Sequestration Cuts take effect as the UK regains 6th place in GDP rankings

Week commencing Monday 4th March 2013

Overriding Market Themes

On Friday, the scheduled sequestration cuts went into effect in the US and seems set to dominate the markets for the coming weeks. Analysts believe that the effect on GDP will be shocking if left, with growth projected to fall to 1.4% in 2013 if the cuts are not delayed or replaced, compared with the 2.2% growth the US experienced last year. Republicans continue to oppose replacing the sequester with a mix of tax hikes and spending cuts and seem to have settled on simply giving the OMB the flexibility on how to implement the cuts. This political stalemate seems set to stir markets into the near term, especially as a new continuing resolution to fund the government will be needed to prevent a shutdown by the end of this month.

The UK purchasing managers' index (PMI) for manufacturing fell to 47.9 last month, from a downwardly revised 50.5 in January. It was the first reading below 50 (which indicates contraction) since November and could mean that the sector will act as a drag on the economy in the first quarter. Reading into the figures, both output and new orders fell in February, while purchasing activity was also cut markedly as manufacturers continued to show a preference for holding less stock. Staffing levels also declined at their quickest pace in more than three years. In fairness to the UK economy, February's figures suffered a knock-on effect from the bad weather at the end of January, and were also hit by a stronger-than-usual effect on global trade flows from the Chinese New Year holidays. With this in mind, and considering the weaker pound, we expect the sector to return to growth as early as next month.

The rate of unemployment in the eurozone rose to a fresh record high in January, with a surprise jump from 11.8% to 11.9%. The highest rate was 27% in Greece, although the most recent figure there was from November, while the lowest rate was 4.9% in Austria. With inflation at an almost 2 year low and unemployment so high, we see it more likely than ever that the European Central Bank will cut its interest rates later this year.

The Brazilian economy grew at its slowest pace for three years in 2012, according to official figures.  GDP saw growth of a mere 0.9% throughout the year against the government’s own target of 4.5%. In 2011, Brazil notched up growth of 2.7% and overtook the UK to become the world's sixth-biggest economy. But on the basis of 2012's figures, Brazil has now fallen back to seventh place, even though the UK's economy only grew 0.2% in 2012. This is thanks to a decline in the value of the Brazilian Real, causing the country's economy to shrink in dollar terms to USD 2.2 trillion, while the UK's grew to USD 2.3 trillion.

GBP This Week

We start the week with Construction PMI, which has been stuck below the 50 level since November 2012, indicating sustained contraction in the sector. The estimate for the March release is slightly higher than the previous reading, at 49.2 points. Services on the other hand have been above the 50-point level for over a year, with the exception of the January 2013 release. This indicates that the UK service industry has been steady, with modest expansion. The previous reading came in at 51.5 points, and the March estimate stands at the same figure. We then move to Mervyn Kings speech at the parliamentary committee on Banking Standards, which we expect to be somewhat dovish and therefore Sterling negative. Finally, Thursday’s Bank of England rate and QE announcement is widely expected to be the highlight of the week. No change in the base rate or the asset purchasing program is expected however.

The pound is having a disastrous 2013, and there remains very little good news on the horizon for the UK. As UK economy continues to sputter, and the US continues to produce mixed results, Cable is likely to remain under considerable pressure, especially with the Pound dipping into 1.49 territory level on Friday, breaking the all-important 1.50 level of psychological support. GBP/EUR may see more luck, with dismal European data expected and political instability in Italy, we expect to see some Sterling comeback this week.

USD This Week

US ISM Non-Manufacturing PMI starts off the week. The Institute for Supply Management reported that the PMI for the non-manufacturing index dropped to 55.2 in January, following a revised reading of 55.7 in December. The reading was in line with predictions and is still in positive ground, indicating expansion. A small decline to 55.0 is forecast this time, and should provide us with some hints for the upcoming Non-Farm Payrolls release, which is out on Wednesday. US private sector employment gained 192,000 jobs in January, according to the January ADP National Employment Report. The reading followed an increase of 185,000 jobs in December and a further increase of 168,000 is forecast this month. Moving to Thursday, US Unemployment Claims should show a small rise to 356k. Finally the Unemployment Rate should show that despite the moderate job growth in January and in the two previous months, the unemployment rate should remain roughly in line with its current reading at 7.9%.

EUR This Week

We start the week with Spanish unemployment, which rose to 4.98 million in January, with a 132,055 new unemployed in January alone, following a reduction of 59,100 unemployed in December. This high figure indicates the Eurozone’s fourth-largest economy is struggling with the highest unemployment rate since the death of General Francisco Franco in 1975. A rise of 77,500 unemployed is expected this time. GDP follows on Wednesday, with the initial GDP report showing a significant contraction of 0.6%, led by a contraction of the same rate in Germany. While the German contraction is seen as a one-time event, many other countries are in a long recession, and will probably see it going on for a few more months. A further 0.6% drop will likely be confirmed now. Finally, we are watching the Eurozone rate decision, and think the ECB is unlikely to move on rates in the March meeting. Draghi’s warning on the euro exchange rate have already had a significant effect, and the elections in his home country already did more than a rate cut could have done to weaken the euro. The focus is expected to remain on the press conference. Draghi is likely to try and balance between the current gloomy economic situation, and the optimism for growth in H2 2013, coming now from higher business confidence in Germany. An ongoing political turmoil in Italy could bring the OMT back into the limelight. The drop in inflation to 1.8% and the rise in unemployment to 11.9% could lead Draghi to hint about a rate cut in April. This could come in a form of saying that the decision was not unanimous, and that some members wanted a cut in this round.

While the Italian political mess could now be priced in, the troubles for the euro are far from over. The next sell-off could be now triggered by Mario Draghi. With a deep recession, rising unemployment and low inflation, the ECB now has more room to cut the rates. A rate cut is not priced in and has little chances. If it does happen, the euro will fall fast. However, even a hint of a rate cut has the potential to send the pair down.

In Other News

The Queen is spending a second night in hospital after falling ill with suspected gastroenteritis. News of her illness first emerged on Friday night and she cancelled a trip to Swansea on Saturday to mark St David's Day in a military ceremony. Although only precautionary, the Queen was admitted to hospital and is expected to remain there under observation for the next couple of days. We wish Her Majesty a speedy recovery.


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