Two big weeks lie ahead for markets, which are likely to set the tone for the coming months. Aside from various central bank meetings (for the eurozone and the UK among them), this week’s economic news includes various purchasing managers’ surveys and culminates with Friday’s US Non-Farm Payrolls, which could set the stage for Fed action next week.
However, what markets are really waiting for is Thursday’s ECB meeting when detail on the operating framework for bond market intervention and, generally, for ‘repairing’ the transmission mechanism for effecting ECB monetary policy is to be announced. The Bundesbank has put up much resistance to ECB support for the bond markets, but there is no turning back for Mr. Draghi. The markets will judge Thursday’s delivery as a test of his and the ECB’s resolve to deal credibly with ‘whatever it takes’ to preserve the euro.
China will likely be in focus this week too. More data comes out next week but the official purchasing managers’ survey for manufacturing in August was released this past weekend and came in below 50 for the first time since late last year (chart above). The reading points to a further loss of momentum for the economy and gives markets more reason to fret over a hard landing. We judge the latter as unlikely – the authorities actually want the economy to slow down. However, markets are still likely to be occupied by what lies ahead for next week, which kicks off with more economic news on inflation for China as well as output and retail sales, among other data, and the thought that the central bank will ease again.
A week this Wednesday, Germany’s Constitutional Court will rule on the legality of the European Stability Mechanism (ESM) as well as on the Treaty underlying the fiscal compact. The day after, the FOMC meets to review policy. Given what the Fed Chairman had to say in his Jackson Hole address at the end of last week, more non-traditional policy stimulus could be on the cards.
QE works! That was the Fed Chairman’s message. Output and employment in the US would have been lower without it and, moreover, it mitigated deflationary risks. Also, the difficulty of implementing nontraditional policies and their costs in terms of the associated risks ‘appear manageable’.
If conditions warrant it, further use of such policies should not be ruled out and considering the ‘grave concern’ expressed by the Chairman about the ‘stagnation of the labour market’, conditions do warrant it. That was also the message contained in the last set of FOMC Minutes, but the Chairman reinforced it last Friday with the comment that ‘unless the economy begins to grow more quickly than it has recently, the unemployment rate is likely to remain far above levels consistent with maximum employment for some time’. If the ISM surveys and especially Friday’s Non-farm payrolls disappoint in any way, next week’s FOMC meeting will likely vote for more QE. That, on top of a favourable ruling for the ESM and coupled with the ECB’s readiness to support for bond markets, would leave equity markets with only one place to go.
Just on the latter point, in his Jackson Hole remarks, Mr. Bernanke made the comment that the financial crisis and the recession have weakened the channels though which monetary policy is transmitted. This is the very comment Mr. Draghi made at the ECB’s last press conference in relation to market fragmentation and it is a reason why the ECB, under Mr. Draghi’s guidance, is preparing to come forward with its response.
There has been much leakage over what the ECB will actually deliver on Thursday, but if it delivers a viable and credible operating framework, this will mean that the full collective force of the monetary policies of the major central banks will be geared towards the reflation of aggregate demand, albeit in their different ways, some being more direct (e.g., the Fed, the BoE, the BoJ) than others (ECB, possibly).
Not only are equity markets higher than one might think against the backdrop of weak global growth and faulty transmission mechanisms for monetary policy, but you may wonder whether that ‘full force’ referred to above is already affecting market dynamics.
As the chart below shows, the price relative for the FTSE 250 against the FTSE 100 is challenging April’s peak. We have picked up on this price relative before, not only as a gauge of market recovery, but also as indicative of the associated rotation from defensives to cyclicals. The recent action in the price relative shown in the chart has yet to be demonstrated generally. However, the UK equity market has been a good example of the responsiveness to changes in market leadership in view of the concentration of cyclicals in the mid-cap FTSE 250 index and the concentration of defensives in the FTSE 100.
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