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A number of political developments over the weekend have shaken investor confidence worldwide, sending global equities sliding as we head into the end of the month.   The revision to the Chinese HSBC manufacturing PMI figure from the previously reported 51.2 to 50.2 has also helped dampen risk appetite overnight, reinforcing the notion that the recovery in China will be a slow and gradual process, not the credit fueled boom seen pre-crisis.   The political tensions on both sides of the Atlantic have led to the “safe-haven” currencies of JPY and CHF finding some buying interest, with USDJPY weakening into the mid-97s.   The Yen strength acted as a double-edged sword for the Nikkei, guiding the index lower by 2.06% by the conclusion of the session.

The potential for a government shut-down in Washington edged closer to reality  on Saturday night, as the Republican-controlled House passed a spending bill that would keep the government funded until December 15th, but also included the provision Obama’s Affordable Care Act would be deferred for one year.   The move to delay the implementation of what is commonly referred to as ‘Obama-care’ will almost certainly face defeat in the Senate, as there is no indication party lines will waver from what we saw last week when the Senate Democrats stuck together to advert the dismantling of Obama’s health care reform.   The vote goes to the Senate today, and if turned down (which will most likely be the case), the ball will be back in House Speaker John Boehner’s court to see if Washington can cobble together some sort of resolve beforemidnight  and avert a government shut-down.   With the chances of a limited government shut-down increasing dramatically, the political quagmire in Washington is finally starting to shake investor confidence, as equity futures deteriorate ahead of the opening bell in North America.

While a government shut-down of only a few days would have little impact on fourth-quarter GDP, the destabilizing effects for markets will be the uncertainty surrounding the length of a government shut-down (if there is one), and what the lack of cooperation between the Democrats and Republicans means for the more pressing debt ceiling negotiations.   Although the furloughing of government employees has more of a direct impact on GDP, the implications of a default on US debt will have a far more drastic effect on the market’s psyche, and even though the risk of default is minor, the ramifications of continued saber-rattling from both sides of the aisle will be heightened volatility across all markets and asset classes.

While equities have been under pressure the last week, the modest price declines give the impression investors are banking on a last-minute outcome as cooler heads prevail.   The uncertainty surrounding a government shut-down and the associated volatility should give corporate hedgers some attractive opportunities to enter the market, as the corresponding fiscal-drag from short shutdown is unlikely to derail the American recovery.   In addition, one of the rationale’s for Bernanke and Co. holding fire on tapering earlier this month was to do with fiscal uncertainty, so it is also very likely should a prolonged shut-down sufficiently upset the incoming economic data, the expectations for a Fed taper will be pushed further out into 2014.   Any impending “flight-to-safety” trade that benefits JPY and USD will be a good opportunity for corporates that are long the aforementioned currencies to take advantage, as the likely last-minute aversion of the debt-ceiling fiasco will re-focus markets attention on the Fed’s timeline for slowing its asset purchases.

Political instability over the weekend was not just contained to the US, as news hit the wires that in a move to push for new elections in Italy, Berlusconi would be withdrawing his party’s cabinet ministers from the coalition government.   The abandonment of Berlusconi’s minsters now has Prime Minister Letta scrambling to find additional the additional support required to cobble together a new government, and avoid the dissolving of the current coalition by the President.   Italy’s dysfunctional political system has been a major theme of the European debt crisis throughout the last few years and it is becoming clear that as the ongoing instability continues to act as a drag on economic reforms and a weighs on consumer sentiment, a base for a meaningful recovery can’t be formed until the issues in government are resolved.   Expect the EUR and Italian bond prices to remain under pressure should the Italian President be forced to dissolve the five-month old administration if Letta is unable to win the confidence vote  on Wednesday, as there is likely some exposure international investors would like to shed if the instability continues.

The EUR is slightly stronger against the big dollar as we start the week, however had been flirting with the south side of the 1.35 level overnight as a weaker than expected German Retail Sales saw consumer spending come in at an increase of 0.5% for the month of August, lower than the median forecast of 0.8%.   Italian bonds are once again under pressure, pushing the yield on the 10-year benchmark up to 4.65%.

The one major piece of North American economic data on the docket this morning was the monthly GDP reading for the Canadian economy, which was forecast to see a gain of 0.5% over the month of July, enough to net out the ugly 0.5% decrease that was seen in June.   The official numbers came in a little  warmer than expected, showing the Canadian economy grew by 0.6% in July, led by strong increases in the construction and manufacturing sectors.   The Loonie is on stronger ground against the USD heading into the North American open, buoyed by the strong GDP print and weakness in the USD as a result of Yen and Swissy buying.   USDCAD is looking to entrench itself below the 1.0300 handle and could give corporates that are short USD an attractive opportunity to cover off short-term exposure.

As we head into the end of the month, the looming government shut-down and month-end flows will drive market action.   The relative outperformance of the US equity market in September most likely has international money manager under-hedged in their portfolios, which would drive a bout of USD selling.   The question now remains whether this will be enough to stymie any flight to quality should there be no progress in Washington as the deadline for a shut-down approaches.

Further reading:

Italian poltical crisis a dampener for the Euro

Canadian dollar set to rise (technical analysis)