Tuesday, July 22, 2008

The Week Ahead

This week will be a litmus test of the age-old saying “when the US sneezes, Europe catches a cold”. This issue, set amidst the broader context of global decoupling, is currently on the market’s agenda. However, we can not ascertain how hard the US is sneezing to begin with: While underlying weakness in the US is being masked by tax rebates (the consensus forecast for second quarter GDP growth is around 3%), domestic demand growth is likely to ease further through the second half of the year as the effect of the rebates wears off. In addition, manufacturing production has fallen in the last three quarters and private sector payrolls have contracted every month this year. All in all, while there is still some doubt, we are likely to see more and more evidence that the US is in recession in the coming weeks.

On the other hand, it is much harder to ascertain just how weak Euro Area growth is. GDP grew at an annualized pace of 3.2% in the first quarter of this year. While this figure compares favorably with US’s 0.9%, Euro Area growth is likely to get a correction when the second quarter figures are announced on August 14th. However, GDP numbers are notoriously volatile, so business surveys are probably a better indicator of the common currency economies, and this week, we get important indicators on that front, most notably the German ifo survey and Euro Area manufacturing PMIs, both on Thursday. The market is expecting the latter to remain below 50, signaling continuing contraction in the manufacturing sector. Similarly, the consensus view is for another substantial fall in the ifo survey (to 100.0). While these outturns, if realized, would suggest that the downturn in the Euro Area is well underway, the economy is likely to avoid a technical recession (defined as two consecutive contractions of GDP), given that consumption continues to hold well and exports are still being buoyed by the relative strength of emerging markets in the export-oriented big three economies. However, credit and macro analysts from leading banks and research houses are pointing to decoupling of a different kind in Europe, that the varying growth prospects in Europe are being reflected in the spreads of sovereign credit default swaps, which insure against the country’s debt of defaulting. In particular, as it has been noted, it has become increasingly expensive in the last couple of weeks to get insurance against the debt of Greece and Italy, while German and French CDSs have barely bulged. While the claims certainly make sense, there might be a liquidity effect going on as well, since the bond markets of the latter are much more liquid, an issue which I tend to return to later in the week. The upcoming European business survey will also shed light on this issue.

Meanwhile, on the other side of the Atlantic, we get house prices, the Fed's Beige Book, existing & new home sales, durable goods orders and the final Michigan reading for June. As is the norm, there will be a couple of Fed speakers, which the market will be tuned in order the have a better sense of the Fed’s perception on the risks to inflation on one hand and growth, on the other (note that with the financial strains easing, the markets have raised their expectations of rate hikes for the year from 25bp to 50bp). In Europe, we also get German consumer prices, Euro Area money supply & credit, and in the UK more mortgage lending figures and the latest Bank of England minutes. Among this second-tier data, I would devote my attention span to the money figures, as the European Central Bank (ECB) follows those figures carefully for early signs of inflationary pressures- in fact, the ECB recently published a couple of research papers reestablishing the link between money & credit and inflation. Finally, it's another relatively quiet in the emerging world this week, with no change in interest rates expected in Hungary.

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