Politics Overshadows Economics Today, but Japan's Economy Unexpectedly Expanded in Q1

Overview:  Encouraged by the election results, investors bid up Indian and Australian currencies and equities. Japan offered a pleasant surprise by reporting the world's third-largest economy expanded in Q1.  Most other equity markets in Asia fell, and European stocks have the week with small losses. The US decision to isolate Huawei sent ripples through the suppliers and customers. OPEC+ indicated supplies may remain tight and oil prices opened firmer and are seeing early gains of 1% pared.  Global benchmark 10-year yields are higher. Core yields are around two basis points firmer, while the periphery is lagging, and Italian bonds are bucking the move. The US dollar is trading heavily against most of the major and emerging market currencies. The yuan posted small gains. Sterling is trying to end its record-long 10-day slide against the euro.  

Asia Pacific

Polls showed a tight race in Australia, and when the dust settled, the governing Liberal-National coalition won re-election, securing a majority in parliament. The campaign pushed back against the progressive agenda of Labor that had focused on the environment and higher taxes on the wealthy. Prime Minister Morrison intends on pushing through tax cuts quickly. The Australian stock market, already at record highs, surged nearly 1.8%. It was the fourth day of advances, and the gain was almost as large as the previous three sessions put together.  

There had been nearly universal agreement that the Japanese economy shrank in Q1. Instead, the government reported that the economy grew 0.5% and 2.1% at an annualized.  The surprise seemed to stem from the fact the business investment did not contract nearly as much as had been expected. Business investment fell 0.3%. Economists had expected the decline was closer to 2%. Consumption fell 0.1%.  The net export function also contributed to growth, not because exports were strong, but because imports were weak. Although the capital expenditures are subject to revision, the positive growth, even if of weak quality, may be sufficient to silence the talk of a delay in the sales tax. Note that there continues to be speculation that Abe will dissolve the lower chamber and plan for joint elections in July.  

What began off a security breach for Huawei (breaking the US embargo against Iran) and one that President Trump was at one point willing to wrap up into a trade agreement, now has turned into an existential exercise.  The US will ban most sales to and purchases from Huawei. This includes semiconductor chips, software updates (Android), and the app stores. Reports indicate that some non-US chip makers will participate. Huawei is thought to have been preparing for this eventuality and has stockpiled chips. We anticipate two strategic responses. First, China will seek to rapidly develop its own semiconductor production capacity.  Second, there had been reports suggesting that Huawei has developed its own mobile operating system. Currently, the US had a duopoly between Android and OIS.  

For the third consecutive session, the dollar made new highs against the yen, reaching almost a two-week high a little above JPY110.30.  However, the upside momentum faded in Europe, leaving the greenback little changed. There are options for nearly $1 bln set in the JPY109.90-JPY110.00 area that will be cut today, though initial chart support is seen at JPY109.80. The Australian dollar opened up higher (~$0.6925) in response to the election results and remains close to there in late European morning turnover. Note that the odds of an RBA rate cut in early June as fallen about a 70% chance before the weekend, interpolating from the derivatives market to about 55% today. Support is seen near $0.6890.  The Indian rupee is the strongest of the emerging market currencies, gaining 1%, as Modi's coalition appears to have secured a majority. The dollar gapped lower, falling to two-week lows (~INR69.365) before finding a bid. The Chinese yuan steadied after selling off last week.  

Europe

Conventional wisdom looks for trouble from the periphery of Europe. Italy's bad loans and unstable government are usually the first port of call.  Greece is a perennial challenge.  Yet, we have argued that the problems emanating from the core are often more critical.  While speculation has increased that following the EU elections, the unlikely coalition of the Five Star Movement and the League in Italy may breakdown, leading to new elections, Austria has stolen the jump.  Its government collapsed over the weekend as the Vice-Chancellor (from the populist right Freedom Party) was caught offering to fix government contracts to a woman posing to be the niece of a Russian oligarch. This follows a series of other more minor scandals.  Snap elections have been called. By snap, European means before the end of the parliament session, but not immediate.  Elections are likely after the summer, four months.  

Another political story is brewing, and it has received less attention than either the Italian machinations or the fall of the center-right Austrian government.  If true, it has farther reaching implications.  The report is that Merkel's handpicked successor Annegret Kramp-Karenbauer (AKK) is privately urging Merkel to step down after the EU Parliament elections later this week.  Apparently, she is encouraging Merkel to become the next EU President.  The problem is quite familiar to Merkel.  Losing the head of the party, left Merkel's CDU predecessor, Kohl vulnerable and Merkel outflanked him. AKK is in the same position now as Merkel was then. She cannot emerge in her own right with Merkel still on the national stage.  Merkel's still 28 months of her term.  She will be hard to dethrone if she does not want to leave, which all signs suggest she wants to stay. It is also not clear that the EU presidency is for the taking, not just because of other candidates, but also it is not clear that Merkel's parliamentary group will win.  

There is a sense that UK Prime Minister May may have one more fight before she steps down.  An informal leadership contest has already begun. She wants the Withdrawal Bill, with a small adjustment on labor, to be voted on again by Parliament early next month. The Tory MPs get the first vote in the leadership contest, and some see this as a check on the more extreme hard Brexit camp candidates before the rank and file vote.  Labour's position continues to evolve, and Corbyn appears to be more clearly supporting a "confirmation referendum" after an agreement is reached. Reports also suggest he is willing to negotiate about free-movement. The UK reports CPI (and PPI) and retail sales this week.  Firmer price pressures and weaker retail sales are expected, but the focus is on Brexit and May's likely successor. 

The euro is in less than a 20-tick range through the European morning.  It has been unable to distance itself from $1.1150 where a 720 mln euro option that is expiring is stuck.  Today is the fifth consecutive session that the euro has fallen below the previous day's low. Resistance is seen in the $1.1180-$1.1200 band.  Sterling is trying to end its six-day slide against the dollar and a 10-day fall against the euro.  Sterling is in a little more than a third of a cent range above $1.2725.  The nearby cap is pegged at $1.2770-$1.2800.  The euro is inside the pre-weekend range against sterling as its consolidates its recent gains. A move below GBP 0.8730 would likely begin forcing out the momentum players.  

America

While we had focused on the implications of the breakdown in the US-Chinese trade talks and the escalation of the tariffs, we were slower this time to draw the knock-on effect for the broader US trade approach.  The US moved to protect its flanks by lifting the steel and aluminum tariffs on Mexico and Canada, boosting the chances that their legislatures approve the new trade agreement.  It postponed the auto tariffs but did stake out a position that the auto imports undermine national security.  And the US unwound some extra tariffs on Turkey, though Ankara is still going ahead to take delivery of the Russian-made anti-aircraft (NATO) defense system. 

While the prospects of the NAFTA 2.0 have been enhanced, it is still far from a done deal.  The tariffs blocked it, but there is another hurdle, which may not prove as easy to overcome, and that is the US Congress.  The Democrats have a majority in the House of Representatives and the signals from crucial committee chairs, like the powerful Ways and Means Committee, is that several changes (on labor, environment, enforcement provisions, and access to affordable medicine issues) are being discussed.  Previous free trade agreements have generally narrowly passed on a bipartisan basis with mostly Republicans and a free-trade wing of the Democrat Party.  It has required intense lobbying by the President.  We have subjectively raised the odds of NAFTA 2.0 being passed to 50% from 20%, while the tariffs would in place.  

The week's North American calendar begins off lightly, and Canadian markets are closed today for the Queen's birthday.  Four Fed officials speak today, including the three leaders, Powell, Clarida, and Williams.  Harker, the Philadelphia Fed President, also speaks.  The US dollar remains mired in a CAD1.34-CAD1.35 range.  The dollar also looks range-bound against the Mexican peso.  A push below MXN19.10 could spur more dollar selling.