John Greenwood, Chief Economist of Invesco Perpetual provides his Quarterly Global Economic Outlook:
Main points:
Eurozone inflation is threatening to soon fall short of the ECB’s target level, posing a real risk of deflation
The UK will take a decade to return to pre-crisis levels of real GDP with balance sheet repair, fiscal restraint, a weak sterling and above target inflation all holding back growth
’Abenomics‘ has gone some way to restoring Japanese exporters’ competitiveness but a full assessment of recovery in the domestic economy must await more evidence
Introduction
The second quarter was dominated by abrupt falls in equity and bond markets following signals from Federal Reserve (Fed) Chairman Ben Bernanke in testimony on 22 May and then at a press conference on 19 June that the Federal Open Markets Committee (FOMC) expects to reduce and then cease its provision of extraordinary liquidity to the markets through large scale asset purchases or quantitative easing (QE) during the next eighteen months. The response in the markets was probably faster and more violent than Fed officials intended, but what really matters is whether the underlying progress of economic recovery is affected.
Yields on the 10-year US Treasury bond increased nearly 100 basis points and caused global equities to decline by about 8% since mid-May. Lower quality emerging market equities and bonds as well as sub-investment grade bonds in developed markets suffered most.
Despite the inflation rate shock the US economy remains on track for growth of close to, but probably below, 2% for the year as a whole, held back by fiscal drag – the effect of the tax hikes in January and the Federal spending cuts under the sequester – and moderate growth of consumer spending. I expect inflation to remain below the Fed’s informal 2% target.
In Europe the outlook is not nearly so promising. Although financial markets were re-assured by the statements of the ECB last July and September, economic activity has been constrained by continued austerity without monetary easing and without currency depreciation. Currently it is hard to see any basis for a recovery, and inflation continues to fall. There is a real risk of deflation in the eurozone.
The outlook for the UK economy is roughly mid-way between the prospects for the US and eurozone. The Bank of England’s monetary stance remains very accommodative and could see some further easing after Mr Carney takes over as Governor on 1 July, but balance sheet repair, fiscal restraint, a weak sterling and above target inflation have all contributed to holding back growth.
In Japan, two of the three arrows of Shinzo Abe’s economic revival programme have been implemented, but we await the third arrow, namely economic re-structuring. The yen has depreciated enough to restore Japanese exporters’ competitiveness, but evidence of recovery in the domestic economy is still tentative.
In the largest emerging economies – China, India and Brazil – growth has slowed, and the leaders are struggling to ensure smooth transitions to domestic-led growth models. In many other emerging economies growth remains very dependent on exports in a world where the main export markets are either in sub-par growth mode or are suffering recession.
I continue to forecast that 2013 will be another year of slower than normal growth with low inflation as the dual problems of balance sheet repair in the developed economies and structural rebalancing in the emerging economies continue to restrain overall activity. See figure 1.
United States
The early months of the year saw an increasingly buoyant mood in the economy and financial markets. Between January and mid-May this resulted in significant rises in the Michigan and Conference Board indices of consumer confidence and powered the S&P 500 Index to rise by 17%1. However, since then markets have been dominated by the signal from Fed Chairman, Ben Bernanke, in testimony on 22 May and then at a press conference on 19 June that the FOMC expects to reduce and then cease its provision of extraordinary liquidity to the markets sometime over the next eighteen months. Although Mr Bernanke was only talking about reducing the monthly rate of asset purchases or QE, investors jumped to the conclusion that interest rate hikes were imminent, and asset prices responded abruptly.
The response in financial markets was probably faster and more violent than Fed officials intended, as evidenced by the subsequent chorus of Fed governors and presidents echoing Bernanke’s view that a Fed funds rate hike will not happen any time soon. This calls for two observations related to Fed policy. First, the Fed’s commitment to “forward guidance” implicitly provided a guarantee that market participants relied on to leverage up on longer duration assets. Consequently the Fed should not be surprised when early hints of a policy reversal lead to the sudden unwinding of those leveraged positions. Second, although market rates have risen, what really matters is whether the underlying progress of economic recovery is affected. The most sensitive arena will be mortgage interest rates and their impact on the housing recovery, a result we will not know for some weeks.
On the economic data front the final release of real GDP data for the first quarter was revised down significantly. Initial and revised estimates of 2.5% and 2.4% respectively were lowered to just 1.8% annualised – a notable reduction by past standards. Key elements of the revision included lower consumer spending due to the impact of tax increases at the start of the year, and declines in business investment and exports reflecting the weaker global economy. Since April an array of data has suggested some further moderation in growth. For example, figure 2 shows Citigroup’s Economic Surprise Index – a rolling compilation of the performance of economic indices relative to market expectations which was notably weak in late May and early June. Although the trend of data releases has improved since mid-June, the index is tracking well below the performance of last autumn or the first quarter of this year.
In the background fiscal tightening – due to tax increases in January and reduced federal spending under the ’sequester’ – plus the continuing need for consumers and financial institutions to repair their balance sheets are acting as a drag on growth. I expect real GDP growth to reach only 1.7% for 2013 as a whole and inflation to remain around 1.6% – below the Fed’s unofficial target of 2% – due to sustained low money and credit growth interacting with the continued existence of spare capacity.
The key question is whether the unintended rate increases act to tighten monetary conditions, or whether continued Fed easing and asset purchases counteract the tightening. Although 30-year fixed rate mortgages have risen by nearly 1.2% from 3.4% to 4.5% it seems unlikely that this will have any drastic slowing effect on the housing recovery. The rate increase is similar to the temporary jumps in rates seen in 2009 and 2010 both of which were ultimately overpowered by Fed easing actions.
The Eurozone
The eurozone remains mired in continued economic recession, with GDP falling by 0.2% in the first quarter of the year, the sixth successive quarterly decline. Although financial markets have been re-assured by the “whatever it takes” promises of the President of the ECB, Mario Draghi, last July and September, economic activity has been constrained by continued fiscal austerity without monetary easing and without currency depreciation. For although the ECB cut its main refinancing rate from 0.75% to 0.5% in May, broad money growth (M3) remained sluggish at 2.9% in May, and bank lending across the eurozone declined to – 1.6% year-on-year. Discussion at the ECB governing council has included the question of whether the bank should impose negative rates on bankers’ deposits at the ECB in order to encourage banks to lend. However, in my view these bankers’ deposits are a symptom of risk aversion which will not be eliminated by such threats. Currently it is hard to see any basis for a recovery, and inflation continues to fall. It could soon fall short of the ECB’s target level of “below, but close to 2%”, posing a real risk of deflation in the eurozone.
The EC composite PMI shown in figure 3 rose slightly in June to 48.8, although still below the no-change threshold of 50, and has been below 50 for 21 of the past 22 months (i.e. since September 2011). The index is pointing to a further contraction of GDP in Q2 of about 0.2%. Meanwhile unemployment increased to a new record high of 12.2% in April with youth unemployment reaching 24.4%. Unemployment rates are especially high in southern Europe with France at 26.5%, Italy at 40.5% and Spain at 56.4%. The refusal to engage in QE or other steps to boost liquidity during a period of widespread de-leveraging has imposed serious disinflationary pressure on the eurozone, with the annual HICP inflation rate falling to 1.2% in April and 1.4% in May.
At the political level there has much discussion and some progress towards the formation of a banking union with plans to allow the ESM to use up to €60 billion to assist in the recapitalisation of eurozone banks.
Another significant easing measure was that in May the EC eased its fiscal targets for Spain, Portugal, Slovenia and France, allowing them each two more years to correct their excessive fiscal deficits. On the other side the EC was able to propose abandoning the Excessive Deficit Procedure (EDP) for Italy as the economy met its debt ceiling in 2012 and is expected to maintain budget deficits below 3% of GDP in 2013 and 2014. The number of economies in EDP will decline from 20 to 16 out of 27 EU members.
Looking forward the ECB revised down its GDP forecast for 2013 to – 0.6% (in line with ourselves and the consensus), and inflation to 1.4%. However, whereas the ECB is forecasting a recovery to 1.1% growth in 2014, on my assessment of current policies it is hard to project any sound basis for a sustained recovery.
United Kingdom
The third quarter starts with the arrival of the new Governor, Canadian Mark Carney, at the Bank of England. By mid-August we should know if he has succeeded in persuading the other members of the MPC either to adopt some form of conditional ’forward guidance‘ to keep interest rates low, or to engage in additional asset purchases.
Meantime the economy should continue to reflect the broadening set of improvements that have started to be reflected in the data this year. In addition to the steady rise in employment – a trend that has been in place for two years now – the housing market has notably strengthened during the recent months. In part this was due to the two official stimulus schemes – ‘Funding for Lending’and the initial phase of Chancellor George Osborne’s ‘Help to Buy‘ scheme. Gross mortgage lending in May was £14.7 billion, up 17% on a year earlier and the highest monthly total since October 2008. Housing starts in the first quarter were up 15% year-on-year and by 62% compared with the trough in 2009. Moreover, according to the BBA the 54,000 loan approvals in May was the highest number in over a year, helping most house price indicators to show recoveries of 1-3% over the past year. However, there is a long way to go before the market returns to annual net lending of £100 billion seen before the crisis. Nevertheless, it seems clear that an upturn in both activity and prices is under way.
More broadly real GDP increased by 0.3% quarter-on-quarter in 2013 Q1, and looks set to grow at stronger rates in Q2 and Q3. Moreover, based on more accurate corporate data the ONS has revised away the double-dip recession of late 2011 and early 2012, but has also concluded the economy fell further and more steeply in 2008-09 than previously believed. Neither the Chancellor’s Spending Review nor the arrival of Mr Carney will immediately transform the outlook in my view, but with public spending set at £745 billion or 43% of GDP in 2015-16 it is now, in my opinion, going to take a decade to return to pre-crisis levels of real GDP. Unfortunately even the proposed partial welfare spending cap (which excludes most pensioner benefits) to be imposed from April 2015, and the elimination of automatic or ’progression‘ pay hikes in the public sector in my view, will not ensure that the excessive growth of Britain’s public sector is properly curtailed. There are still too many areas of ring-fenced (protected) government spending, and too little commitment to long-term fiscal soundness.
For the year as a whole, I expect 1.2% real GDP growth and 2.7% inflation.
Japan
Since the start of the second quarter ’Abenomics‘ has made a further major step forward with the appointment of Haruhiko Kuroda as Governor of the Bank of Japan (BOJ) and the first stages in implementing a more aggressive policy of QE. On April 4 the Policy Board set a new course of doubling the monetary base in two years (by December 2014), and raising the inflation target from price stability to 2%. See figure 4.
This is the second arrow of Prime Minister, Shinzo Abe’s three arrow strategy following the adoption of a larger fiscal stimulus policy early in the year. After the Upper House election in July and assuming Mr Abe succeeds in obtaining a healthy majority, market participants should expect to hear more details about the third arrow – structural reform and market deregulation.
Between 13 November last year and 22 May the Japanese yen fell from 79 yen per US dollar to about 103, a decline of 30%, representing a major boost to the competitiveness of Japanese firms. While this was reflected in a substantial stock market rally, lifting the Japanese Topix index of equities by 75% in yen terms2, there has as yet been comparatively little impact on the domestic economy. Real GDP increased at a very strong 4.1% annualised in the first quarter, but since this was before much of the new programme had been implemented let alone spelled out it would be rash to claim that this was entirely due to Abenomics. Nevertheless, a range of economic indicators such as bank loans, retail sales and the important ’Tankan‘ or short-term index of business confidence published by the Bank of Japan have shown significant improvements.
Expectations are undoubtedly high, but the big question is whether the BOJ can induce sufficient changes in behaviour amongst the commercial banks whose lending has been static or falling for most of the past decade, or amongst the firms and households that have been unwilling to increase their indebtedness by borrowing more. So far the evidence is mixed. Loans have increased only marginally and banks are still finding that they have more deposits than they can allocate to loans. A full assessment of Abenomics must await more evidence.
China and non-Japan Asia
The gradual, structural slowdown of the Chinese economy has continued through 2013 Q2 and appears likely to continue through the rest of the year based on three sets of indicators. First, cyclical measures of economic activity such as the official PMI, which covers 3000 large firms and HSBC’s PMI, which relies on a sample of 430 small and medium enterprises both slipped into contraction territory over the past few months and showed only minimal improvement in May and June. Export growth is likely to remain in single digits, while domestic demand drivers such as infrastructure and real estate investment should exhibit continued stability but no acceleration.
Second, there have been numerous signs of excess capacity in some of China’s key industrial sectors such as steel and solar energy panels. For example, Chinese firms have been selling off surplus steel on foreign markets and cutting orders for raw materials, contributing to a significant fall in world prices of iron ore and coking coal. In the solar energy space the global over-supply has led to the bankruptcy of China’s largest firm, and widespread publicity about the extent of subsidies and official support for local companies – problems associated with the inherent corruption in China’s system of provincial government. The response of the central authorities has been to target new areas of investment such as infrastructure, public services and urbanisation, and to encourage private sector investment alongside.
However, the third source of the slowdown – tighter monetary policy – points to a broader set of problems that China needs to address if it is to achieve a steady growth trajectory over the next few years. The reason why the authorities have been compelled to squeeze the money markets over the past few weeks is that unofficial or shadow banking sources of credit have continued to grow far too rapidly at 30-40% p.a. compared to regulated bank credit growth of 13-15% p.a. (See figure 5)
Underlying the shadow banking problem is the failure to deregulate official bank interest rates and the continued use of administrative measures to manage the monetary system. To enforce some discipline the People’s Bank of China (the central bank) allowed money market rates to rise sharply in June, coinciding with the sell-off on Wall Street. However, unless such tightening moves are coupled with serious efforts to deregulate foreign exchange controls the result is likely to be a surge of unofficial inflows from Chinese companies with funds abroad. The new Premier, Li Keqiang, has announced that he intends to produce a programme for dismantling exchange controls by yearend, but this is unlikely to be a big bang, single event, more likely a phased programme. Even so, Chinese leaders have often expressed such broad aspirations before without delivering concrete results.
I expect China’s real GDP to slow to 7.6% for the year as a whole and CPI inflation to remain subdued at 2.2%, held back by deflation at the producer price level and a firm currency.
The outlook for the rest of non-Japan Asia outside China is broadly similar to China’s on cyclical grounds – the slowdown of key export markets and the inability to pump-prime too much at home. Fortunately most of non-Japan Asia lacks the structural distortions faced by China. In Indonesia, for example, the fuel price has recently been further deregulated to bring it closer into line with market forces. However, irrespective of their flexible currency arrangements several economies may feel the need to tighten monetary policy in response to prospective tightening in the US and the shift of funds out of emerging markets, although only Indonesia have raised rates so far.
Commodities
Following the upswing in commodity prices between June and September 2012, the direction of travel has been generally downward since then. This applies both to indices like the unweighted CRB which excludes oil but emphasises precious metals and to the GDP-weighted S&P/Goldman Sachs Spot Index, both of which are down close to 10% since early February3. These trends reflect weak demand and excess supply stemming from the sub-par growth of GDP across the developed economies as well as the slowing trend in emerging economies. In addition, they reflect the unwinding of financial and speculative positions taken in commodity funds which were often based on the mistaken notion that the solution to the global financial crisis would be found in highly inflationary policies by central banks. Although there is still room for banks to promote faster credit and money growth, my view has been that as long as balance sheet repair remains the order of the day then rapid growth of bank balance sheets would not be possible, thus preventing the inflation that would justify heavy weightings in commodities.
As central bankers keep saying, inflation expectations are well-anchored. The fundamental driver behind this trend is that balance sheet repair is inherently disinflationary, or even deflationary. Consequently as long as the major economies are in balance sheet repair mode, commodity price surges can only result from local or temporary supply disruptions such as we see from time to time in the agricultural complex.
Conclusion
In the first five months of the year to 21 May the MSCI World Index increased by 13.6% in US$ terms. Since then, and following Ben Bernanke’s testimony to Congress on 22 May, world equities fell nearly 8% before recovering nearly half their lost value. This sharp correction and the abrupt increase in volatility is both a reminder of the sensitivity of all markets to central bank policies, and a timely reminder that central banks cannot entirely control the impact of interest rate normalisation that major economies must undertake over the next three or four years.
After a traumatic shake-out in 2008-09, US households are at last seeing their wealth and incomes starting to recover; US non-financial companies are enjoying healthy profits and can raise funds cheaply on financial markets; and even the US financial sector is finally returning to growth and profitability, albeit at lower (and safer) levels of leverage. The next stage will be for central banks gradually to reduce their injections of QE, and then to embark on a gradual and measured pace of interest rate increases – always assuming that the economies are strong enough to tolerate the rate hikes while continuing to grow. In the past these kinds of rate-normalising episodes have had very mixed results, ranging from very painful in 1994-95 to much less damaging in 2004-06. This time much will depend on how far balance sheets have been repaired, how strong the underlying recovery is, and the extent to which leveraged positions have been built up in financial markets based on central bank commitments.
Since the entire spectrum of investable assets from government bonds to equities, commodities and real estate in both developed and emerging markets are all affected by the trend of US interest rates, no asset class is likely to be able to escape the forthcoming adjustment.
1 Source: Bloomberg, capital returns, as at 21 May 2013.
2 As at 22 May 2013
3 Source: Bloomberg, capital returns, as at 30 June 2013
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