Odds of Larger ECB Cuts Increase

Eurozone's growth outlook remains anemic. The latest PMI data (preliminary readings for November) showed a veritable nosedive.

• Europe Must Do More to Help Itself
• Will BoE Accelerate Rate Cuts?
• BoJ Waiting in the Wings Now
  
• Spotlight on Next Week

Weekly Highlights

Eurozone Needs to Help Itself

Speaking at a European banking conference this week, ECB President Lagarde lamented the lack of capital markets integration in the region, saying that while the urgency for action has risen over the past year, it “has not been met by tangible progress”. As a case in point, she highlighted that the EU had nearly 300 different trading venues in 2023.

We wholeheartedly agree with President Lagarde’s assessment. In fact, we would take it a few steps further. The need and urgency for action are not contained to capital markets; they run the gamut from energy policy, defense, general business regulatory environment, fiscal policy, etc. We had long in these pages highlighted the need for a more pro-growth mindset and policy impetus in the region but progress has been incremental at best. France is trading places with Italy as a key source of fiscal instability in the region.

The region’s growth outlook remains anemic and increasingly vulnerable to changes in external demand, whether for goods (China) or services (United States). The latest purchasing managers’ indexes released this week (preliminary readings for November) showed a veritable nosedive, particularly in service industries. The German services PMI index dipped into contraction (49.4) for the first time since February. The French services PMI index plunged to 3.5 points to 45.7, the weakest level since January.

The combination raises the odds of a 50-bp ECB rate cut at either the December or January meetings. For now, we stick to our prior 25-bp cut projections. However, even if the ECB were to speed up the pace of rate cuts, that would still be nothing more that a small bandage on the region’s much larger injury of competitive decline. The solution does not rest with the ECB but with the national governments and the European Commission. It is time for Europe to not only discuss and debate the Draghi report, but to implement it. The region’s economic leaders agree on this, but will its political leaders?

UK: Will Weak Activity Accelerate Rate Cuts?

As expected, CPI inflation is now back above the Bank of England’s 2% target. Headline inflation rebounded strongly to 2.3% in October, above market expectations and is expected to get close to 3% in January. Importantly, services inflation is likely to oscillate around the current level of 5% for the next couple of months. All that means that, without any downside surprises, the December rate cut is very unlikely, and the bank will most likely continue its gradual rate-cutting path for now.

However, concerns on recent activity may mean the bank will be more actively reconsidering the position. Both October's retail sales and November's flash UK PMIs disappointed, reflecting some impact from the budget announcement.

Retail sales fell a sharp 0.7% m/m in October, partly due to household concerns about recently announced tax increases. Meanwhile, both UK manufacturing and services PMIs fell markedly to 48.6 and 50.0, respectively, indicating that real GDP growth is slowing in mid-Q4. PMI weakness stemmed from declining output, job cuts, persistently high inflation, and lower business optimism. Worryingly, the bigger drag is likely to come from services sector with loss of confidence being linked to rising payroll costs and disincentives to invest largely due to an increase in employer NICs.

Admittedly, there were noises around the October retail sales data and the fall followed three consecutive monthly gains. The PMIs also does not include government spending which is rising. Still, the underlying momentum of the economy appears to be weaker than we previously thought.

BoJ Waiting in the Wings Now

This week’s inflation data brightened the chances of a December hike by the Bank of Japan (BoJ). Nationwide CPI weakened two tenths to 2.3% y/y in October, but the core CPI (excluding fresh food) surprised the consensus by a tenth to the same 2.3%. The global equivalent metric (excluding all food and energy) accelerated sequentially to 0.3% m/m from a flat reading in September. Higher prices were observed for rice, food away from home, and public services. Goods contributed 1.53 ppts, slightly lower than last month, and services added slightly more, 0.72 ppts. As higher labor costs are increasingly passed through to output prices, we expect inflation to remain around the 2% price target with a bias for staying above target, given the weaker yen in the recent times.

Separately, the government had approved a stimulus package of JPY21.9 trillion ($141.8 billion), matching that of the last year and having cash handouts to low-income families and those with children. When private sector’s spending is taken into account, the total stimulus rises to JPY 39.0 trillion. The government would allocate only JPY 13.9 trillion from the general account, limiting the hit on revenues for now. Furthermore, the government was reportedly also considering lifting the ceiling of tax-free income from JPY1.03 million, the main campaign promise of the key partner, the Democratic Party for the People. If the limit is raised to the party’s proposed JPY1.78 million, revenues could take a JPY8 trillion hit according to government estimates, which may eventually lead to higher government borrowing.

This higher borrowing is not necessarily a bad idea for Japanese markets; as such, yields on the long end of the curve have steadily been eclipsing those of China’s. Such higher long-end yields will help Japan’s domestic institutions invest more at home, one of the most important long-term changes that are yet to happen to complete the post-Covid revival of the economy. One of Japan’s largest insurers, the Nippon Life Insurance was reportedly lifting their promised yields in January from 0.6% to 1.0% for annuity insurance and others, for the first time in 40-years.

Spotlight on Next Week

1. US consumer spending growth to moderate.
   
2. Japanese unemployment rate to tick up from low levels.