US insulated from Euro area events, not immune

• Greek polls still mixed, but real economy across euro area suffering on uncertainty.
• Heavy US data schedule, economy remains insulated from euro area, but not immune.
• UK economy faltering under euro area strain - manufacturing PMI to herald contraction.

Euro area officials have repeated they want Greece to stay in the Union, but that it needs to comply with bailout conditions. Tension continues to strain markets and will be almost the exclusive theme over the next three weeks until the re-run of Greek elections. Recent polls have been mixed. One shows the anti-austerity SYRIZA continuing to gain ground, but most see it stable for now, while the bailout committed New Democracy and Pasok have seen a combined 10 point gain since the last election.

In the meantime, the coming week’s figures are likely to highlight that the crisis is weighing on the real economy, with confidence falling and the euro area looking set to post another quarter’s contraction in Q2. May’s ‘flash’ PMIs showed a sharp decline in the manufacturing sector, with Germany also seeing its IfO survey post the biggest fall since August last year. Euro area unemployment is likely to rise to a record 11.0% - admittedly a more psychological than economic event. Money supply data are likely to confirm the continued problems with private lending. Indeed, the recent sharp decline in the euro suggests that capital is starting to increasingly move out of the area, not across it as had previously been the case. This is adding to pressure for the ECB to provide more stimulus. We think this is unlikely before the election and next EU Summit at the end of June, but will watch ECB President Draghi’s comments on Wednesday.

The real news this week will be from the US. The start of the month brings the key payrolls and ISM survey releases. Against a background of weaker ‘flash’ euro and Chinese (and a new US PMI measure), the outlook for the ISM is for a decline. Indeed, weaker payrolls growth in recent months has been consistent with a deceleration in US activity. Payrolls rose by just 115k in April and while we pencil in a gain of 140k in May, this is nearly half of that seen in January. Q1 GDP revisions also look set to confirm a softening and we expect the headline measure to be revised down to 1.8% from the 2.2% initial estimate. Q2 GDP will also prove relatively subdued, with orders only starting to recover from the end of the capital spending tax deduction at end-2011 and the rise in gasoline prices from the start of the year. However, Monday’s Memorial Day, the traditional start of the ‘driving season’, sees US gasoline prices markedly lower. This should lift US activity in Q3. The risks for the US are twofold. The ‘fiscal cliff’ remains a key concern, although its shadow may not impact Q3 activity. The euro area is a further risk. The US pick-up in H2 2011, in the midst of the previous euro area crisis, suggests the US economy and most important its banking system, can withstand negative headwinds from euro areas adjustments. Yet a Greek exit would be a global shock of a different order of magnitude, from which the economy would not be immune.

The domestic economy is not insulated from the euro area. This week is likely to see May’s manufacturing PMI slip below 50 for the first time since November. We forecast 49.5. The UK has its own issues and the publication of April’s M4 money supply figures is likely to show the scale of adjustment in some areas of the financial system. However, the deterioration in outlook in the euro area and the impact that has on the economy via banking channels and sentiment, quite apart from export prospects, is dominating. Like the ECB, the MPC would prefer to await the removal of some uncertainty (the election) before acting. But the need for further stimulus for the UK economy is pressing.

Encouragingly, the government also appears to be looking into measures to boost growth through forms of credit easing. These are likely to be necessary if Greek elections continue to commit the economy to austerity and critical if not.

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