from the National People’s Congress, and the data does not reflect the impact of the new stimulus measures.  China’s stimulus measures are a potential game changer.  If could help provide a buffer if the trade talks with the US to do not work out.  Recent reports suggest a reversal of positions may have taken place, with the US sounding more optimistic than China.  

The China hawk camp in the US has been in charge of the negotiations since Mnuchin/Ross deal was rejected by Trump year ago.  After all the drama and disruptive tariffs, if there is an agreement, it does not seem all that different from what was in place previously.  China agrees to buy more US agriculture and energy, adopt additional market-opening measures, and have regular consultations with the US on various levels.  China may have dropped references to “Made in China 2025” in deference to the mercurial Americans, but the spirit lives on, and manufacturing is thought to be a primary beneficiary of the VAT cuts.   Without assurances of a trade deal, especially given the recent abrupt break down of talks with North Korea (which some link to domestic problems in the former of his former lawyer testifying before Congress and others say was instigated by Beijing), 

It behooves China to move out of the US crosshairs as soon as possible, and let the Trump Administration get on with its agenda.  Trade talks with Europe formally began recently. Europe will not really engage the US while the steel and aluminum tariffs are in place.  There is already a dispute over whether agriculture will be included.  Trump continues to threaten tariffs on autos and auto parts, and the EU has prepared a list of potential retaliatory measures.  Talks with Japan could begin before the end of the month, some reports indicate. Missed by many, the US launched a new national security investigation into titanium sponge imports, of which nearly 100% came from Japan last year.  Moreover, the US is also demanding currency clauses be inserted into trade agreements that require intervention to be limited and transparent and warned the same would apply to the UK in a post-Brexit trade accord.     

Trump’s disruptive agenda is more about relations with allies that strategic competitors.  From China’s perspective, Trump may be part of the forces weakening the West.  Look at the reports that suggest the US is demanding that Germany and Japan, and eventually other countries that have US military bases pay the full price for the American soldiers stationed there–and a 50% premium for the privilege.  This may very well see some countries chose not to offer territory for US bases or decide to reduce the US presence. 

This comes amid a greater divergence of US and European interests. The US withdrew from the Paris Accord.   The US unilaterally withdrew from the treaty with Iran and demand that Europe respect its new sanctions, including its exclusion from Belgium-based SWIFT.  The US is insisting that Huawei not be used for 5G, but several European countries may decide otherwise, and some might be just as suspicious of US “backdoors” (see Snowden) as Chinese.  The US did not want European countries to join China’s initiative Asian Infrastructure Investment Bank, but several did, and now Italy appears poised to be the first to join the Belt and Road Initiative.  Trump has been critical of the Nord Stream II Pipeline that will bring Russian gas to Germany bypassing Ukraine.  

The US Treasury goes to market next week to raise $78 bln in coupons.  The nominal yields are a little lower (the three and 10-year yields are six-seven basis points lower than the high print at the last auction, while the 30-year yield is virtually unchanged.  Inflation, as we have seen, has edged higher.  There is no concession to induce buying.  Consider, for example, that the 10-year yield closed slightly below 2.63% for its lowest weekly close since mid-January 2018. 

If there is it a concession, it is to foreign investors (or investors who use foreign funding).  Consider that the US 10-year premium over Germany reached at least a 30-year high of almost 280 bp in November 2018 and it a little shy of that now.   The US 10-year premium over Canada set its high back in 2015 near 90 bp.  It finished last week near 86 bp. The US offers 60 bp over Australia for 10-year borrowing, the most since the early 1980s.  The Japanese yield curve is negative out 10 years.  The German curve is negative through nine.  Spain, where the minority Socialist government collapsed after failing to pass a budget, can borrow out four years at negative rates.  

Equity markets have staged impressive rallies at the start of 2019 that have been just as dramatic as the meltdown at the end of last year. Something appears to have come to an end.  The MSCI Asia Pacific Index fell for its second week for a 2% pullback.  The Shanghai Composite, which had been up 23.5% until Friday when it shed 4.4%, amid concern that a brokerage firm’s rare sell recommendation was a signal that officials were concerned about the pace of gains. The Shanghai Composite snapped a nine-week advance, while the NASDAQ saw its 10-week streak end, with a 2.5% drop.  Europe’s Dow Jones Stoxx 600 fell for the last three sessions and ended a three-week rally.  It closed just above its 20-day moving average and has not closed below it since January 3. 

The S&P 500 fell every day last week.  It did not do that even in last year’s rout.  It did fall every day in the four-day week that was marked by Labor Day in 2018, but you have to go back to early November 2016 the last time the S&P 500 fall every day in a five-day week. It gapped lower and below the 20-day moving on Thursday (~2767.25-2768.70). Overcoming this gap may be the early signal that the correction is over.  The S&P 500 gapped lower again after the employment report and slowly climbed higher to fill the gap late in the session.  With the gap closed, the technical pull higher may have weakened.  The performance on Monday could set the broader risk appetite for the coming sessions. 



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