ECONOMIC DATA ANALYSIS - WILL THE CHANCELLOR LOOSEN THE PURSE STRINGS?

ECONOMIC DATA ANALYSIS

FRIDAY 16 MARCH 2012

WILL THE CHANCELLOR LOOSEN THE PURSE STRINGS?

UK Budget on Wednesday, fiscally neutral despite modest outperformance of public financesFlash estimates of Euro area and Chinese PMIs to point to continued improvementUS focuses on housing market, watching for further signs of life

Bond markets have suffered a sharp sell-off this week, the US 10-year Treasury rising around 30bps to 2.33% in three days, with international counterparts seeing similar increases. The Federal Reserve’s acknowledgement of economic improvement prompted the move, although we also suspect some reversal of Euro area safe-haven flows. Gilt markets have not escaped this sell off and the 10-year gilt yield is now yielding 2.45% - its highest since October. Indeed, the gilt market has been buffeted by a number of factors this week including Fitch rating agency’s downgrade of the outlook for the UK sovereign credit rating and the (perhaps not unrelated) official consultation over ultra-long gilts: centuries (100-yr) or perpetuals.    

The gilt market will continue to be our focus as the Chancellor delivers the UK Budget on Wednesday. Public finances released before the Budget statement are likely to confirm the 2011-12 deficit will be lower than November’s forecasts of £127bn. We expect £120bn for the year. Our preview, No Largesse From the Chancellor This Time”, spelt out why we see this Budget as being broadly fiscally neutral, with measures aimed at supply-side reform. Much speculation continues to surround the 50p higher tax rate. We doubt that the Chancellor will be ready to lower this politically significant tax rate, despite evidence questioning its economic merits. Indeed, the Budget looks more likely to facilitate making dramas (via an extension of film tax relief), than make any itself. While the Budget will be the main focus for the coming week, we doubt it will alter the macroeconomic outlook.    

The domestic market sees other key releases. CPI inflation on Tuesday is likely to fall to 3.4%, declining at a slower pace in part because of food and energy price inflation. This  is likely to feed the MPC’s creeping concern about the scale of disinflation over the remainder of this year. MPC minutes on Wednesday will provide further insight into the Committee’s latest thinking. We fully expect both policy decisions to have been unanimous in March. However, we will watch for precursors of the debate to be held in May when the current phase of QE expires. Few members seem to be championing further stimulus at this stage. Admittedly, Thursday’s retail sales look set to decline after an impressive run. We also expect a fall in February to set the tone for the coming months, which may strengthen the case for more stimulus in May. But, at the moment,  we doubt the MPC will add to QE at its next Inflation Report meeting. 

The flashâ estimates of Euro area PMIs will also be watched this week (not least in the UK, where these heralded a sharper decline in domestic indicators last month). Continued strength in the ZEW survey, alongside growing signs of confidence elsewhere, leads us to doubt that February’s dip marked the start of a trend. Indeed, we believe that the receding crisis should dampen the corrosive impact on business confidence. We expect a small rise in key Euro area PMIs in March. We will also watch the flash estimate of the Chinese manufacturing PMI. This will give us the first New Year distortion free reading of the year. We forecast a pick-up in the output and export components.  

In the US, there are growing signs of strength, despite the increase in gasoline prices. Attention this week turns to the housing market. The housing market was the genesis of the financial crisis and has been a continuing headwind against a broader recovery. But recent construction surveys have improved, pointing to a pick up in housing starts, while pending sales suggest that home sales may be on the rise. Any genuine recovery in housing will be a journey of a thousand miles. But signs that the housing market has made its first step is likely to add to bond market nervousness.  

UK DATA PREVIEW                                                FRIDAY 16 MARCH 2012

CPI inflation (Feb) Inflation has continued its sharp decline in recent months with the anniversary of the VAT rate increase contributing to January’s drop to 3.6%. We forecast this decline continuing in February and look for 3.4% in the coming week’s release. However, the pace of this decline is slowing. To some extent this is natural as VAT accounted for a large change in the annual rate a year ago. However, the pick-up in fuel and seasonal food prices is removing some of the disinflationary zeal we had expected. We still envisage inflation slipping below 3% in Q2 2012 – the first time since 2009. However, deceleration beyond that is likely to be more subdued and more dependent on the precise path of global commodity prices. A less decisive downward trend in inflation may check the MPC’s ambition for further monetary policy stimulus.

MPC minutes (Mar) Having sanctioned a further £50bn of asset purchases as recently as last month, this month’s MPC decision should have been more academic. While we expect the vote to maintain the current policy stance to have been unanimous, the Committee's assessment of the recent improvement in the flow of economic data (both domestic and international) will be of great interest. We suspect that members Posen and Miles will maintain their bias for further stimulus in the months ahead, but other members may have been encouraged by the recent signs of improvement in the economy and, absent a significant deterioration in the growth outlook, this appears a turning point in the policy debate. As such, we believe that while finely balanced, the probability of additional QE once the current tranche ends in May has slipped below 50%

Public finances (Feb) The latest micro-developments in the public finances are likely to be overshadowed on Wednesday by the Chancellor’s Budget statement later in the day. Nevertheless, we expect February’s figures to supplement the trend improvement that has characterized recent news on the finances. We forecast a deficit, excluding financial interventions (PSNBX), of £7.9bn (£5.0bn including financial transactions). This would mark an improvement of around £0.9bn on the previous year - smaller than previous months as the impact of last year’s VAT increase comes out of the comparison. Nevertheless, we view this as consistent with a full year 2011-12 deficit of £120bn, £7bn lower than forecast in November. We do not expect the Chancellor to spend this ‘windfall ’ in this year’s Budget, bolstering his deficit cutting credentials.

Retail sales (Feb) January’s surprise 0.9% gain in retail sales suggested that sales activity maintained momentum following December’s punchy 0.6% rise. This relative strength appears to be the result of a pick-up in housing market activity ahead of the end of the stamp duty holiday this month. This effect looks likely to have supported February’s reading as well. However, we still look for sales to reverse some of the recent month’s gains and pencil in a 0.5% drop in headline sales (a 0.4% fall ex-auto fuel sales). With longer-term conditions for the consumer remaining challenging, as real incomes continue to contract and labour market conditions remain fragile, we expect the recent recovery in retail sales to falter in coming months, once the short-term boost from housing fades.

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