China stumbled while Italy is reprimanded

Today's news headlines:

  • 'May gambit to extend post-Brexit transition angers Tory MPs’. In UK politics, both wings of the EU denounce the idea, despite supportive remarks by Merkel. (Financial Times)
  • ‘Trump concedes it “looks like” Khashoggi is dead’. US President Donald Trump receives briefing as Turkish and Saudi experts conclude forensic search. (Financial Times)
  • ‘China quarterly economic growth slows to 6.5%’. China’s GDP figure shows weakest expansion since depths of financial crisis. (Financial Times)
  • ‘EU says Italy’s planned budget deviation is “unprecedented”’. Commission asks Italy for clarification on budget in letter. (Bloomberg)

Risk sentiment soured on Thursday and into Friday morning on a number counts. A UK domestic political backlash to the latest Brexit solution raised the prospect of a no-deal Brexit outcome. Italy finally received the EU’s response to its defiant budget. Finally, in the early morning on Friday, China, the world’s second largest economy, reported a slowdown in economic growth.

Markets moved into risk-off positions. The Euro Stoxx 50 was down a moderate 0.04%, with the S&P 500 0.65% lower on the day, following disappointing earnings reports. The main Chinese equity indices opened lower, before finding support from Chinese officials’ words of action to prop up growth.

In the currency markets, the US Dollar was the clear winner from the risk-off tone, gaining against the Euro and Sterling. The Japanese Yen, however, remains the dominant safe-haven play with USD/JPY hitting a low of 111.95 in yesterday’s trade. Interesting price action was seen in Cable (Sterling-Dollar) which failed to weaken after disappointing UK retail sales. Short GBP bets are now so extended that it is difficult for the Pound to fall further. This shows where the risk lies. We would expect a sharp Sterling appreciation against the Dollar on a Brexit breakthrough.

Italy finally received the EU’s response to its defiant 2019 budget deficit plan. In the letter, EU officials described the planned budget deviation as ‘unprecedented’ and called it a serious source of concern. The letter noted serious non-compliance with EU budget rules, referring to the EU’s Stability and Growth Pact, and asked for clarifications.

The EU’s response is now underway and could culminate in a decision by the Commission to issue a negative opinion next week, essentially rejecting Italy’s budget, and asking the Italian government to send it back with revisions. Other key event risks for Italy are rating downgrades. The Standard and Poor’s (S&P) rating agency is due to review Italy’s rating on 26th of October with a Moody’s decision coming by the end of the month. The premium Italy pays over Germany to finance its borrowing rose to a new historic high and is now at levels last seen at the height of the Euro Sovereign Debt Crisis. Portuguese, Spanish, and Greek bond yield also edged higher in the first signs of contagion to the rest of the Euro Area.

In the early Asian morning, China reported a Q3 Gross Domestic Product (GDP) print of 6.5% YoY, its slowest growth since the aftermath of the great financial crisis. In a statement after the release, the National Bureau of Statistics said the economy faced an ‘extremely complex environment abroad and the daunting task of reform and development at home’. While the US-China trade war seems an obvious culprit behind the weakness, the Chinese deceleration has been mostly domestically led, with infrastructure spending, contracting, and car sales coming in weaker. In fact, traders have largely front-run tariffs, ordering more Chinese exports before the next round of tariffs is implemented. China is attempting to wean itself off the credit drug. Risks and pitfalls lie ahead, but slower growth is almost inevitable.

For the day ahead, the UK release of public borrowing figures for September will also be revealed. The UK deficit has fallen by about 30.0% over the last year. With UK Prime Minister Theresa May’s recent pledge to end austerity and the Chancellor to release the new budget on October 29th, these readings take on renewed importance. Canada will release its September CPI and August Retail Sales data. US September Existing Home Sales are expected to persist with their decline after stabilising in the previous month. The US housing sector continues to feel the effects of increased interest rates and high house prices.

Bank of Japan (BoJ) Governor Haruhiko Kuroda will speak in the early European morning. Bank of England (BoE) Governor Mark Carney will talk at the New York Economics Club. With the Bank’s Chief Economist recently warning that domestic inflation is on the rise, Carney needs to justify sitting on his hands ahead of Brexit uncertainty while domestic growth increasingly justifies a rate rise. The US Federal Reserve’s Raphael Bostic, a centrist, will speak on the economic outlook.