GDP contraction

The British pound has strengthened its leadership in the G10 currency race thanks to the U.S. employment report. The increase of 209,000 jobs in June disappointed USD supporters, causing GBP/USD quotes to soar to the highest level since April 2022. However, it failed to consolidate at that level as the unemployment rate dropped to 3.6% and average wages accelerated to 4.4%, indicating that the Federal Reserve still has a lot of work ahead. The Bank of England also faces challenges. Wage growth in the United Kingdom is outpacing that of the United States. Bloomberg experts forecast a 7.1% increase in May.   The current values, along with sustained elevated inflation at 8.7%, are perceived by companies as a greater incentive for price increases than the BoE's optimistic forecasts of CPI slowdown. BoE Governor Andrew Bailey and his colleagues are determined to prevent inflation from solidifying at elevated levels, but their actions could lead to a recession. Indeed, the short-term market expects the repo rate to reach 6.5% by March 2024. Such a high borrowing cost could risk a recession. Additionally, the yield curve inversion signals an impending downturn.     At first glance, the pound is at a turning point: the projected 150 basis points increase in borrowing costs could trigger a GDP contraction. Markets generally perceive this negatively, as was the case with the U.S. dollar at the turn of 2022–2023, when its quotes were falling. However, it's important to remember that in any currency pair, there are two currencies. The current success of GBP/USD is only partially related to expectations of a repo rate increase to 6.5%.   It's also influenced by some weakening of the U.S. dollar against major global currencies. Some Forex experts believe that the most aggressive monetary restriction by the Federal Reserve in decades will eventually worsen the health of the U.S. economy. Meanwhile, Bloomberg experts predict a slowdown in U.S. consumer prices to 3.1% in June, causing the USD index to decline. The pound faces a test with the release of UK labor market data by July 14. Alongside the previously mentioned wage growth of 7.1%, Bloomberg experts forecast a slowdown in employment from +250,000 to +158,000.   According to Pantheon Macroeconomics, this change will not be sufficient to stop the Bank of England. The repo rate hike toward 6.5% will continue. Considering that markets were anticipating 5.3% a month ago, the pound's successes are logical.     In my opinion, investors have been somewhat excessive in selling the U.S. dollar based on mixed U.S. employment statistics. This vulnerability makes sterling positions vulnerable. Technically, on the daily GBP/USD chart, a reversal pattern like a Double Bottom may form, or an upward trend may resume. In the first case, we sell the pair on a breakthrough of the pivot level at 1.2785. In the second case, on the contrary, we buy it upon a new local high at 1.285.  

UK banks pass stress test results By Michael Hewson (Chief Market Analyst at CMC Markets UK)   The latest set of stress tests by the Bank of England have shown that the UK banking sector is resilient and well able to handle the problems caused by the sudden rise in interest rates that is currently putting the UK economy and households under increasing pressure financial stress.   The criteria were adjusted higher from similar tests in 2019 and are based in the following.   It is assumed UK monetary policy tightens, with Bank Rate assumed to rise from under 1% to 6%, in the first three quarters of the scenario, above the 4% used in previous tests. UK GDP contracts by 5.0%, and unemployment more than doubles to 8.5%, while residential property prices fall by 31%.   The Bank of England went on to say that all 8 UK banks, would continue to be resilient in such a scenario and well positioned to support households and business, even if financial conditions worsened and rates were to go higher from here.    We've seen significant weakness so far this year particularly from the likes of Lloyds Banking Group and NatWest Group, who are particularly exposed to domestic factors after paring back their investment banking divisions so today's results are likely to be good news for these two especially, and should offer a respite to recent weakness in their share price.   The Bank of England went on to say that the portion of UK households with high debt ratios was likely to rise, and that while they are borrowing more, arrears are currently low. While this may be true this figure on arrears is likely to rise due to the lag effects of monetary policy.   Most mortgage borrowers are on fixed rate mortgages with about 4.5m set to see a rise in repayments on loans that were set more than two years ago. When these come up for refinancing any new rate could see a typical payment rise by £220 a month.   To give an indication of how much 2-year rates have risen, 12 months ago UK 2-year gilt yields were at 1.68%. They are now just below 5.5%. Similarly, 5-year gilt yields have risen from 1.55% to 4.9%. When these deals roll-off and refinance, the size of mortgage payers monthly repayment will soar, which means homeowners may well have to consider various options including switching to interest-only repayments if rates continue to remain high.   The rise in rates is already hitting the buy to let sector with the Bank of England saying that landlords are already starting to sell, which is positive in terms of new supply, however it also means that the rental sector will get tighter as supply comes off the market.   For businesses corporate insolvencies are increasing but are still low.

Italian business confidence falls in August The deterioration in confidence is more marked in industry and construction, but services are not immune either. Consumers remain relatively upbeat, possibly helped by a resilient labour market. This all points to a stagnating economic environment.   Consumers remain relatively upbeat Consumer confidence only slightly edged down to 106.5 in August (from 106.7 in July). The deterioration in the perception of the current and future economic climate contrasts with the improvement in personal circumstances. We believe this has to do with the combination of declining inflation and a very resilient labour market. Indeed, the unemployment expectation component of the survey slowed down on the month. When matching this with an increase in the current opportunity to save sub-index, we sense that a possible stabilisation in the savings ratio might be in the making, limiting the scope for a strong pick-up in private consumption, at least in the short term.   Manufacturing confidence softens further On the business front, confidence unsurprisingly declined again among manufacturers to 97.8 (from 99.1 in July), the lowest level since January 2021. Here, softer orders coupled with a stable inventory component resulted in a decline in the production expectation component. Softer demand in key export destination countries such as Germany and, to a smaller extent, China, is apparently taking its toll, with the domestic component unable to compensate. Interestingly, the investment goods segment seems less affected, suggesting that some demand linked to the implementation of the Recovery and Resilience Facility might still be in place.   Construction confidence fall suggests that the effect of tax incentives is fading The six-point decline in the construction confidence index to 160.2 (from 166.5 in July) sends a warning signal. While the index remains close to its historical highs, the push coming from the residential component is gradually fading as generous tax incentives come to an end. While the existing backlog of orders related to incentives looks set to keep the sector afloat into year-end, the exceptionally high contribution of construction investment to GDP growth looks set to vanish in 2024.   Services only marginally down, with tourism relatively weak Confidence in market services fell to 103.6 in August, from 105.5 the previous month. The decline affected all big aggregates, except information and communication. Interestingly, it also affects tourism services, where an improvement in the current affairs component contrasts with declining order expectations. This broadly fits with other evidence available pointing to a good summer tourism season.      Modest GDP growth in the second quarter still possible All in all, today’s confidence data suggest that conditions are still ripe for the continuation of a soft economic environment. After the disappointing 0.3% GDP contraction in the second quarter (we will get the full details for this on Friday), a very small rebound still looks possible in the third quarter. Whether this will materialise or not will depend on whether services are strong enough to compensate for industrial weakness. We still hold average Italian GDP growth of 1% in 2023 as our base case.

The monthly GDP numbers have been highly volatile, but we do expect slower growth over coming months as the cooler jobs market and higher rates continue to bite.   The UK economy contracted by half a percent in July, though frankly, these numbers have been all over the place recently. Remember that output had increased by the same percentage in June, thanks in no small part to a highly unusual surge in manufacturing. That boost to production, which was linked to car production and pharmaceuticals, partially unwound in July. But the hit from there was amplified by the service sector, which saw output fall by 0.5%. Strikes offer part of the explanation, with losses most visible in health. But we also saw declines in a range of other sectors, including IT and admin/support services, and this is harder to explain. Cutting through the noise, the economy seems to be still growing, albeit fractionally. The change in activity over the past three months relative to the three months before is still slightly positive. We think the economy is likely to more or less flatline over coming quarters – and a mild recession can’t be ruled out. The jobs market is cooling, while the impact of higher rates is still yet to hit the economy. The average rate paid on outstanding mortgages is roughly 3%, up from a low of 2% but well below the 6%+ rates being quoted on two-year mortgages for new lending. As more and more borrowers refinance, we expect the average mortgage rate to rise above 4% in 2024, even without any further Bank of England rate hikes. That’s a gradual process so we don’t expect an abrupt hit to GDP in any specific quarter, but it will act as an ever-increasing drag on consumer spending.   Corporates have felt the impact of higher rates more quickly than households   The caveat of course is that considerably more households own their home outright than 10 years ago (39%), relative to those with a mortgage (28%). Then again, businesses have already felt the full effect of higher borrowing costs, given lending is more typically on floating rates. Back to this latest data, and given the volatility in the GDP figures, we expect the Bank of England to largely ignore them. Officials have been clear that they are focused on wage growth, services inflation and labour market slack – and not a lot else. We expect one more rate hike at next week’s meeting, before a pause in November.

Eurozone PMI once again signals contraction in activity in September The PMI ticked up slightly from 46.7 to 47.1 in September. This is better than expected but does not ease concerns about a possible contraction in GDP in the second half of the year.   To be fair, the PMIs are getting harder to read at this point. The slight tick-up from last month does end a streak of four consecutive declines in the composite PMI, but it remains firmly in contraction territory. While better than analysts had expected, the overall picture remains rather bleak on economic growth and adds to contraction concerns. Still, at least today’s PMI indicates that the deterioration of conditions has stopped for the moment. Perhaps that’s the glass-half-full take because the underlying picture that the PMI paints is far from positive. The decline in demand is worsening as new orders fell at the fastest pace since late 2020. Manufacturing has performed poorly for quite some time, but the fact that services are the main contributor to the drop in new orders shows that the weakening of demand in the eurozone is becoming more broad-based. Businesses are still working off old orders at the moment, which is keeping output reasonable right now. Still, that suggests a weaker outlook for the months ahead. With hiring slowing to a snail’s pace, concerns about activity in the months ahead remain. Our base case is for a continuation of very slow growth, more or less stagnation, which means that a quarter of negative growth is certainly imaginable. The inflation picture is also getting more complicated. The surge in oil prices and high wage growth have caused input prices to increase again, which is mainly the case for the service sector. In manufacturing, input prices have turned deflationary. Still, the increase in service sector costs has not resulted in accelerated selling price inflation. Weaker demand is resulting in slowing selling prices in services and in outright drops in prices for manufacturing. Music to the ears of the European Central Bank, no doubt.

Japanese data improves but we still don’t expect a BoJ policy shift this month Although third-quarter GDP was revised down unexpectedly, the improved current account and cash earnings suggest a rebound in growth in the current quarter. Market speculation about the Bank of Japan's possible policy turnaround at the December meeting has been amplified after recent remarks from Governor Kazuo Ueda and Deputy Governor Ryozo Himino.   GDP contraction deepened in 3Q23 Third-quarter GDP was unexpectedly revised down to -0.7% quarter-on-quarter (seasonally adjusted) compared to the flash estimate and market consensus of -0.5%. The largest revision came from private consumption, which fell 0.2% (vs 0.0% in the flash estimate) and the inventory contribution to GDP, which was down by 0.2% ppt. The negative contribution of inventory should be a good sign for the inventory restocking cycle. But household spending still lagged amid high inflation despite relatively healthy labour market conditions, which should be a real concern for the Bank of Japan. We think that weaker-than-expected GDP could justify the Bank of Japan's current easing policy at least for now.   Meanwhile, GDP for the first quarter was revised up meaningfully from 0.9% to 1.2% resulting in an upward revision to annual GDP. Thus, now we expect 2023 GDP to rise 2.0% year-on-year.    However, other data releases today - labour cash earnings, household spending, and current account - point to a rebound in growth in the fourth quarter, thus we believe that the BoJ will shift its policy early next year.   Contraction deepened in 3Q23   Labour cash earnings rose in October Labour cash earnings rose 1.5% YoY in October (vs 1.2% in September, 1.0% market consensus) beating the market consensus. Contractual earnings gained steadily by 1.3% (vs 0.9% in September) while volatile bonus earnings (7.5%) rebounded after two months of declines. Also, hours worked bounced back 0.7% for the first time in four months, thus overall labour market conditions and earnings appear to have recovered in October. However, wage growth was still short of inflation growth, thus real earnings dropped 2.3% in October, although at a slower pace than the previous month's -2.9%.  Nominal wage growth continues and is clearly faster than the previous year. Also, there are several news reports that big companies plan to raise wages above this year's level of growth. Thus, we believe that next year's wage growth should accelerate a bit more than the current year.    Cash earnings and household spending improved in October   Current account surplus widened in October In a separate report, the current account surplus widened more than expected in October to JPY 2.6tn (vs 2.0 in September, 1.8 market consensus). Despite the global headwinds, the current account surplus will likely widen in the coming months. Due to falling commodity prices, the merchandise account will turn to surplus while an influx of foreign tourists will help the travel account to remain in surplus. We expect the trade of goods and services to improve in the current quarter.    Current account surplus in October led by service (travel)   BoJ preview Several remarks by the Bank of Japan, including Governor Ueda, have shaken the FX market quite strongly. Deputy Governor Himino said that ending the negative interest rate policy would have only a limited impact on the economy and Governor Ueda yesterday met with the prime minister, highlighting the importance of sustainable wage growth and inflation, which led to a fairly rapid shift in market sentiment betting on the Bank of Japan's policy tightening. Dollar weakness is also supporting the sudden move of the yen partially, especially ahead of today's release of the US nonfarm payrolls data.   It seems like the BoJ is paving the way to a gradual normalisation and giving the market a signal that the time is approaching. However, since these comments were made outside of the BoJ meeting, any sudden major change of policy is not expected this month. Yes, we remember that Governor Kuroda surprised the market with a yield curve control tweak last December, but we believe Governor Ueda is unlikely to adjust policy without prior communication. Thus, we expect some changes in the statement and dialogue from Governor Ueda at the BoJ meeting on 18-19 December.    As we have previously argued, we think the Bank of Japan's rate hike will come in 2Q24, most likely at its June meeting. By then, the BoJ will be able to confirm a solid wage increase with Shunto's results. In terms of inflation, it will trend down early next year, but still core inflation, excluding fresh food, is expected to remain above 2%. Even if the BoJ carries out a rate hike, we believe that the Bank's JGB buying operation will continue in order to avoid a rapid rise in long-term yields.

The Australian dollar has struggled so far this year, as receding bets in favour of Fed rate cuts hammer risk assets, while economic data suggests that the Australian economy contracted at the end of 2023. Last week’s preliminary PMI data for December was a disappointment. The composite index edged upwards in the final month of the year, although fell short of expectations and continued to print well below the level of 50 for the third straight month (46.9). Quarterly GDP data won’t be released until early-March, although it would be reasonable to assume that a QoQ contraction in activity is a distinct possibility. Investor expectations regarding the state of the Australian economy will be key in determining the extent of any continued rebound in AUD in the coming weeks. This week will be a relatively busy one in that regard, with housing, retail sales and trade data to be released on Tuesday and Thursday. Arguably the most important data point will, however, be Wednesday’s monthly inflation print for November. Any downside surprise here could further weigh on AUD this week