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Macro insights: Italy’s budget saga continues, US bond yields rise and China steps up easing

Italy’s budget saga continues, US bond yields rise and China steps up easing

Macro insights

Italian Budget saga amid disappointing European cycle.  After disappointing manufacturing surveys, German industrial production came in on the weak side, dropping 0.3% month-on-month (m/m) in August. In this worryingly weak European cyclical context, the Italian government announced revised deficit targets of 2.1% in 2020 and 1.8% in 2021 (vs. 2.4% each year in the first draft). We believe these targets are unlikely to be met. First, underlying real growth forecasts are overly optimistic (1.5% each year on average; we forecast 1.0% next year), even after including a generous Keynesian multiplier on the extra spending (partly offset by the tightening of financial conditions); this optimism is even larger when looking at nominal GDP growth. Second, although we are lacking full details of the measures included (available on 15 October), they should cost in excess of 1.6pp of GDP. Altogether, tensions may mount in the coming weeks with the European Commission likely to consider that Italy is in serious breach of compliance with the Stability and Growth Pact rules (opinion given by end of October), thus asking for a new draft budget. The European Commission has however no binding power and will only provide its recommendation to the European Council. We still expect a one-notch downgrade from Moody’s and Fitch (review due by end of October), while S&P should downgrade the outlook to negative on 26 October. 

10-year US Treasury yields have risen above 3.2%, their highest level since 2011. From a macro perspective, the increase was encouraged by solid data last week: while the manufacturing ISM index retreated from its 14-year high, the non-manufacturing index posted its best result since 1997. Moreover, last week’s payrolls disappointed in job gains but the three-month average remains a solid +190,000. In addition, unemployment fell to 3.7% and average earnings, while slipping to 2.8% in September (from 2.9% the previous month) did so largely on base effects that look set to boost earnings to 3% next month. In addition, markets are re-pricing the chances of US Federal Reserve tightening with the probability of three hikes next year nearly at 25% from below 5% in early September. Technical factors including pension fund demand, rising assessments of neutral rates and inflation concerns are likely to be also contributing. Thursday’s CPI inflation will likely be the next focus for markets, with headline expectations softening but an expected rise in core rates to 2.3%.

China steps up policy easing to counter growth and external risks: The Peoples Bank of China (PBoC) announced a 100 basis point (bp) cut to the banks’ reserve requirement ratio (RRR), effective from 15 October. This is the third RRR cut since April and is more broad-based than the targeted moves in April and June, suggesting that the pace and scope of monetary easing has stepped up. We estimate the latest move will release a total of RMB1,200bn liquidity into the system. Of which, RMB450bn will be used to offset the maturing Medium-term Lending Facility (MLF) loans in mid-October, while parts of the remaining RMB750bn liquidity will help to counter the end-October tax payments. Hence, the net liquidity injection into the real economy will be less than meets the eye. Nevertheless, we think the latest easing will serve three purposes: 1) supporting the economy confronted with intensifying headwinds; 2) counteracting bearish sentiment in the onshore financial markets; and 3) preparing the economy for more, nastier conflicts with the US. The key risk to the move is the reaction in the FX market and capital outflows.

Jair Bolsonaro (PSL) in the lead after first round of Brazil’s general elections. After gathering 46% of votes, against 29% for left-winger Fernando Haddad (PT), according to latest estimates, far-right candidate Bolsonaro scored much better than polls predicted and should win the run-off to become the next Brazilian President. Bolsonaro’s economic team, led by a Chicago school economist, Paulo Guedes, intends to clean up public finances through a massive privatisation plan and structural reforms, giving hopes that his administration would tackle Brazil’s explosive public debt issue. Yet, the ability to reform Brazil will depend upon the political structure of the future Congress, which is still unclear at this stage. Early estimates point to strong gains for the PSL party. More “centrist” elements are likely necessary to form a coalition.

Upcoming events
Euro Area:
GE Trade balance and Current Account (Tuesday), FR and IT IP (Wednesday), FR and SP HICP and ECB account published (Thursday), EU19 IP and GE HICP & CPI (Friday)
US: PPI and wholesale inventories (Wednesday), CPI (Thursday), Michigan consumer sentiment and US sovereign debt rating by Moody’s (Friday)
UK: BoEs FPC publishes statement (Tuesda0), Aug GDP, IP, Manufacturing & Construction output and Trade data (Wednesday), RICS Housing Survey (Thursday)
Japan: Trade balance, Current account balance (Tuesday), Private ‘core’ machinery orders (Wednesday)

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