A Couple of Surprises Start the New Month

Colored Map with Countries and Labels Marc

  • UK manufacturing PMI posts record bounce, sending sterling a cent higher
  • French and Italian PMIs disappoint
  • China’s official manufacturing PMI is at its highest level since October 2014
  • Japan’s soft capex figures warn of risk of downward revision to Q2 GDP, and corporate profits fall 10% in Q2

Sterling shot higher on the economic surprise, but the dollar remains firmer against the euro and yen. The euro remains mostly in yesterday’s range while the dollar is poking through JPY103.50. The Antipodean currencies are firm, even though Australian data (PMI and retail sales) disappointed. The dollar is firm against most emerging market currencies, with the notable exception of the South African rand, that is bouncing around as political issues continue to be worrisome. The MSCI Asia-Pacific Index eked out its third gain this week, during which time it up 0.1%. MSCI Emerging Market equity index is off for third day this week. The 0.3% decline, though is the smallest this week. European stocks are mostly higher with the Dow Jones Stoxx 600 up 0.7%, while the FTSE 100 is flat to lower. Of note, as we have been noting this week, the financial sector in Europe continues to perform well. It is the strongest sector. Italian bank shares are also rallying. This is their third day of the march higher, during which time, they have risen over 9%. Benchmark sovereign bonds yields are most firmer, with the 10-year Gilt yield jumping 6 bp to lead the move.

The new month has begun with a couple of surprises. The biggest surprise has been the record jump in the UK manufacturing PMI to 53.3 from 48.3. A much smaller rebound was expected in August after the Brexit shock drop in July.

There is a linear type of thinking that appears to be driving the market’s response which was to take sterling a cent higher against the dollar. The idea is that pundits, economists, many policymakers (including the Bank of England) and investors have bought the hype about Brexit being bad for UK economy. However, this misses the point and misunderstands an important aspect of how markets work.

The reason the PMI jumped was driven by the decline in sterling. It is about exports. While the market logic of taking sterling higher on the better than expected news is understandable, from an economic point of view, it blunts a key driver.

Two points need to be made. First, when thinking through the impact of a shock event, investors need to consider not just the event, but the market response. This is the kernel of truth in the self-correcting aspect of the market, which may be exaggerated by market fundamentalists. The decline in sterling and UK interest rates will help cushion a potential economic blow, and the short-term cost of which is greater price pressures, which were also evident in the PMI report.

Second, while some observers played up the impact of the referendum on more than market psychology, many, including ourselves, were more concerned about the implications after the divorce for the UK and the future of a medium-sized country with a large current account deficit, reliant on financial services in an era of deleveraging. We also recognized, like many, that business decisions will take the time to filter through. We have compared the issue to cooking frogs rather than frying bacon. Don’t be lulled to sleep by warm water. The risks are that it will still boil.

The immediate hurdle for sterling is near $1.3280 and then $1.3370. Given the spike up on the news, many short-term participants will watch how the pullback unfolds to help determine whether and or where to fade this bounce. The euro fell to test GBP0.8400. The August low was seen near GBP0.8340, which would be the next downside target.

The eurozone surprised today too. Its final manufacturing PMI slipped to 51.7 from 51.8 of the flash reading and 52.0 in July. It is the second consecutive decline. Next week’s service PMI is more important, not just because it is a larger part of the economy, but also because services reflect more domestic rather than international forces. Yesterday’s slightly softer than expected CPI also seemed to reflect weakness in service prices. This is a yellow flag about the economic momentum, which will likely be noted by the ECB next week.

The headline disappointment is minor compared with a couple of the country reports. Germany matched the flash reading, so we cannot look to Berlin. France’s manufacturing PMI was revised down to 48.3 from 48.5 flash estimate and 48.6 in July. It has not been above the 50 boom/bust level since February. Italy was even a bigger disappointment. Its reading fell to 49.8 from 51.2. It is the first sub-50 reading since January 2015.

There were three surprises from Asia-Pacific to note. First, the Australia’s manufacturing PMI dropped to 46.9 from 56.4. It is the first sub-50 print and the lowest reading since June 2015. Australia also reported flat July retail sales figures, for which the median forecast was for a 0.3% bounce after 0.1% gains in May and June. However, the Australian dollar was not sold. It is recovering from yesterday’s dip below $0.7500 for the first time since the start of August.

Second, Japan’s surprise was the weaker than expected Q2 capex figures, which warn of the risk that Q2 GDP is revised lower. Capex was expected to have risen by 5.5% after 4.2% gain in Q1. Instead, it increased by 3.1%. Separately, Japan reported that corporate profits fell 10% in Q2, which is the largest decline since 2011. It was a function of two factors, a 3.5% drop in sales (weaker domestic demand) and the rise of the yen (translation of foreign earnings).

Third, China surprised. The official manufacturing PMI rose to 50.4 from 49.9. It is the highest reading since October 2014. The Caixin measure, which has a greater weight for smaller companies than the official measure, slipped to 50.0 from 50.6. The official services PMI eased to 53.5 from 53.9. It appears that China can host the G20 meeting this weekend and note the economy appears to be stabilizing.

The euro has been mostly confined to yesterday’s ranges. We again highlight support in the $1.1110-$1.1125 area, which houses a retracement objective and the 200-day moving average. Resistance is seen near $1.1170. Meanwhile, the dollar is extending its gains against the yen for the seventh consecutive session. If a foothold above JPY103.50 is secure, the market appears to have its sights set on JPY104. Support is pegged just below JPY103.

The North American session features a full slate of data, but two reports stand out: the manufacturing ISM and the auto sales. Both are expected to soften a bit. The other reports, like Q2 productivity and labor costs, are not typically market movers, though important for understanding the economy and US competitiveness. Weekly jobless claims do not attract much interest the day before the national report. Construction spending is also not a market mover, but an increase in July would snap a three-month drop, and boost confidence that GDP is recovering, and it broadens outside of consumption.