Europe’s recovery takes a stumble and China’s tightening efforts

The October flash PMI readings for the currency bloc were underwhelming to say the least. French manufacturing tumbled back into contractionary territory below the crucial 50.0 mark; and even Germany missed expectations for a pick-up in the service sector. Overall, the composite PMI was a disappointing 51.5, down from 52.2 in September.

So what is causing the weakness? Some of the decline in sentiment can be blamed on events the other side of the Atlantic, but overall it suggests that Europe’s recovery is not accelerating, and rather than a V-shape, the currency bloc is experiencing an L-shaped recovery and we could be skirting just above the bread line for some time yet.

Although these are only preliminary numbers and we will get the revisions in a couple of weeks, France still looks like the weakest link, it’s manufacturing sector experienced its 20th consecutive month of contraction, which is more akin to a weak peripheral economy rather than a “strong” core one. Germany, the jewel in the Eurozone’s crown, is also showing a lacklustre pace of growth, and is lagging behind its European neighbours in the UK, where the pace of growth is surprising the Bank of England.

Overall, the composite PMI data may be in expansion territory, but the Eurozone is in no state to be able to withstand a global economic shock. With US fiscal issues unresolved and Chinese money market rates rising once again, threats are swarming on the horizon.

Perhaps Spain’s predicament best exemplifies the Eurozone: yesterday the Bank of Spain announced that it had exited recession with a 0.1% growth rate for Q3, while today’s unemployment rate fell to 25.98% in Q3, down from 26.26% in Q2. So there is a recovery going on, but it’s moving at a glacial pace.

Are Chinese money market rates worth worrying about?

Back in June, Chinese inter-bank lending rates shot higher after the Chinese authorities refrained from adding liquidity to the system. This caused some jitters in the markets, with fears surfacing that China was at risk from its own credit crunch. Today Chinese Shibor (inter-bank lending rate to you and me) rose nearly 60 basis points. Now, if that happened in the US it would mean all out panic, but in China it meant a 0-.9% drop in the Shanghai Composite exchange, while global markets shrugged it off: European markets are mostly higher and the Aussie market jumped to a fresh 5 year high.

So why the nonchalance? Monetary policy tightening in China is a much less scary prospect in October compared to June, as we now know that the Fed has put its tapering plans firmly on the back-burner, in June there was a concern that China and the US would tighten at the same time. Added to that, a PBOC official said last week that China will embark on a mild tightening to regulate extreme credit growth and property prices, rather than the heavy-handed way it handled tightening back in June, when 1-month rates jumped just shy of 10% (they are only 5.4% today).

Also worth noting was October flash Chinese PMI data, which rose to 50.9 from 50.2. This is the HSBC version, which can differ from the official figure released early next month. Although this is a good number, it is worth remembering that October can see a seasonal bump in manufacturing activity and in November there is a big Communist Party Conference that could shift the economic outlook. Thus, today’s data may not have a huge impact on the market.

Balancing global liquidity

Thus, with one hand doth the Fed give out liquidity and with another doth the PBOC try to take it away. The Fed’s $85bn of liquidity will continue to leak out of the US economy (it sure ain’t creating US jobs, anyway), and help prop up risk assets and weigh on the USD for some time, in our view.

The contrasting stances of the US and China

Today’s events in China show how the US and Beijing are polar opposites. The US loves dramatic political showdowns, the Chinese (try to) deal with things behind closed doors. The Fed errs on the side of loosening, while the Chinese err on the side of tighter monetary policy. Within 5 years, is my guess, we should ultimately find out which stance is correct.

From an FX perspective, the overall weak dollar theme persists although we have backed away from recent highs in EURUSD, AUDUSD and GBPUSD; however, we continue to think that the US’s Federal Reserve remains the most accommodative central bank out of this group, which may support further USD weakness. The outlook for USDJPY is more nuanced as Friday’s Japanese CPI data could determine if the BOJ needs to do more to stimulate the recovery and boost inflation. Today the BOJ released its economic report for October and maintained its stance from September that the “Japanese economy is on the way to recovery at a moderate pace”.

Ahead today, after the dismal US payrolls report from Tuesday we expect the initial jobless claims to be the chief focus. Any further weakness in US jobs numbers could weigh further on USD, so beware a bout of USD volatility at 1330 BST/ 0830 ET.