General market tone: Wait and see.
Risk markets bounced back on Tuesday in reaction to comments from the White House and positive economic data but traders remained cautious with Europe missing its growth projections.
Production in Korea fell 2.5% from the previous month to land 8.4% lower than a year ago. Expectations weren't strong, but this is a particularly weak reading. Any remaining BoK hawks must surely change their views.
Month on month production growth in Korea is a volatile series, with all sorts of seasonal aberrations to contend with, so at first glance, the 2.5%MoM decline in industrial output (most of it from a 2.1% decline in manufacturing) might be written off as statistical noise. But a lot of that noise disappears when you examine the year on year growth. At -8.9% in September, you have to go back to 2009 and the aftermath of the global financial crisis to find weaker production data. This is no aberration.
The weakness wasn't confined to industrial production either. Construction activity also dropped for a second consecutive month and is running at -16.6%YoY. Even public administration (government) which you might have expected to be bucking this trend thanks to increased hires in the public sector, registered both a month on month and a year on year decline. In short, the Korean economy looks in bad shape currently.
An old-fashioned inventory cycle is at least part of the explanation for the current weakness. Manufacturing production plotted against inventory to shipment ratios (inverted) shows that inventory ratios have risen sharply, requiring production to be cut back sharply in the near term. The same negative relationship holds for inventory ratios and equipment investment, shown below.
What isn't explained is why demand for the output is so slack that these inventories have risen so much. Looking at the components of production, it is actually a whole batch of old-economy products that are looking particularly weak. ELectronics isn't growing strongly, but it at least registers a positive sign for growth.
If this were a spillover from the trade war between the US and China, you would expect the production weakness to be mirrored in weakness of Korean exports to Asia. It isn't. Export growth to China is about 7.66%YoY. Where growth is particularly weak is to SE Asia (Singapore, Philippines, Thailand, Vietnam, Malaysia bucks the trend), and some of the frontier economies, Bangladesh, Pakistan. Exports to Taiwan are extremely robust. So it looks hard to pin this weakness on the trade war, or on some electronics-based product cycle. in short, this is puzzling, but nonetheless worrying.
Markets are responding appropriately to this economic weakness. Korean 2Y bond yields are now down to 1.877%, from a little over 2.0% earlier this month, as any thoughts of BoK tightening in November are swept away by bad data. The KRW is also looking weaker. We expect it to reach 1145 before the end of the year. We will also be revising down our GDP forecasts for Korea in the light of this weakness.
Following weak September manufacturing activity, we have cut our 3Q18 GDP growth forecast to 3.7% from 4.1%, and full-year 2018 growth forecast to 4.2% from 4.3%. Recent data weakness not only undermines the government’s optimism on the economy's growth this year but also dampens the prospects of the central bank tightening policy anytime soon
Consistent with the consensus view, manufacturing output contracted on a year-on-year basis in September. However, the 2.6% fall was much steeper than the consensus median of only a 0.5% fall. Coming on the heels of unexpectedly weak exports (-5.2% YoY), the steeper manufacturing fall isn’t a complete surprise.
The decline in exports and manufacturing in recent months has been partly the result of high base effects; growth was accelerating during the same period of 2017. A sharp slowdown in manufacturing in 3Q18 to 0.9% YoY from 3.7% in 2Q18, will have undoubtedly pulled GDP growth lower (see figure). It’s not only manufacturing though. Service sector activity has also started to take a hit from falling tourist arrivals, especially visitors from China.
We expect that China's manufacturing PMI and non-manufacturing PMI will continue to drop but show that activity is still expanding, thanks to tax cuts and other stimulus measures.
We expect the manufacturing PMI to fall from 50.8 last month to 50.3 in October.
The main reason for this is that the trade war will be hurting manufacturing activity as tariffs imposed by the US are too costly for Chinese exporters to fully absorb. But we still expect the reading to be above 50 because we think that stimulus measures (e.g. export tax rebates) and salary and corporate tax cutting measures should support domestic consumption for the time being. Therefore manufacturing activity for the domestic market should continue to rise.
We expect the non-manufacturing PMI will also fall from 54.9 to 54.5 in October.
Real estate activity will be the main drag on the non-manufacturing PMI. But this may not last long because if home prices start to fall across the whole country, some local governments will have to re-think their attitude to mortgage borrowing. We expect that some locations may ease housing constraints a bit to avoid home price falling steeply. This would help real estate's sub-index in the non-manufacturing PMI.
Banking activities slowed in October. This may be reversed in November as we expect a rise in financial activity as easing measures boost bank lending to SMEs and other private-owned entities.
With an escalating trade war between China and the US, the Chinese government is using both fiscal and monetary stimulus measures to support local demand.
We see domestic demand as a crucial factor to support the whole economy as it will avoid massive job losses and drive activity from export demand to local demand. As we have claimed before, the current Chinese economy is now advanced enough to absorb goods that are designed for export, which is very different from 10 years ago, when exported goods did not match local market demand due to big differences in purchasing power.
Tariff news will continue to weaken the yuan, and USDCNY is heading towards 7.0. We believe that USDCNY will hit 7.0 a few times before crossing over, so it will not create any surprise to the market when it happens.
In a slew of weak manufacturing reports from Asia recently, Thailand yesterday reported a steeper than expected manufacturing fall for September and Korea joined in today with even more dismal industrial production figure. China manufacturing PMI is an important release for the markets today